“Global Economic Challenges and Fostering Future Prosperity” Address at the University of Iceland by IMF Deputy Managing Director Nemat Shafik
October 28, 2011Address at the University of Iceland by IMF Deputy Managing Director Nemat Shafik
Reykjavik, October 28, 2011
As prepared for delivery
|Webcast of the speech|
Good afternoon. It’s truly an honor to be here. I would like to thank the Dean of the University of Iceland, Dr. Kristín Ingólfsdóttir, for her kind invitation to talk to you today. I would like to congratulate the university for one hundred years of academic excellence, and I am proud to participate in its centennial celebration.
More generally, it’s an honor to come to Iceland to pay tribute to the remarkable achievements of your country over the past few years, in the face of incredibly difficult circumstances. It’s a great privilege to come to Iceland to see what lessons it might offer to others.
In my address today, I will talk about the global economic challenges, which are extremely severe and urgent right now. I will offer some immediate policy prescriptions, and I will also try to tease out some lessons from the crisis for the future. Economic outlook
Let me begin with the global economic outlook. Overall, we expect global growth to slow to 4 percent this year and next. But tempestuous currents flow beneath these seemingly tranquil waters.
The recovery is looking more and more uneven. In the advanced economies, it is still weak and bumpy, with unacceptably high unemployment. They will only manage an anemic 1½ to 2 percent in 2011-12. Compared to its advanced economy peers, Iceland is doing reasonably well, with growth expected at closer to 2½ – 3 percent over the same period. Meanwhile, the emerging markets and developing countries should get growth in the 6 – 6½ percent range.
What about the tempestuous currents? Although we expect the recovery to continue, the risks are severe and growing. Financial stress has risen dramatically. Adverse feedback loops between the real economy and the financial sector are gaining strength. Concerns about public debt sustainability in the euro area have intensified, leading to fears about the health of the area’s banks.
It’s a dark picture. The world is suffering from a collective crisis of confidence. And uncertainty has been made worse by policy indecision and political dysfunction.
Without action to halt this vicious circle, we could face a long lost decade of low growth and high unemployment. Even worse, we cannot rule out a downward spiral of uncertainty and risk aversion, dysfunctional financial markets, unsustainable debt dynamics, and a collapse in global demand.
In such dire circumstances, it is folly to believe that the emerging markets and low-income countries can chart their own course. The global south can take little comfort from rising tensions in the global north—their economies would likely sink under the weight of large and abrupt capital outflows and lower trade. And any underlying vulnerabilities related to excessive credit growth would be cruelly exposed.
And Iceland of course would not be immune—even with the shield of capital controls, it would be hit. Exports would be hurt by both lower demand and reduced commodity prices, and foreign borrowing would probably become more expensive. In such trying times, let’s never forget what it’s all about—preserving sound economic policies to protect the welfare of the ordinary person. Graduates like you looking for a job. The unemployed who find it so hard to find another job. People who face increased economic anxiety and insecurity, increased vulnerability and marginalization, and even increased poverty and misery. We must all be attuned to the hopes and fears of ordinary people. And that includes the IMF.
So far, I have painted a pretty gloomy picture. And yet, I believe there is a way out. There is a policy path forward—a way to regain economic stability, which also the way to keep the social fabric intact. Let me talk about what that path looks like.
Clearly, the primary responsibility for addressing the crisis lies with the advanced economies, especially Europe and the United States. I see a number of key priorities.
First, for advanced economies with well-anchored inflation expectations, monetary policy can stay accommodative, and central banks can deploy unconventional measures if needed. Iceland is of course in a different position than many others, because inflation expectations have jumped up a bit and also because lifting of the capital controls will mean higher policy interest rates.
Second, on fiscal policy, a focus on strong and credible medium-term consolidation can restore confidence. It can also create the space to accommodate growth and jobs in the short-run. This is an area where Iceland is ahead of many of its peers—the fiscal credibility gained in the aftermath of the crisis has already created space to better support growth through a more gradual fiscal consolidation going forward.
Of course, the available space differs by country. Those under market pressure have little choice but to forge ahead with adjustment. But others can ease off the brake if growth slows further. In the United States, the proposed American Jobs Act would provide the needed support.
Third, many countries need to make urgent progress with financial repair. Making sure that banks have adequate capital buffers to withstand further turmoil can boost confidence and get credit flowing again, which in turn can boost growth and hiring. Policymakers should urge banks to raise private capital first, but should use public capital injections if necessary. Fourth, enhanced liquidity provision in Europe can help avoid a deeper downward spiral and ease funding strains.
Regarding Europe, Fund management welcomed the recent steps taken by eurozone leaders toward establishing a comprehensive framework to address the crisis. On Greece, the agreement reached on key parameters for private sector involvement is of the utmost importance to improve debt sustainability, and shares the burden appropriately between the private and official sectors. The decision to leverage the capacity of the European Financial Stability Facility can strengthen Europe's defenses against contagion and help ensure the proper functioning of the sovereign debt market. And the agreement reached on a coordinated mechanism to recapitalize banks and strengthen their funding is a major step forward.
A fifth policy dimension is household balance sheet repair. This mainly applies in the United States, where the challenge is to liberate people from the millstone of excessive debt. Some options include more expansive mortgage refinancing and modification programs or even allowing the courts to modify mortgage terms. Again, Iceland is ahead of the curve here—it is one of the few countries taking serious action to relieve the debt burden on households and firms.
So then—these are the broad contours of the policy path to recovery among the advanced economies. But other regions also have a part to play, for if the advanced economies go underwater, everybody will sink together.
In particular, the key emerging markets with external surpluses need to provide more global demand, by switching to more domestic sources of growth. This is in their own interest. More domestic growth is more inclusive growth, so the people win. And the global economy also wins.
More generally, the emerging markets and low-income countries need to prepare for any potential cold winds that blow from the north. They need to rebuild the policy buffers that served them well during the crisis.
This is especially important for the low-income countries, home to millions of marginalized and vulnerable people trying to eke out a decent livelihood in increasingly difficult circumstances. These are the true innocent victims of the crisis, the hardest hit by bad decisions made in faraway places.
But most countries need to continue to advance better targeted structural reforms to support employment and sustainable growth. “Demand friendly” policies in high-value areas should move ahead now, such as tackling high unemployment, to support growth. Further action is also needed to progressively enhance supply potential, particularly in advanced surplus economies that have low potential growth. These reforms would help sustain growth spells and thus pave conditions for improving income equality across economies.
Lessons from the crisis
So far, I have talked about the policies needed to stop the hemorrhaging. But it is also important to take a step back, and look at the lessons learned over the past few years. Hopefully, this can help us avoid some of the mistakes of the past, and build a better and more secure future for our children.
We learned a number of key lessons.
We learned that the global economy is incredibly complicated and interconnected.
We saw that it is riven by financial fault lines that can transmit economic tremors at lightning speed and in all directions. Iceland, of course, is painfully aware of this reality.
We need to get a better grasp of the vulnerabilities and spillovers that run through our interconnected world, and the IMF has been working on this on many dimensions, most notably on strengthening financial regulation and supervision, as well as identifying and correcting data gaps. We also need to improve the global financial safety net, to protect countries from sudden and powerful economic fallout.
We learned that our approach to macroeconomic policy was somewhat narrow.
We paid too little heed to financial stability. While monetary policy focused on inflation and growth, great dangers lurked off screen—soaring asset prices, booming credit growth, a financial crucible of toxic assets, and large current account imbalances. Now, we need to learn how to use a new toolkit of macroprudential policies that protect financial stability—such as maximum loan-to-value ratios to guard against housing price bubbles or making banks hold more capital when times are good.
This is an area where I know the Central Bank of Iceland has already begun to work, and these new tools will be essential to protect Iceland’s future and avoid of repeat of past excesses.
We also discovered anew the virtues of fiscal policy. Before the crisis, the orthodox position was to put in on auto pilot, not tinkering too much. But when monetary policy ran out of steam, fiscal policy came in from the cold—propping up aggregate demand and saving the world from an economic freefall.
We learned that the financial sector was too poorly regulated.
The crisis was caused by an explosion of risky lending and reckless behavior. Regulators and supervisors were not looking closely enough at the murky practices in the financial sector.
Today, there has been some progress in correcting these mistakes, especially with higher quality capital and liquidity standards. But the work remains unfinished. We need better regulation of the large banks, the systemically-important financial institutions, so that they can never again hold the taxpayer for ransom. We need better regulation over the shadow banking system, to bring all risks to light, seen and unseen. We need better regulation of derivatives, which some people call the dangerous dark matter of the financial system. And we need to improve supervision, as even the best rules in the world are toothless if not implemented properly.
Iceland has in many ways been the extreme example of financial collapse. While work is still underway to make it safer, the new banking system that is rising from the ashes is much leaner and simpler than the old one. Is there a lesson for other countries? Perhaps. The notion that taxpayers should not bear the full brunt of the financial sector mistakes could be one of them. How this is implemented will vary by country, but we must not risk turning financial crises into sovereign crises.
The IMF also believes that the financial sector is under-taxed, and so supports a Financial Activities Tax, levied directly on wages and profits of financial institutions. This fixes the under-taxation of financial services that arises from their exemption under the VAT. It is the best way to get the financial sector pay its fair share. Once again, this is an area where Iceland is at the cutting edge, having just introduced a Financial Activities Tax.
We have become more aware that the social dimension is critical for macro stability.
Economists have traditionally focused on the twin goals of macroeconomic stability and sustainable growth. These goals are as important as ever. But too often, we looked only at the broad statistics and failed to look behind the curtain, to see how actually people were faring. And here, there was sometimes a disconnect—the top8212;line numbers looked good, but too many people were being left out. Too many people could not find decent jobs, especially young people. And growth in too many countries tended to mainly benefit the top.
Fundamentally, a more equal income distribution is good for macroeconomic stability and sustainable growth. This is borne out by IMF research, and it must guide policy.
So what do we need? We need growth that supports jobs. The real risk is that we lose a generation of young people, who become increasingly unmoored from the productive economy and the bonds of society. Economic policies must stay focused on preserving and sustaining jobs. Especially in such challenging budgetary times, this should be top of the agenda when choosing short-run measures to sustain the recovery.
We also need more inclusive growth that benefits the whole of society. So we need policies to reduce inequality. We need decent social safety nets. We need fiscal policies that take distribution into account. We need efforts to bring everybody into the labor market. We need better access to education. We need better financial regulation.
Remember—if we want sustainable growth, if we want macroeconomic stability, we need inclusiveness and social cohesion.
In the aftermath of much discontent, I see some encouraging trends. I am hopeful that the dreams of the Arab Spring bear fruit, unleashing more inclusive growth, greater employment prospects, and a more humane economy that respects human dignity. I must also point out that Iceland should be proud of its social model. Even though the last three years have been incredibly challenging, you have gone through the fire while protecting your social welfare system—a lesson that other countries in crisis should emulate. This is a tremendous achievement, and the fruits of the shared sacrifices of the Icelandic people will be felt for years to come—in the form of sustainable, inclusive, and hopefully robust, growth.
And finally—the crisis and its aftermath has reminded us that cooperation is an essential ingredient of success. During the crisis, it was the cooperation that saved the day. Policymakers from all over the world came together with a sense of unity and purpose, and managed to stave off a second Great Depression—an outcome that was by no means assured. They did this under the auspices of the G20. And in our present hour of need, I am optimistic that the G20 meeting in Cannes next weekend will once again seize the reins and do what it takes to restore confidence and seal the recovery. But this kind of cooperation should not be merely a once-off event when our backs are to the wall. It must become a permanent way of doing business.
I should note that cooperation within countries and within regions is equally important. Difficult decisions are best taken in a spirit of national unity.
Indeed, I think this is key reason Iceland is getting over the hump—its much-praised consensus-based policymaking helped ease the adjustment. This tradition has deep roots in Iceland. I would even say it goes back over a thousand years to the founding of the Althingi [AHL-thing-ee], the oldest surviving parliamentary body in the world. You have history on your side. In this context, we all have something to learn from Iceland’s experience. That includes the IMF too. We learned that we should not shy away from using unconventional measures—such as capital controls—when the circumstances call for it. And we worked closely and cohesively with the government. It was a two-way street—the government took the lead and proposed policies, and we analyzed these policies and offered advice and guidance based on our long experience with crisis management. This recipe worked very well and we hope to use what we have learned here in other countries as well. I could also point to Ireland, with a strong tradition of social partnership. Or indeed to Germany, which saw no increase in unemployment during the crisis. Why? Well, one reason is its Kurzarbeit, its short-term work program that encourages firms to reduce hours rather than lay off workers, with the government providing some subsidies.
I have talked today about the short-term policies needed to move the global economy out of this dangerous phase, as well as the longer-term lessons for propelling prosperity and sustaining stability.
In celebrating its centennial, your university has embraced the theme of “fostering future prosperity”. My greatest wish for all of you today is that you can take your rightful place in a more prosperous and more confident world. But to get there, we need concerted action over the coming weeks and months. Policymakers need to put aside short-term political and partisan concerns and focus on the national and global good. The time for timidity has past. We must restore the momentum. We must regain the recovery. We must renew the commitment to strong and inclusive growth. And we must create enough jobs to bring down unemployment. If leaders make the right choices, 2012 could mark a new dawn for the global economy—your global economy. Success is within reach. Do we have the courage to grasp it?