Transitions in an Interconnected World and Germany’s Role, by David Lipton, First Deputy Managing Director International Monetary Fund
October 31, 2013
The 2013 Kurt Viermetz Lecture at The American Academy in Berlin
David Lipton, First Deputy Managing Director, IMF
October 31, 2013
As Prepared for Delivery
Good evening. I am very pleased to be here to speak before the American Academy, a mainstay of transatlantic dialogue in Berlin. I would like to express my gratitude to the Academy for this distinguished invitation, and particular appreciation to Kurt Viermetz for making this occasion possible. I would also like to thank Gary Smith and Pamela Rosenberg for their kind hospitality.
It is very important to me to be speaking in Germany—for years among the largest IMF shareholders and an essential voice for international cooperation in our councils. Every visit to this great city, with its rapidly changing panoramas of heritage and modernity, provides a reminder of the incredible journey Berlin has taken since the Cold War. This city has excelled in preserving what is good and what is proven to work while charting new directions for the future. That is also the very challenge at the core of the policy agenda for our increasingly interconnected world economy.
As the community of nations emerges from five years of global financial crisis, it is clear that interconnectedness is not an unmitigated blessing. In fact, it is harder now to make the argument that we all have more to gain from interconnectedness than it was 10 or 15 years ago. We all know stories of lives and businesses disrupted when factories move to developing countries or financial market sentiment changes and the availability of capital becomes limited. At the IMF, we are very sensitive to this issue, because our genesis came about in the wake of the last devastating global economic crisis. By the end of the Great Depression and World War II, the economic world had fragmented with barriers to trade and capital flows and the devastation of the conflict. Our founding purpose was to help joining members rebuild links and capture gains from trade and finance. At the same time, we sought to instill a commitment to sensible and mutually agreed rules that could prevent a return to self-serving behavior destructive to commerce and well being. For nearly 70 years, the IMF has pursued global stability and prosperity through an era marked by deepening globalization and interconnectedness.
Now as the world emerges from another deep financial crisis, the G20 countries have taken on the job of promoting economic recovery and reforming the rules governing finance designed to reduce the odds that a crisis will recur. The IMF is supporting that effort. We do this because we firmly believe the world still has much to gain from interconnectedness. The evidence is seen in the emerging markets that have been on steep upward convergence paths toward advanced economy living standards. It is also evident in many low income countries, which—in aspiring to emerging market status—have boosted their growth rates and are poised for a convergence takeoff. Take, for example, Ghana, a country that has significantly reduced the proportion of its population living on less than $1.25 a day. It’s one of several frontier market countries that have recently been able to issue Eurobonds in international capital markets. Not only is there unprecedented potential for poverty alleviation and better living standards across the globe, but convergence, if it can be sustained, will create the markets of the future—potentially vast markets for Germany and other advanced economies.
However, that upside scenario can only materialize if the international community works together to reap those gains. Equally important, we need to better manage the risks that arise from interconnectedness. We have seen how weaknesses and failures in banks and capital markets can spread through the international financial system. Whether in the world of economics, or in the areas of the pollution, pandemics, or international security problems, the benefits of interconnectedness come with risks of crisis propagation. The challenge is to work together for mutual gain, while minimizing risks.
In the realm of economics, each nation must act first and foremost by putting its own house in order. But one of the frustrations national leaders and politicians today must feel is that they are operating in a world in which they cannot satisfy the needs and calm the concerns of their people acting on their own. Some pundits have observed that there cannot be good global governance until we overcome the shortcomings of national governance. I suspect that we are more likely to find that national governance can only be effective once there is adequate international cooperation.
This is not a new conundrum for Germany or its European partners. Over the past generations, Germany has had first-hand experience managing interconnectedness as it embarked first on the remarkable journey of European economic integration and then the unification of East and West. Of course, the global challenge is to foster cooperation, not formal integration as is taking place in Europe, But there is a parallel: national well-being depends on the stability and growth, and cooperation of the broader community of nations.
Having offered that preamble, what I would like to do this evening is to describe for you the economic horizons that lie ahead as the world economy emerges from this difficult crisis. Traversing the landscape we face will require navigating several complex transitions, transitions that will take time to resolve. How we do so will determine the course of much of the 21st century.
Before doing that, let me say a few words about the outlook for global economic recovery. Our most recent World Economic Outlook projects global growth of 2.9 percent this year, a level insufficient to restore the millions of jobs lost during the crisis. However, growth is returning in the advanced economies, and financial stability is being restored. The U.S. is recovering steadily, as shown by the rebound of housing and the recovery of the private sector. This is taking place despite the back and forth in Washington and an unnecessarily sharp fiscal adjustment. Europe is emerging from its deep recession, but only just. Japan is looking up, but still has a ways to go.
The recent deceleration in emerging economies—a crucial engine of growth since the crisis hit—suggests that the recovery will remain uncertain. Only the developing countries are showing real strength, with Sub-Saharan Africa now the world’s second-fast growing region after the emerging markets. This positive trend only underlines the importance of getting global growth back on track. We are not there yet.
There is something new and striking about this tentative global economic recovery. As the fog of the crisis recedes, we now see quite clearly that the path ahead is strewn with huge obstacles that will be hard and time consuming to traverse. Following most recessions, once recovery begins, normalization takes places naturally and relatively quickly. Central banks return interest rates to normal levels over a year or two. Budgets rebalance as recovery boosts tax receipts. And banks go back to making loans as business confidence returns. However, the legacy of the global financial crisis is that this time is different; this time we have our work cut out for us. And it is work that will be with us for a number of years to come.
The First Transition: Europe
One transition that is well known to all of you is centered on this continent. I will not offer you a detailed set of prescriptions for Europe. Perhaps you will be relieved that I see this as a topic for a different speech. Indeed, many of you will have been pleased that Europe is no longer dominating global discussions such as at the IMF Annual Meetings held a few weeks ago. But allow me to make some broad observations.
Over the past two years Europe has taken crucial steps to secure the euro, and thus has averted acute crisis. The importance of this achievement for the global economy cannot be overstated. But Europe still faces two daunting objectives. The first is to cope with the remnants of crisis, including remedying insufficient demand in the countries around the eurozone periphery, dealing with the overhang of private and sovereign debt, and addressing the imbalances within Europe. The second involves adjusting the financial and fiscal architecture of Europe to secure the foundations of the monetary union and to provide a basis for stable, sustained, and strong growth.
Each of these tasks will take time. It is imperative that Europe restore its banks to health by assessing and filling any capital shortfalls. There already is a calendar for establishing a single supervisory mechanism. There also are political commitments to the several elements of a banking union. However, implementation will involve further decision making and the development of well-functioning institutions. This work is imperative.
The future of fiscal arrangements in Europe is clearly a matter for future consideration. But in the short term, for individual countries, the task is to balance medium-term consolidation with the immediate need for growth-friendly policies. I know that these are difficult questions, and that fiscal union is particularly controversial in this country.
Europe’s issues are not intractable, but addressing them will take time and effort. That is for Europe to do, but the implications of Europe’s decisions and actions for our interconnected world are enormous, especially those involving the structure and regulation of the financial system. Just as the U.S. cannot address its policy challenges in isolation, a subject I will turn to next, so Europe, and of course that includes Germany, should keep in mind the interests of the international community—and then engage over them. The IMF has been brought into these issues in recent years—as you know, we are partners in the Troika with the EC and ECB in addressing the crisis countries—and we are prepared to offer advice and a setting for global dialogue.
While Germany and its European partners may have an understandable tendency to focus on this transition, there is much else going on in the world that will profoundly affect you and your economic interests.
The Second Transition: U.S. Monetary Policy
For months, financial markets and emerging country policymakers have been focusing on the upcoming normalization of U.S. monetary policy, because that task will be difficult and poses uncertainties for markets and the world. The decision of the U.S. Federal Reserve and other central banks—including the ECB—at the height of the crisis to launch what has come to be known as Unconventional Monetary Policy was a game-changer. By pushing monetary policy to the limit, including unorthodox asset purchase programs, they stabilized financial markets, averted an economic catastrophe, supported activity and thereby laid the foundation for eventual recovery.
But soon the U.S. will need to begin to normalize financial conditions. The Fed has invented an unconventional communication strategy to deal with the exit from its unconventional monetary policy. They have offered what they call forward guidance, explaining that normalization will be state dependant, not date dependant. This means they will begin to exit when certain growth and employment thresholds have been met, rather than at a certain point in time.
This is further compounded by the uncertainties surrounding U.S. fiscal policy. The political battles last month over the shut-down of the Federal Government and the debt ceiling demonstrate how unsettling the lack of decisive national policy making can be—at home and abroad.
Central bankers and market participants around the world are scrutinizing every Fed utterance. I am told by my colleagues that at a seminar with African central bankers held within sight of Mount Kilimanjaro last summer, topic Number One was Fed policy and communications. That would not have been the case even a decade ago, but in our interconnected world it is now business as usual. I can tell you that every policymaker I spoke to at our meetings earlier this month asked me when the Fed would act, and how markets would react.
The reason for this is that as the United States recovers and the Fed tightens, the world will gain from more demand associated with a stronger U. S. economy. But it also will feel the effects of higher interest rates. Most will gain on balance, but some countries or companies will feel pain. And, we do not know how markets will react along the way. Moreover, while normalization of conventional monetary policy—i.e. interest rates—after a more typical recession might take a year or two, normalization of unconventional policy after this deep recession is expected by markets to take many years. So this transition will be part of the global policy landscape for quite some time.
We have suggested that as exit from unconventional policies evolves, the U.S. authorities have a special obligation to communicate their intentions clearly, to act in an orderly fashion, in dialogue with other central banks. The international community and the markets have a stake in working together to understand and react wisely to what lies ahead.
The Third Transition: Japan
Japan, too, is undertaking a difficult transition as it attempts to escape decades of stagnation and deflation. We sometimes lose sight of Japan’s importance because of the shadow cast by China’s rapid economic rise. But as the third-largest economy in the world, Japan’s renewed economic vitality is crucial. A sustained Japanese revival would be extremely beneficial to a global economy seeking to regain a firm footing.
Japan's bold actions appear to be having an impact. The economy is growing, and there are some signs that deflation is ending. However, more needs to be done to cement success. What Prime Minster Abe calls his three arrows all need to be fired. Specifically, in addition to bold monetary action: Japan needs well-specified medium term plans to address fiscal challenges, and wide-ranging structural reforms. These include deregulation of product and service markets and steps to increase the participation of women in the work force.
Japan’s economy—and the capital flows that are part of its global presence—have a major impact on its Asian neighbors and countries half a world away. The policy measures underway, especially in the monetary area, have broad implications. Japan will manage its policy reforms, but it is essential that its policymakers also remain cognizant of their international obligations and the spillovers their policies may cause.
The Fourth Transition: The Emerging Markets
Of course, ours is no longer a world dominated by the advanced economies. Emerging markets have generated growth over the past decade that has helped keep the world economy on its feet. And beyond that, they truly have emerged since the crisis hit. You are aware of their arrival just by going to the store or heating your home. The development of China, India and others is a success story that has transformed the lives of hundreds of millions of people. Demand from these economies for natural resources and other products has been a force driving the recent growth of low-income countries. Germany’s role in this transformation—particularly through the export of capital goods—has been very important. But the emerging markets now face their own transition. Only a few years ago a considerable concern among the emerging markets was that optimism and risk taking by investors, to some extent spurred by the Fed’s stimulus, was leading to unmanageable capital inflows. Now capital is flowing out as financial markets reassess the risks in these countries and tie the terms of finance more closely to underlying economic fundamentals. The upshot is that economic growth in emerging markets is slowing. Some countries are asking themselves whether the slowdown is an inevitable turn from the elevated, unsustainable levels reached during the pre-crisis period, or whether higher growth rates can be recovered through better policy management and new structural reforms.
Whatever the answer to that question, emerging markets clearly face a period of adjustment and recalculation.
These developments have a direct bearing on the global economy, including the advanced economies. Germany already sends around 30 percent of it exports to emerging markets and developing countries and much of the potential for future export growth comes from beyond Europe and even beyond the advanced economies. However, German exports to markets outside Europe have been falling—down some 7 percent in August—suggesting how important these markets are to Germany at a time of slow European recovery.
The Fifth Transition: The Financial Sector
To this point, I have focused on events within individual countries and regions. But a transition that truly transcends borders is the post-crisis evolution of the global financial system.
The reforms put in place since the crisis seek to remedy flaws that contributed to the near collapse of the financial sector. That work is well advanced, but not yet complete. But in the coming years it will be, and the landscape for banks and non-banks will be substantially redrawn, with new rules affecting capital ratios, leverage and liquidity, along with a host of other regulatory changes. The economics of banking will be different.
Already, the business models of individual banks are changing in response. We are seeing some big banks turn away from core banking activities that ironically have been judged too risky under the new rules—for example, lending to small and medium-sized enterprises, mortgages, and project and infrastructure finance. I say ironically because these activities, while risky if not well managed, provide essential support for a growing economy—as long as they are undertaken in moderation and with adequate capital adequacy supports. And we are also seeing the migration of some activities out of the banking sector. The shift to a new equilibrium will likely take many years.
And while there can and should be no turning back from the new, stronger regulatory environment, policy makers the world over need to understand what is happening so they can manage the transition to that new equilibrium. Economic recovery and strong but sustainable growth depend on building a financial system that provides the right amount of finance to the right activities on the right terms—without shifting risks to taxpayers. In this interconnected world, every country has its work to do, but national policy makers must work together and be willing to look beyond their own borders, just as their bankers do.
Tonight I have tried to describe the key features of the economic landscape we see before us and what they mean for global economic policy management over the remainder of the decade. I do not want to leave the impression that these are the only issues ahead. Rather, they are at the heart of the policy challenges facing us as we emerge from the recent crisis—and the ones that most require us all to work together.
There are of course other long-term trends that also will have profound effects on our economies, our societies and our ways of life. Three that you might think would not preoccupy the IMF, but actually seem to us very relevant to the future of global growth and stability are demographic shifts, changes in income distribution, and threats to environmental sustainability. For example, we have recently taken on the subject of energy subsidies, including the implicit subsidies that result from ignoring the polluting externalities of carbon emissions. Addressing all these tonight would require another speech. So let me just offer a few numbers to illustrate the immense challenges policy makers will face: by 2030, there will be 1.1 billion more people in the world than today—97 percent of them in emerging and developing countries. One billion people will be 65 years or older.
The Role of Cooperation
Let me end by reverting to my original theme. No single country—be it the U.S. or Germany—can expect to manage these long-term trends alone. But their ramifications will be huge, and we have no choice but to manage them together.
Why does the IMF care about this subject?
Our core purpose is international cooperation. We need engaged member countries in order to carry out our mandate to support global economic growth and stability. How the world manages the challenging issues I have described could well make the difference between a weak, jobless global economy in the coming years, and one that thrives and creates jobs and wealth for citizens the world over. Better outcomes require national action, international cooperation and collective action to take place simultaneously. We at the IMF can convene and cajole, but only countries can act.
I believe this is an important challenge for Germany as well as its European partners. No doubt the job of building a stronger and more stable European economy is foremost in the minds of German policymakers, just as it is important to the German people. But in the long run a growing and stable global economy, with prospects for steady convergence in emerging market and developing countries, may play an even greater role in supporting German living standards. Certainly, Germany would face grave risks in the event that global interconnectedness is mismanaged. My appeal to you tonight is that as Germany carries on the work of the European project, it should lift its sights to the global horizon as well. In the domestic debate, in the European debate, Germany should make time to assess the stake it has in the management of the global economy and the role it can play in managing the arduous transitions facing the international community in the years to come.