New Policies for a New WorldA Commentary by Dominique Strauss-Kahn, Managing Director, International Monetary Fund
Published origianlly in Japanese in Nihon Keizai Shimbun
January 4, 2011
Over the last quarter century, the global economy enjoyed a remarkably long period of high growth and low and stable inflation. This extraordinary period in economic history lulled many people into a false sense of security, and made policymakers too complacent about their ability to manage the economy and cope with financial crises. Managing developed economies seemed deceptively straightforward. A simple doctrine gradually emerged, comprising a few common-sense rules (fiscal and monetary) underpinned by the idea that markets were infallible.
But this illusion of stability was shattered by the global financial crisis. Almost overnight, the Great Moderation turned into the Great Recession.
In retrospect, there were many fault lines beneath the old economic model, and the financial crisis ripped them open. The global growth model turned out to be unbalanced and unsustainable. It relied too much on excess borrowing by some countries, made possible by excess saving by others. Many countries also saw large increases in inequality that tugged at the social fabric. In the United States, for example, inequality on the eve of the crisis was back where it was just prior to 1929. Insufficient financial regulation and supervision were also to blame. Buoyed by a boundless optimism about rising asset prices and economic fortunes, financial institutions took risk to new heights. They engaged in complicated financial engineering that both magnified and disguised risk. In too many cases, policymakers had bought into a culture of deregulation and a belief that financial markets could police themselves effectively.
Today, we need to start from scratch, and develop a new economic paradigm. We need a little more humility about the power of policies and markets. We need to better understand the complex linkages between the financial system and the broader economy—and also the linkages between countries themselves. Most important of all, countries need to work together to build a more successful and more stable global economy. This cooperation will be the major legacy of the crisis, and it must not be squandered.
Let me address what this means in terms of policy.
It is first of all imperative to address the safety and soundness of the financial sector. This requires robust regulatory oversight. Here, the recent Basel III proposals represent a major improvement in the quality and quantity of bank capital. This is a big step, but still a limited step, as these tougher standards apply only to banks, and not the “shadow banking system” that came to light during the crisis. Also, rules are only as good as their implementation. We need financial sector supervision that is not afraid of saying no to powerful interests. We also need coherent resolution mechanisms—both domestically and across borders—to allow failing firms to be wound down with minimal cost to taxpayers and to end the scourge of too-big or too-important to fail.
Ultimately, we must extricate ourselves from the cycle of privatized gains and socialized losses. When the next financial crisis hits—and it is a matter of when, not if—we must be prepared. We cannot expect taxpayers to once again foot the bill. This is why the financial sector must shoulder a substantial yet fair share of the costs that risk-taking imposes on the economy. This is why the IMF has proposed a tax on financial activities.
Moving to the broader economy, we have learned that for growth to be healthy, it needs to be balanced. At the national level, this requires tools to prevent excesses in one sector from bringing down the entire economy. And at the global level, it requires a better distribution of growth across countries, to prevent destabilizing imbalances. In practice, this means that the surplus countries must shift from an external to an internal growth engine, including by developing strong social safety nets and investing in infrastructure.
What are the implications for macroeconomic policy?
Monetary policy needs to pay much more attention to financial stability, beyond its core focus on low and stable inflation. The debate now is how exactly to factor this into monetary policy, and how to coordinate the work of monetary and regulatory authorities.
For fiscal policy, the crisis showed the value of maintaining low public debt and deficits during good times, as countries with healthier public finances had more space to cushion the economic impact of crises. This was a key reason why so many emerging markets and low-income countries bounced back so quickly this time around—a marked difference with the past. But the Great Recession has caused public debt and deficits in many advanced economies to soar. How quickly should they be brought back down again—and what is the right balance between higher taxes and lower spending? The answers will vary by country—reflecting factors like the strength of the economic recovery, the market’s appetite for debt, and initial spending and revenue ratios. But the common objective for fiscal policy must be to support durable medium-term growth and job creation.
The distribution of income is another important issue. The consequences of rising inequality and its effects on social cohesion can no longer be ignored. Rising inequality may also have increased vulnerability to crisis—with fewer people able to dip into savings during bad times, the hit on growth is even larger. This points to the importance of adequate social safety nets and progressive taxation.
And what about the international dimension?
Policymakers must be aware of the global interconnections and the idea that “economic butterfly effects” can reverberate across the world. There must be a better understanding of how one country’s policies “spill over” to other countries. This approach lies at the heart of the G-20’s efforts to achieve strong, stable and balanced global growth. The IMF is also stepping up work in this area, through “spillover reports” on systemically-important countries. These reports will assess the impact of policies in these economies on the rest of the world, exploring the powerful economic and financial interlinkages through which they are transmitted.
Gaining a better appreciation for the financial linkages between countries is also important. During the crisis, we saw how quickly capital fled from countries previously considered safe bets. Today, many of these countries are reeling from a tsunami of returning money. How should they react? Capital flows can certainly be beneficial in helping transition to internal sources of growth. But these flows can also be destabilizing, and lead to financial instability. Because of this, macro-prudential tools or even capital controls are sometimes justified to prevent an inflow becoming a deluge.
Advanced countries can help reduce the pressure by speeding up financial sector reform, normalizing credit conditions and thereby alleviating the need for accommodative monetary policy. But countries must continue to tackle problems in a cooperative spirit. “Currency wars” are wars with no winners.
Global financial insurance is an important related issue. Just as a family back-stops its savings with insurance, countries should be able to tap into a global financial safety net. Much has already been achieved since the crisis, thought more resources for the IMF and new financing instruments. But more is needed, and the IMF is exploring cooperation with regional financial arrangements and new ways to use our instruments in a systemic crisis.
Let me tie this all together.
One of the principal failings of policymakers in the run-up to the crisis was a lack of imagination, as we failed to see the fault lines embedded in the global economic and financial system. Going forward, our next failing should not be a lack of cooperation. We must reach across old dividing lines—both within economies and between them—and work together to build a stronger, more resilient, fairer global economy. The welfare of the generations to come depends on it.