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IMFSurvey Magazine: Policy

IMF Outlines Three Lines of Defense for Global Economy

Simon Johnson discusses the IMF's 2008 forecast during a press conference at the Fund. (photo: IMF)

World Economic Outlook

IMF Outlines Three Lines of Defense for Global Economy

By IMF Survey online

April 9, 2008

Faced with a slowing world economy and continued fallout from the subprime crisis that is affecting global markets, the IMF has outlined three lines of defense for countries to limit the impact of the slowdown.

In its latest World Economic Outlook, the IMF said governments need to be prepared to use a variety of tools to combat the spreading effects of market turmoil, triggered by the subprime crisis in the United States. The IMF expects world growth to slow to 3.7 percent in 2008, led by a downturn in the United States.

World growth is expected not to pick up much in 2009, and there is a 25 percent chance that the global economy will record 3 percent or less growth in 2008 and 2009, equivalent to a global recession, according to the forecast, released on April 9.

IMF Chief Economist Simon Johnson said governments can use a combination of monetary policy, fiscal stimulus, and public funds, as appropriate, to play a complementary role in helping economies address the current turmoil by supporting demand and limiting the negative interaction between financial markets and the real economy.

What are the three lines of defense?

    1. Interest rates. Monetary policy remains the first line of defense, says Johnson. Central banks in several advanced economies—notably, the United States—have appropriately eased policy rates as their growth outlooks have worsened, and they may need to continue easing until their economies find a firmer footing. In the euro area, current inflation remains uncomfortably high, but we expect that inflation will come down over the relevant roughly two-year policy horizon in the context of slower growth. This should provide some room for future policy easing on the part of the European Central Bank, he adds.

    2. Fiscal policy. Fiscal policy is the second line of defense. The U.S. fiscal stimulus, for example, looks likely to provide timely support in the second half of this year. However, the use of fiscal space, where available, should be temporary and not jeopardize efforts aimed at consolidating public finances over the medium term.

    Resorting to fiscal policy, when monetary policy is not sufficient to address the macroeconomic issues of the day such as the global downturn, says Johnson, depends on two factors. "And those are fiscal space—what is the level of the current deficit and debt of a country, and monetary space—to what extent a country has an issue with inflation and worries about inflation expectations," he explains.

    3. Public funds. Using the public sector balance sheet is the third line of defense. It may be needed to support housing and financial markets, according to Johnson. In the United States, steps have already been taken to ensure the availability of mortgage financing and to stem systemic risk, but more may be needed before financial and housing markets find completely stable ground, he adds.

    But Johnson clarifies that resorting to this third line of defense has to be looked at carefully, on a "case-by-case" basis, because "when you use public money in any fashion, you have to be careful about how that changes incentives for people, moving forward. And that is going to be very much about the kinds of terms the shareholders and creditors get when you rescue a financial institution or support an asset class."

On the whole though, Johnson warns, you cannot ignore the international aspects of the current financial crisis: "solutions implemented in `national silos' may not be adequate to resolve an underlying global problem of capital adequacy in the financial system."

Comments on this article should be sent to imfsurvey@imf.org


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