2011 In Review: Four Hard Truths
IMF Blog, December 21, 2011
Source details
- Canonical URL
- 2011 In Review: Four Hard Truths
Other formats
Bibliographic details
- Authors: Olivier Blanchard
- Published: December 21, 2011
Context and opening assessment
- Author: Olivier Blanchard, Economic Counsellor and Chief Economist at the International Monetary Fund.
- Date: December 21, 2011.
- Starting point: 2011 began in recovery mode—“admittedly weak and unbalanced”—with hope that major problems (excessive housing debt in the United States; adjustment in Euro-area periphery countries; volatile capital inflows to emerging economies; financial-sector regulatory improvements) were tractable.
- End point: By year-end, recovery in many advanced economies was at a standstill, with investor concerns including potential breakup of the euro zone and the real possibility that conditions could be worse than in 2008.
Four main lessons
- First: multiple equilibria and self-fulfilling outcomes
- Post the 2008-09 crisis, the world economy is “pregnant with multiple equilibria”—self-fulfilling outcomes of pessimism or optimism with major macroeconomic implications.
- Historical parallels: self-fulfilling bank runs, attacks on pegged exchange rates, wholesale funding runs affecting banks and non-banks.
- Newer observation: liquidity problems and runs can also affect governments because government liabilities are more liquid than assets (largely future tax receipts).
- Mechanism: if investors doubt solvency and require higher rates, those higher rates may lead to default; higher debt levels reduce the distance between solvency and default and between the interest rates associated with solvency and default.
- Example: Italy described as “the current poster child.”
- Policy implication: without adequate liquidity provision to keep interest rates reasonable, many governments are exposed.
- Second: incomplete or partial policy measures can make things worse
- High-profile meetings or announced plans that promise solutions but deliver only partial measures can worsen perceptions.
- Such announcements often reveal limits of policy and disagreements across countries, reducing investor confidence about the ability to deliver comprehensive solutions.
- Counterintuitive outcome: public attempts that fail to fully deliver can lower investor expectations and worsen market conditions.
- Third: financial investors’ conflicting reactions to fiscal consolidation and growth
- Investors initially react positively to news of fiscal consolidation but later react negatively when consolidation reduces growth.
- Preliminary IMF estimates (work in progress) suggest that it does not take large multipliers for the joint effects of fiscal consolidation and lower growth to increase, not decrease, risk spreads on government bonds.
- Behavioral consequence: governments may be induced to consolidate “too fast,” even from the narrow viewpoint of debt sustainability.
- Normative stance: substantial fiscal consolidation is needed and debt levels must decrease, but it should be gradual—“a marathon rather than a sprint.”
- Time horizon: “It will take more than two decades to return to prudent levels of debt.”
- Fourth: perception molds reality
- Conceptual frames and perceptions change with events and are persistent; once changed, they “do not go away.”
- Examples:
- Italy: although little changed economically over the summer, once perceived as at risk the perception persisted and deterred real-money investors from returning quickly.
- Euro zone breakup: even without significant economic deterioration in the second half of the year, market talk of a possible breakup altered perceptions and prompted investors to construct contingency strategies.
- Implication: persistent perceptions can materially affect market behavior and economic outcomes.
Aggregate explanation and policy priorities
- Combined effect: the four factors—multiple equilibria, partial policy measures, investor schizophrenia about consolidation and growth, and persistent perceptions—help explain why 2011 ended worse than it began.
- Policy priorities to restore recovery:
- Credible but realistic fiscal consolidation plans.
- Liquidity provision to avoid multiple equilibria and self-fulfilling runs.
- Plans that are not only announced but implemented.
- Much more effective collaboration among all involved parties.
Closing view
- Tone: cautious optimism—“I am hopeful it will happen.”
- Warning: the alternative (failure to act effectively) is “just too unattractive.”
Published on iMFdirect blog.