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The Euro At 10: the Next Global Currency? Speech by Dominique Strauss-Kahn, Managing Director of the International Monetary Fund at the Peterson Institute
October 10, 2008
As Prepared for Delivery
Introduction
We are facing a very serious situation this week in the financial markets and in the global economy. We have some hard choices to make, and we must start making them very soon. Because of this, I will use the bulk of my time today to talk to you about what needs to be done to contain the crisis, and about its implications for the global economy.
I apologize in advance if it seems that I have spoiled a birthday party for the euro by talking too much of the storm outside. But I want to take advantage of this gathering, as well as the broader gathering of the Annual Meetings to discuss with you what we need to do to.
I think we can solve the problems we are seeing in the financial markets and in the global economy, so long as we act quickly, forcefully and cooperatively.
This week, the IMF gave its assessments of what is happening in the financial markets and in the global economy. Let me talk first about the outlook for financial markets, and the actions we must take there: because, as we all know, the heart of the problem is in financial markets.
An Action Plan for the Financial Markets
First, the numbers. We now estimate that financial sector losses could be about $1.4 trillion: almost 50 percent higher than our estimates in the spring, which were thought to be pessimistic by others. About half of these losses have been realized but there are still significant losses in the system.
But the problems in the financial markets now go beyond the cash losses. We are facing a crisis of confidence.
The private sector cannot restore confidence on its own. Macroeconomic policy measures by governments will not restore confidence on their own. Piecemeal measures on financial markets will not restore confidence on their own.
What will restore confidence is government intervention which is clear, comprehensive and cooperative between countries. Action should be governed by a few simple principles.
Principle 1: Government action needs to have a clear objective so that effective oversight of how public money is used is possible.
Principle 2: National plans need to be comprehensive: they must contain guarantees to depositors and assurances to creditors that are sufficient to ensure that markets function; they must deal with distressed assets and provide liquidity; and most importantly they must include bank recapitalization.
Principle 3: Action should be coordinated, at the global level and at the regional level when appropriate—for example in the EU.
Principle 4: Action should be fair, in that taxpayers, who are taking on the downside risks, should be able to share upside gains once the crisis passes.
How might this be applied in practice? I would highlight four sets of actions.
First, as many governments have now concluded, the fragility of public confidence has reached a point where some explicit public guarantee of financial system liabilities is unavoidable. This means not only retail bank deposits but probably also interbank and money market deposits, so that activity may restart in these key markets. Of course, such a step should be temporary, and include safeguards such as heightened supervision and limits on deposit rates offered.
Second, the government needs to take out troubled assets and force the recognition of losses. Asset purchases should be done at fair value. Why fair value? Because transparent bank recapitalization and restructuring of balance sheets is essential to the process. If capital is to be attracted to banks, it is better to pay a lower price now, recognize losses, and give banks an upside if the implied loss turns out to be smaller than expected.
Third, private money is scarce in today's environment. Therefore, support from the government is needed. One strategy that has worked in past crises is to match new private capital subscriptions with government capital, which imposes a market test for the use of public funds.
Fourth, a high degree of international cooperation has become urgent. During the past week the collapse in confidence in the markets has been almost matched by a collapse in confidence between countries. We saw a very bad trend toward unilateral measures taken with national interests in mind, with unintended "beggar-thy-neighbor" consequences for others.
We are beginning to see a turnaround in this. At the ECOFIN meeting earlier this week we saw some principles agreed, and early on Wednesday we saw coordinated moves by major central banks. We need more coordination. Financial institutions now span many countries and credible rescue plans must be consistent across many jurisdictions. I urge European countries especially to work together. There is no domestic solution to a crisis like this one. I know, having myself served as a Minister of Finance of my country, how difficult it is in the European Union to reach consensus and to make decisions. I do not underestimate the problems. Nevertheless, cooperation and coordination in actions is the price of success both at the European and the global levels. The weekend's meetings will be an opportunity for finance ministers to talk about how to bring about the needed cooperation. All kinds of cooperation have to be commended. All lonely acts have to be avoided, if not condemned.
How is the financial sector turmoil affecting the global economy?
One of the reasons action is so important is that the turmoil in the financial markets is having serious effects on the global economy.
Even if strong and coordinated action along the lines I have been talking about is taken, we think the world is going to experience a serious slowdown.
This is as we foresaw in the Spring. At that time, we were criticized for being too pessimistic. Now, I am afraid that it seems we were too optimistic. Our best forecast is now that world growth will be around 3 percent in 2009. This number may not sound so bad. But the projection for advanced countries is worse: very close to zero until at least the middle of 2009, with a slow recovery during the rest of that year. World growth will be driven increasingly by growth in emerging and developing countries. And they will grow at a lower rate than they have in the recent past: 7 percent in 2008, and 6 percent in 2009.
The financial market crisis is also going to have longer-term effects.
The United States
In the United States, a new generation of households, businesses and banks will now have fresh and vivid memories of a financial crisis. They will be more cautious, and take fewer risks. This is not a bad thing. In fact it is part of a long-term correction which is due. Before the crisis, people—and especially banks—took too many risks. Now changed attitudes to risk will reshape patterns of consumption and investment. We are already beginning to see this.
How should macroeconomic policymakers in the United States respond to this? My answer is that they should not try to fight the long-term change, but that if both private investment and private consumption fall sharply in the short-term—as private savings rise—then there may be a need for the government to support the economy. The options for fiscal policy will be constrained by the large addition to the federal debt caused by the recently passed rescue package. But fiscal stimulus measures may still be justified in the near-term so long as they are balanced by longer-term measures which promise to contain deficits and debt, especially reform of entitlement programs.
Europe
In terms of economic impact, Western Europe has been hit at least as hard as the United States this year. This is partly because of the appreciation of the euro.
But let me make one point, which is very relevant to the subject of this conference.
We have not yet seen a foreign exchange crisis. Sure, we have seen a couple of days when the euro/dollar rate has moved by a couple of percent, and we have seen some equally sharp movements of sterling and other currencies. But none of this approaches a crisis, and we have certainly not seen the kind of abrupt and disruptive movements of exchange rates that characterized the Asian crisis.
Why is this? Well one reason is obviously the success of the euro. For example, consider what the last year might have been like if Europe had not had the euro.
If the past is any guide, the appreciation pressure on the euro would have gone disproportionately into the German Mark, which may have appreciated much more than the euro now has.
In other countries, political and business forces would have lined up in favor of decoupling or devaluing against the Mark.
Anticipating the possibility of exchange rate realignments, market participants would have withdrawn capital from countries at risk of realignment, driving up interest rates and risk spreads and potentially causing current account financing problems.
Higher interest rates would have undermined housing markets and choked growth.
As in the past, exchange rate realignments would likely have been needed to restore order, and these exchange rate realignments in turn would have caused inflationary pressures in countries that devalued.
So there is no question that the euro has contributed to the stability of its member countries during this crisis. And—for its members—it has become an essential element of the global monetary system.
However, European countries still face major challenges in dealing with the current crisis, and policy options are constrained. Many European countries have limited scope for fiscal stimulus, because of already high debt and aging populations. There is more leeway in monetary policy. Indeed, the ECB has taken appropriate action this week.
Emerging Economies
In 2009, almost all global growth will come from the emerging economies. But the effects of the turbulence are also beginning to mount in their financial markets and in their economies.
Emerging economies are generally in a much better position than in the past. They have large reserve buffers, solid current account positions, and healthier banks. However, there is still a large group of countries that are very exposed to global financial conditions due to high external financing needs and in some cases banking system fragilities.
Policy responses will need to be tailored to the circumstances of individual countries. For those countries with high reserve levels there could be room to draw them down to finance a temporary and sudden shortfall in capital flows—not to defend a particular exchange rate, but to mitigate adverse effects on banks or corporates associated with depreciation. Other countries, though, will need to raise policy interest rates in line with rising risk premia to stem outflows and bolster confidence in their currencies.
Finally, it is possible that some emerging economies will need help, and possibly very substantial help. For our part, the Fund is supporting member countries with advice and if needed we are ready to support them with financing. We have activated emergency procedures to respond quickly to urgent requests, with high access financial programs, based on streamlined conditionality that focuses on crisis response priorities. We have plenty of liquidity to support our members if they need financing.
Before concluding, let me talk about two other issues.
Food And Fuel Crisis
The first issue is the other crisis in the world economy, which is affecting many developing countries. High food and fuel prices continue to put enormous pressure on developing countries. Prices have eased in recent months, but they still remain well above their levels at the onset of the recent price surges.
About 50 countries are really hurting, with uncomfortably weak reserve positions. National budgets are also under pressure, and inflation is on the rise. In low-income countries the average inflation rate is expected to exceed 13 percent by the end of the year. Inflation hurts the poor most, because they are least able to protect themselves, and it leads to greater inequality and sometimes to unrest.
Developing countries can help themselves, for example by shifting budget support toward subsidies for goods particularly consumed by the poor, or, when feasible, better-targeted social safety net programs that protect the poor in a cost-effective manner.
But developing countries also need help from others. The Fund is doing its part—together with the World Bank—with advice and technical assistance. The Fund has also increased financial support to 15 countries, and we have changed our Exogenous Shocks Facility so that we can provide assistance more quickly, in larger amounts, with more focused conditionality, and more flexibly. Donors must also help. One complication is that the budgets of advanced countries will be under more strain because of the financial crisis. It is very important that they do not respond to the crisis by cutting aid—which goes to the poorest and most vulnerable people in the world.
Looking Beyond the Crisis
The second issue on which I would like to comment is that even if we are still in the midst of the financial crisis, we need to think about some lessons we can draw from it.
Lessons in regulation and supervision of the financial sector
For the financial sector we have a good start in the recommendations and the technical work of the FSF, much of which was done in collaboration with the IMF. But of course, strong as they were, the FSF recommendations have not been adopted in time to prevent the crisis from unfolding. In fact, the crisis is the result of three failures: a regulatory and supervisory failure in advanced economies; a failure in risk management in the private financial institutions; and also a failure in market discipline mechanisms.
So now we need to go further. Let me emphasize a few points.
We need to have more flexibility and less procyclicality of some of the Basle II norms, including on the question of "fair value".
The rating agencies have to adapt to the new complexity of the financial sector, to limit conflict of interests, and to accept supervision.
We need to close loopholes and fill information gaps in financial regulation and supervision. This includes looking again at regulation for covering securitization, private equity companies, and mechanisms that increase leverage. We also need to give more thought to how to regulate hedge funds, either directly or indirectly, by regulating their counterparties.
How should we tackle this work? Let me be blunt. I think the IMF can help in coordinating this effort, drawing on the expertise of others. Why? Two reasons: first, the Fund—with its universal membership and demonstrated financial diplomacy (for example our work on Sovereign Wealth Funds)—can bring together the different actors in a global forum that discusses risks to global stability and policy responses; and second, the Fund has the machinery for follow up through bilateral surveillance and FSAPs.
Improving the Financial Architecture
Like a forest fire that leads to renewal of the soil, every crisis gives birth to new ideas, and especially new ideas to improve the international financial architecture. Earlier this week, Bob Zoellick made an inspiring call for a "New Multilateralism". Let me now add to the debate a few ideas of my own.
I think you can trace most of the problems we have seen in the architecture to either lack of legitimacy or lack of effectiveness.
Legitimacy must be conferred by reliance of broader groups. One very simple change that could be made is to extend the G8 to at least China, India and Brazil, and perhaps others.
But I think this needs to be accompanied by greater reliance on multilateral institutions with near universal membership, so that no country that wants to participate in the international system is left out.
Of course, the institutions themselves have to be representative as well as universal, and especially we need to see an increasing role for and responsiveness to emerging markets. Both the reform of Fund quotas and the broader governance reform that we are undertaking is very important for this.
As to effectiveness, I would like to see greater simplicity and more follow up.
To achieve more simplicity we need better coordination between international organizations. It sometimes seems that you need a scorecard to keep track of the players in development: development banks, the UNDP, the World Food Program, national administrations. We also need fewer overlaps between organizations, which requires better definition of the role of the different multilateral institutions.
I think we also need better follow up of agreements and communiqués. There is a certain poignancy in reading past communiqués. They remind me of a discarded children's board game. They once inspired great passion but are quickly forgotten. (This has not changed since I was a finance minister in the 1990s.) One way to follow up better the work for the "Gs" would be to have a kind of secretariat.
Because we have to act. The current crisis is, if nothing else, a wake up call. Put simply, we have to manage the system better than we have so far. And I believe that we can do better.
This is a time of serious challenges, but it is also a time when we can think imaginatively and act boldly. I hope that we will make a good start on this at this weekend's meetings.
Thank you very much.
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