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The Current Macroeconomic Outlook 2009: Issues of Systemic Stability, Speech by John Lipsky, First Deputy Managing Director, DevisenForum 2008: Devisen 2009, Steigenberger Airport Hotel, Frankfurt
December 10, 2008
December 10, 2008
Introduction
I am grateful for the opportunity to address this distinguished audience on such a timely topic.
Over the past few months, a consensus has emerged regarding the seriousness of the near-term threats to the global economy. Many advanced economies have fallen into recession, and activity in emerging economies is slowing abruptly. At the same time, notwithstanding the adoption of bold and comprehensive policy measures by many major advanced economies, there is no sign yet of a fundamental reversal of the financial market dislocation and deleveraging that represent both a sign of and a contributor to the still unfolding global economic strains.
The G-20 Summit on Financial Markets and the World Economy that took place in Washington last month was both an unprecedented response to these daunting near-term challenges, and an explicit symbol of the evolving world economic order. The Summit also confirmed that the most senior political authorities recognize the urgent need to address credibly the underlying causes of the current crisis, even while acting aggressively to reverse its near-term impact.
In several important ways, therefore, the coming months will represent both a test and a turning point for the global economy, for international financial markets and for global governance.
Global Outlook
Global economic prospects have deteriorated sharply in recent months, as the financial crisis has spread and increasingly engulfed emerging economies. In the advanced economies, consumer and business confidence have dropped to levels not seen in decades, and activity is slowing sharply or contracting. Most worrisome has been the sudden-and severe-toll that the crisis has begun to take on emerging economies; in many cases, deleveraging and asset sales have led to capital flow reversals, a sharp widening of spreads on sovereign and corporate debt, and abrupt currency depreciations.
• In November, the IMF revised down its forecast for global growth, less than a month after the publication of its October World Economic Outlook. Based on current policies, the world economy is projected to grow by 2¼ percent in 2009, down from about 5 percent in 2007, before picking up in 2010. The major advanced economies are in recession, and activity is expected to contract by ¼ percent on an annual basis in 2009, marking the first annual contraction in the post-war period for this group of countries.
• Activity in emerging economies is also slowing abruptly. While growth in these economies is still projected to be around 5 percent in 2009, led by emerging Asia, recent developments underscore that many of these economies face very difficult times as they adjust to a deteriorating global environment.
• Unfortunately, even this newly reduced forecast cannot be taken for granted, as downside risks remain significant. The IMF will publish its quarterly World Economic Outlook update in January; based on recent developments, it seems likely that we will further mark down our forecasts for global growth, while maintaining our assessment that a hoped-for stabilization of financial conditions and increased policy support should enable a gradual recovery to begin before the end of 2009.
On the positive side, headline inflation is receding rapidly across advanced and most emerging economies. This has opened additional room for monetary policy easing.
Against this background, policy makers have three broad tasks ahead:
• Bolstering domestic demand.
• Dealing with the immediate fallout of the financial crisis, including the adoption and coordination of policy responses to underpin confidence and restore financial sector soundness.
• Designing and implementing reforms that would decrease the risk of such crises in the future.
Bolstering Demand
Recent policy actions in advanced countries to use public funds to recapitalize financial institutions, provide comprehensive government guarantees, and extend liquidity provision were important and necessary steps, and their swift and effective implementation will be crucial to restoring more normal financial conditions.
However, while these measures are necessary, they are not likely to be sufficient to halt the slide in output. Given the sharp drop in confidence, additional measures will be needed to support demand, reduce potentially negative interactions between the real and financial sectors, and contain the risks of deflation.
• Declining headline inflation—reflecting both falling energy prices and weakening growth—has increased the scope for monetary easing, but there are limits to its effectiveness.
• Many central banks have already taken decisive action including, among other efforts, aggressive Fed action to reduce policy rates and the dramatic cuts in interest rates by the Bank of England, the ECB, and central banks in other advanced economies, including Australia, New Zealand and Switzerland. Several countries, including some in Europe, likely will have room to ease monetary policy further, but others-especially the United States and Japan-have already reduced policy interest rates to very low levels and real rates are rising as inflation falls. Indeed, deflation risks are starting to become a concern in these economies as output gaps have widened. Indeed, as indicated in recent remarks by Federal Reserve Chairman Bernanke, central banks have been considering alternative expansionary policy moves that could be undertaken as interest rates approach zero.
• In any case, monetary easing is likely to be less effective at stimulating demand while financial conditions remain disrupted and uncertainty remains high. More specifically, survey-based data show that banks have tightened credit standards significantly since the onset of the crisis last year. The impact of such a tightening of lending standards on credit aggregates typically occurs with a lag. Thus, the negative effects of the current tightening of credit standards likely will be felt for some time to come. In emerging economies that have relied on capital inflows to finance an expansion of bank credit, the effectiveness of monetary policy may also be limited.
In these circumstances, fiscal expansion will be needed in many economies to help in sustaining domestic demand. An effective fiscal stimulus program should support demand for a meaningful period. Our research suggests that a total stimulus of around 2 percent of global GDP-perhaps accompanied by a firm commitment to do more if the situation deteriorates further-would seem to be commensurate with the depth of the current downturn and the risks of even worse outcomes than foreseen in the baseline. In providing such stimulus, however, policymakers will need to safeguard medium-term fiscal sustainability.
• A diversification of fiscal policy measures would be important in order to insure the effectiveness of the stimulus program, notably in the context of financial fragility and heightened uncertainty concerning the effectiveness of any specific measure. For instance, credit-constrained consumers facing a liquidity problem are likely to increase their consumption spending in response to an increase in transitory income, say through a temporary increase in unemployment benefits and housing-related transfers. Other consumers-possibly making up the majority-who are not credit constrained, but who are reducing their spending because of increased uncertainty concerning economic prospects, are likely to save temporary tax cuts. However, their spending would benefit from policy commitments that reduced perceived risks of a sustained and deep downturn.
• The prevailing uncertainty concerning consumer behavior would argue for boosting government spending as well as cutting taxes. The key is to ensure that such initiatives are well designed in order to boost activity over the relevant time frame and to bring lasting benefits. Two considerations are relevant in this context. First, in several countries with fiscal rules for sub-national governments such as states -- or balanced budget constraints more generally -- governments are forced in downturns either to suspend spending programs, or to raise taxes. In these cases, the pro-cyclicality of rules constraining sub-national entities should be compensated, including through transfers from the central government. Second, the current recessions in several advanced economies could last longer than in previous instances, possibly justifying greater public investment in projects that typically have longer lags but would bring substantial longer-term benefits. In these cases, it would make sense to undertake additional, but carefully selected, capital spending, including infrastructure projects.
• Furthermore, in order to increase the effectiveness of fiscal expansion and minimize cross-border leakages, policy efforts should apply broadly across both advanced and emerging economies where low debt and disciplined policies in the past have provided sufficient policy space. However, countries with greater vulnerabilities, or in the midst of a crisis, will, need to address weaknesses in their fiscal positions as part of the efforts to stabilize their situation.
Safeguarding Emerging Economies' Access to External Financing
While monetary and budget policies are likely to be crucial to sustaining demand, emerging economies face an important additional challenge in ensuring that the unfolding liquidity squeeze does not become transformed into a solvency crisis. Because of financial deleveraging in the advanced countries, foreign investors have been reducing their exposures to a broad swath of these economies, and several countries are suffering from sharp capital flow reversals or "sudden stops." Relatively liquid markets that benefited previously from large carry trade positions have been hit particularly hard, and exchange rate movements have been especially dramatic, with sharp depreciations registered in many emerging economies.
• For countries with flexible exchange rate regimes, the exchange rate should be allowed to absorb much of the pressures arising from capital outflows. Some countries may need to increase the flexibility of their exchange rate regime, while ensuring the maintenance of a credible anchor. Large stocks of international reserves accumulated by many countries in recent years should provide room for intervention to avoid disorderly market conditions.
• Countries need to respond quickly in providing liquidity. Since the intensification of the crisis in September, several emerging economies have provided extraordinary liquidity support to financial systems, including by lowering required reserves and by easing collateral requirements for rediscounting purposes, and should continue to do so. The extension of liquidity may also need to include the non-financial corporate sector in countries where funding markets are quickly disappearing. Countries with large reserve buffers should provide foreign currency liquidity as needed, as acute shortages of dollar funding is increasingly affecting firms' ability to operate.
• The IMF has quickly moved to help emerging economies battered by the crisis and by the sharp slowdown in advanced economies, in particular in Emerging Europe. The Fund today has available more than $200 billion in liquid funds that may be used to support member countries facing financing shortfalls. Indeed, several countries, including Hungary, Iceland, Serbia, and Ukraine, recently have secured IMF financial support, and several other countries are currently negotiating IMF-supported economic adjustment programs. In addition, the IMF has created an innovative short-term liquidity facility (SLF). The SLF provides those emerging market member countries that possess strong macroeconomic positions and records of consistent policy implementation with large upfront access to Fund resources to help address short-term external liquidity pressures.
• Regional initiatives can also be helpful. Efforts aimed at a regional pooling of international reserves, through bilateral swaps, such as in Asia, provide a further backup for individual countries facing external funding pressures. These arrangements could be broadened, for example, by linking them with the use of the SLF.
Reform of the Global Financial Architecture
Looking beyond the immediate challenges, the crisis has made clear that both new thinking and action are needed in at least three areas relating to the global financial architecture. These include the design of financial regulation; the assessment of systemic risk; and creating mechanisms for more effective international action to reduce the risk of crises, and to address them when they occur.
The current crisis has shown the limits of the existing regulatory and supervisory framework at both the domestic and international levels.
• What we at the Fund call "the perimeter of regulation" has been shown to be inadequate and misleading. Major financial firms were able to place risks outside the existing regulatory limits, even though these risks in many cases returned to the parent firm's balance sheet just at moments of greatest stress.
• Financial innovation and integration also have increased the speed and extent to which shocks are being transmitted across asset classes and countries, and have blurred boundaries, including between systemic and non-systemic institutions. Regulation and supervision, however, remain geared at individual financial institutions and instruments and do not adequately consider the systemic and international aspects of domestic institutions' actions. Moreover, macro-prudential tools do not sufficiently take into account business and financial cycles, which has led to an excessive buildup of leverage.
The challenge, therefore, is to design new rules and institutions that reduce systemic risks, improve financial intermediation, and properly adjust the perimeter of regulation and supervision, but without imposing unnecessary burdens.
• More effective capital and liquidity requirements would make financial institutions-especially those that are highly interconnected-more resilient to risk. Counter-cyclical macro-prudential rules appear to be a promising way to limit the buildup of systemic risks. Greater use of centralized clearing houses and organized exchanges would help to improve the robustness of the financial infrastructure to counterparty failures. Supervisory structures for rating agencies and risk management are being revisited to enhance market discipline.
• Supervisory and regulatory frameworks should be more globally coordinated to ensure that the perimeter of regulation and supervision is appropriate. The crisis has underscored the tension between globally active financial institutions and nationally bounded regulators and supervisors.
• Enhanced information provision will also be important for improving the assessment of any build up of systemic risks. This will require reviewing transparency, disclosure and reporting rules. Information requirements will also need to cover a larger set of institutions, from insurance companies to hedge funds and to off-balance sheet entities.
• Of course, it is also clear that the risk management procedures of individual firms must be strengthened substantially. The repeated recent examples of professional investors purchasing complex financial instruments that they clearly did not understand, on the basis that a third party—such as a rating agency—claimed that they were AAA-rated, but yielded more than conventional AAA-rated securities, was both sobering and profoundly worrisome. The impact of the lack of competence was dramatically damaging to the financial system and to the global economy. We need to ask seriously whether the principles first explained by Charles Darwin will be adequate to limit the risks of a reoccurrence of such a disappointing and painful episode, or whether specific new regulatory and supervisory controls will be needed.
The crisis has also made clear the enormous costs of not identifying risks early enough and the costs of a lack of a coordinated response. Clearly, earlier multilateral surveillance was too scattered and warnings of heightened risks typically was too coded. A more effective approach to detecting risks will require close cooperation among key policymakers to bring together the existing scatter of international and national macro-financial information and expertise.
• The starting point for any early warning system must be better information on global financial and economic developments. The monitoring of large financial conglomerates with major cross-border activities and of cross-border derivative positions will need to be stepped up. Better risk assessment will also mean strengthening macro-financial analysis and enhancing work on early warning systems.
• Early warning and surveillance work will also require finding the right incentive balance between countries voluntarily engaging in vulnerability assessments and in making such assessments mandatory.
Conclusion
In summary, action across a range of areas is needed to help the global economy and financial system regain their footing. Macroeconomic policies-especially fiscal stimulus-should play an important role in bolstering demand, while financial sector policies continue to be implemented and fine tuned as needed. And collectively, we must work together to strengthen the global financial architecture in a way that reduces future risks by re-examining regulatory weaknesses, forging ahead with new tools for detecting and warning about vulnerabilities, and recognizing the importance of financial integration and cross-border financing in designing regulations and new mechanisms for crisis prevention and resolution.
The G-20 Summit on Financial Markets and the World Economy laid out an ambitious agenda. My Fund colleagues and I stand ready to help implementing this plan, and the IMF stands ready to use its financial resources and expertise to help pave the way toward a more resilient post-crisis global economy.
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