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Fiscal-Financial Nexus: The Challenges and Lessons of the Global Crisis, a speech by IMF First Deputy Managing Director John Lipsky
June 26, 2009
As Prepared For Delivery
It is my honor and pleasure to welcome you to what I am sure will be an interesting and worthwhile conference. On behalf of my IMF colleagues, I want to thank you for taking the time to join us.
As I am sure you have heard already, the latest economic news from around the world gives some reason for cautious optimism. Tentative signs are emerging that the rate of decline in global output is moderating and that financial conditions are improving. While it is far too early to draw firm conclusions, this news offers positive reinforcement for the unprecedented efforts underway to resist the unprecedented challenge. After all, the breadth and severity of the financial crisis and economic slowdown are the most serious experienced since the 1930s.
Policymakers around the world have responded with flexibility and ingenuity, using all the weaponry available in their arsenal; including large-scale fiscal stimulus, very accommodative monetary policy, plus strong and often innovative support for the financial sector. The speed and magnitude of the policy response no doubt played a key role in beginning to turn around market sentiment, in slowing the decline in economic activity, and in truncating the downside risks.
These grounds for optimism surely are welcome, but caution is still appropriate: clear signs of recovery are visible in some emerging markets, particularly in Asia, but the recovery still appears to be struggling to become established in most advanced economies. In this context, ongoing policy support will be crucial in laying down firmer foundations for renewed growth, including the restoration of financial sector health. In my remarks today, I will touch briefly on near-term issues, but focus more on the medium-term vulnerabilities that could build up without careful policy design, and the related need for exit strategies.
Regarding fiscal policy, the implementation of the announced stimulus measures is an incomplete challenge, with experience varying across countries and programs. Stimulus measures in the form of tax cuts, such as the VAT rate cuts in the United Kingdom and payroll tax cuts in the United States, were implemented relatively quickly. Other measures have not been implemented as rapidly, particularly those related to spending. In the United States, for example, $46 billion or 11 percent of authorized funds had been spent through mid-May, concentrated in health and human services. In France, 11½ percent of authorized funds have been spent. In some other countries1, transfers and capital spending have risen in comparison with past years, but a complete assessment is not yet possible.
It is straightforward to conclude that the spending measures already announced must be implemented if they are to support the incipient recovery. Moreover, if the signs of recovery turn out to be a false dawn, consideration may need to be given to providing additional stimulus.
At the same time, it is appropriate for monetary policy in most economies to remain accommodative, including through unconventional measures where needed. Together with budgetary support, low policy interest rates and steeper yield curves help strengthen both financial institutions’ earnings and their balance sheets, hopefully boosting lending. Monetary policy has been relatively successful in normalizing conditions in money markets, but longer term interest rates are set mainly by market forces, not by policy. Similarly, efforts to stimulate bank lending and to restart securitization markets must contend with a lingering lack of confidence among creditors. The views of conference participants regarding revitalizing financial markets and bank lending will be most welcome.
A crucial point—and one that hopefully will be explored in the conference —is that the effectiveness of fiscal and monetary policies depend in part on the existence of a credible medium- and long-term commitment to maintain macroeconomic stability. The deployment of policy instruments to stimulate demand and to support the financial sector, together with the operation of automatic stabilizers, may have been essential to avoid a much more serious crisis. However, they will leave a legacy of fast growing government liabilities that effectively represents a journey into uncharted territory.
Today’s session on the fiscal implications of the crisis will explore the direct effect, as well as the impact of policy measures, on the fiscal positions of both advanced and emerging market countries. At present, government debt is projected to grow at a rapid pace for several years. In the case of several advanced economies, public debt will approach the highest percent of GDP since World War II. The challenge is clear: Policymakers must navigate between a premature withdrawal of fiscal stimulus that would undermine the recovery, or allowing debt to increase to levels that would cause concerns about fiscal sustainability.
As is well known, central bank balance sheets have surged from massive liquidity support and the purchase or swap of financial assets. Such a development—if sustained—eventually could deteriorate medium-term inflationary expectations while undermining the credibility of monetary policy. Moreover, these operations do not have an immediate impact on government debt, but they could need to be covered by governments if they lead to losses. Such an outcome could further exacerbate deteriorating budgetary positions. So could other contingent liabilities that result from measures taken to stabilize the financial system. The session dealing with financial sector support measures will explore their effectiveness and provide some guidance with respect to potential exit strategies.
In this context, market signals may provide useful information. In the past few weeks, advanced countries’ government bond yields have increased significantly from their late-2008 lows. For example, ten-year U.S. Treasury bond yields rose from close to 2 percent last December to around 4 percent recently. To some extent, this increase reflects expectations that the decline in activity is bottoming out, improving risk appetite, and diminishing deflation concerns.
If the yield curve steepening merely reflected the normalization of inflation expectations, this would not cause much concern, even though it would increase governments’ borrowing costs. Of much greater concern would be an additional rapid increase in bond yields, reflecting market unease about prospective large Treasury issuance and about the governments’ ability to service future debt obligations without resorting to high inflation, debt restructuring or default. This would imply higher government and private borrowing costs, with the risk of market instability and delayed recovery.
Clearly, governments will need a coherent strategy regarding how to unwind their exceptional intervention. Hopefully, conference participants will provide some insights on how governments could go about strengthening their fiscal accounts once the economic situation stabilizes, about how to downsize central banks’ balance sheets, and about how to anchor inflation expectations.
Presumably, these policy shifts will have to be implemented over time. Budget deficits will decline as economies recover but also as consolidation measures are put in place. Central banks’ balance sheets will be downsized only as demand recovers and economic slack shrinks.
The main contours of exit policies will need to be formulated clearly and coherently. Even though their implementation may not be imminent, there is no reason to delay their design. Procrastination or lack of specificity would carry the risk of declining investor confidence. Regardless, the borrowing pipeline is still full, as fiscal deficits are projected to remain high for some time.
Many countries already are taking steps to signal a commitment to fiscal consolidation. Reforming fiscal institutions can help—for example, countries could strengthen fiscal rules or frameworks, or make use of councils. For instance, Germany may adopt a constitutional amendment limiting its structural deficit to 0.35 percent of GDP from 2016; Japan is discussing new fiscal rules with the main objective of reducing the debt ratio; and the U.S. authorities are discussing the reintroduction the pay-as-you-go rule that compels new spending or tax changes to be either "budget neutral" or offset with new savings.
More needs to be done however, including addressing the looming long-term aging and health-care-related fiscal pressures. It should not be forgotten that while the crisis-related increase in public debt likely will be substantial, it is dwarfed by the size of potential liabilities that governments would accumulate in the absence of resolute and timely measures to address these prospective fiscal costs.
Of course, monetary policy eventually will have to be normalized. Moreover, if central bank independence is to be maintained, plans will be needed to transfer credit risks from their balance sheets, re-establishing a clearer demarcation between fiscal and monetary policy. Preserving government solvency also implies maximizing the recovery value of acquired assets. Moreover, as the government withdraws its temporary lifeline, a gradual transition back toward market-based intermediation will have to be engineered.
In thinking about the potential lessons of the current crisis, two areas of interest come to mind. First, the prominent role of fiscal policy in mitigating the cost of crisis has brought to the fore the importance of having enough flexibility to respond to adverse demand shocks, without undermining fiscal discipline and long-term fiscal sustainability. The legacy of the crisis—high public debt—also motivates examining the appropriate institutional and legal frameworks for fiscal policy that would support fiscal discipline.
The crisis also has raised legitimate questions about the yardsticks currently used to assess the stance of fiscal policy. At a recent IMF conference, it was documented how unsustainable asset price increases temporarily boosted tax revenue, making the underlying fiscal balance appear unrealistically strong. Thus, asset price movements can have fiscal policy implications. This is a potential topic for future research.
Second, the crisis has prompted discussion about re-examining monetary policy frameworks. There seems to be a strong prima facie case for better integration of macro-financial linkages into monetary policy considerations, and we are incorporating these linkages into our surveillance process.
I will end on a positive note: It is sometimes said that bad policies are made in good times, and vice versa. If there is some truth in this saying, then the current crisis hopefully is laying the ground for improved policies. If we are able to draw the correct lessons, we should be able to make our economies more stable, while at the same time maintaining the most valuable features of the dynamic and innovative modern market system.
Thank you for your attention.
1 For example, in Argentina, Canada, China, Indonesia, Korea, Saudi Arabia.
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