March 7, 2011
Good morning. I am delighted to welcome you to the Fund for this important conference. I wish to extend a special welcome to David Romer, Michael Spence, and Joe Stiglitz, who are co-hosting this conference with Olivier Blanchard. This illustrious academic quartet has brought together a world-class set of panelists, and distinguished guests from all over the world. I am sure that your discussions will bring important new insights on the key questions that face the economics profession today.
The last few years have not only been a crisis for the global economy, but also a crisis for economists. The Great Moderation led too many of us to underestimate macroeconomic risks—and, in particular, from the point of view of the IMF, to neglect tail risks—with costly consequences.
Two and a half years on from the beginning of the crisis, it’s the right time to take stock of what we have learned so far. I’d like to touch on two interconnected issues. First, the recent experience has raised profound questions about the pre-crisis consensus on macroeconomic policies. And second, the crisis has highlighted the tremendous benefits from international cooperation—though such cooperation is becoming increasingly challenging, as the urgency of the crisis begins to fade away.
Macroeconomic policies
Let me begin with monetary policy.
The pre-crisis consensus held that keeping inflation low and stable was the best way to secure optimal economic performance. Then came the crisis, which breathed new life into the long-standing debate on whether the interest rate rule, implicit or explicit, should be extended to deal with asset prices. The crisis has added a number of targets to the list, from leverage to measures of systemic risk.
But in my view, it is far from obvious that such variables should enter the primary target of monetary policy. Thankfully, policymakers have other instruments at their disposal—call them cyclical regulatory tools. These instruments—such as capital ratios, liquidity ratios, and loan-to-value ratios—have shown some promise as they target the sources of macro-financial vulnerability much more directly than traditional macroeconomic policy tools.
The problem is that combining the use of monetary and regulatory tools raises a range of issues. How does it affect banks’ incentives to take on leverage and risk? And, if macroprudential policy is managed by the central bank, how best to maintain the central bank’s independence, while also ensuring its accountability? This is an important area where we look to academia to help find the answers.
Turning to fiscal policy, it’s fair to say that in the decades preceding the crisis, it had come to play second fiddle to monetary policy as a macroeconomic stabilization tool. But the crisis has put countercyclical fiscal policy back at center stage. As policy rates approached zero, it was clear that monetary policy had reached the limits of its effectiveness. I am proud to say that the Fund played a pivotal role in its early call for a sizeable global fiscal stimulus.
So now we face a new kind of problem. Public debt in the advanced economies is forecast to approach 110 percent of GDP on average in 2014—an increase of roughly 35 percentage points since 2007. Many countries now face a major consolidation challenge. But how fast should adjustment take place? What is the right balance between fiscal adjustment—which is absolutely needed in the medium term—and growth? And in many European countries, would the debate be as strong, and as lively, if growth were at 3 or 3.5 percent? And then, if consolidation has to take place, what is the right balance between cutting expenditure and increasing revenue? These are pressing questions where research can provide important inputs.
Finally, financial regulation and supervision. In pre-crisis days, the focus was on the soundness of individual institutions and markets, and on correcting market failures stemming from asymmetric information or limited liability. As a result, the broader macroeconomic implications of financial sector risks were largely ignored. Given the enthusiasm for financial deregulation, the use of prudential rules for cyclical purposes was generally considered an improper interference in the functioning of credit markets.
But the crisis has taught us that financial regulation can have a major macroeconomic impact. Regulatory weaknesses allowed significant risks to build up. And, once the crisis started, rules aimed at guaranteeing the soundness of individual institutions worked against the stability of the system. For instance, mark-to-market rules, coupled with constant regulatory capital ratios, forced financial institutions into fire sales and deleveraging.
These lessons feed into a broad range of research areas. Macrofinancial linkages clearly matter—and we at the Fund are working hard to understand them better, but we need help. What is the related role of regulation and supervision? Though some might challenge the reforms under Basel III, a lot has been done in the area of regulation. But there has been far less progress on supervision—and many may argue that the crisis was more a failure of regulation than supervision. Again, the question is: what is the right balance between the two? We also need to ensure that the financial sector is put back at the service of the real economy—and the question that follows immediately is what is the right size for the financial sector.
International policy cooperation
The second issue I’d like to address is international policy cooperation.
During the crisis, international policy cooperation was fairly easy. Countries faced relatively similar situations, and the clear and present danger of the crisis spurred leaders into coordinated action. So in 2009 and the first half of 2010, the will to cooperate was strong.
This has led us to build new ways of cooperation. The G-20’s Mutual Assessment Process, which facilitates economic policy cooperation at the global level, is one important example. We also needed a stronger, more nimble IMF. And our members delivered it—boosting our resources, approving a revamping of our lending instruments, and supporting further efforts to strengthen the global financial safety net.
In sum—during the heat of the crisis, the benefits from cooperation were evident, and the costs of cooperation were small.
But the current phase is much more complex. Countries are recovering from the crisis at different speeds—so countries are facing different economic situations. Also, leaders naturally want to go back and deal with problems at home—though they forget that in today’s globalized world, there can be no domestic solution to global problems. This has made international coordination more challenging.
In thinking about this issue, I find it helpful to focus on three different types of situations, where international coordination might help achieve better global outcomes.
First, there are situations where policy changes in a country would advance the global interest, and also the country’s own self-interest. This may seem easy—but there may be strong domestic resistance to move, when there are competing interests within the country. Trade liberalization is a good example—where some groups may be in favor, and some against, but where it is clear that liberalization would be in the best interest of the country as a whole and of the global economy. In this situation, international cooperation could help support the reformers, as they take on vested interests resisting the changes.
Second, there are situations where acting unilaterally could make a country better off, but would ultimately make everybody worse off, once other countries react to the policy changes of the first. Competitive devaluation is one such scenario. While unilateral devaluation may deliver short-term gains to the country moving first, if all other countries do the same, in the end it simply leads to spiraling inflation, without changing relative competitiveness. Similar problems arise when countries undertake competitive weakening of financial or environmental regulation to make them more attractive to foreign investors. Again, this may just be a race, where other countries follow, and we end up with weaker domestic standards—and greater financial or environmental risks—with everyone worse off. In this situation, international mechanisms that bind people to the globally better policy choice are needed to achieve an outcome that leaves everyone better off. But again, the theory of this has not been very well developed.
The third situation—where policy changes in a particular country would make it worse off, but the global economy better off—is perhaps the most complicated one. Let me give you an example, to illustrate the real-world implications of these questions. Stronger financial regulation and transparency would benefit most countries, by strengthening financial stability. But for some smaller offshore financial centers, it may impose a costly loss of business. Some islands have rightly pushed to diversify their economies, away from tourism, and have created financial platforms to do so. And then they may be asked to implement reforms that might destroy their business. Or, while developing countries may appreciate the long-term global gains from their adopting clean technology, these may not be enough to outweigh the short-term costs associated with such structural change.
Could side payments—or penalties—be effective for reaching globally superior outcomes? In the case of the offshore financial center, sanctions might encourage adoption of new financial rules. And in the environmental example, financial support for developing countries could encourage them to adopt cleaner technology. In practice, however, implementing such schemes would face significant challenges, at both the domestic and the international level. Research could make enormous contributions by devising innovative, but practical, solutions to overcome these obstacles.
Coordination between countries makes a lot of sense from my perspective. It clearly showed its worth during the crisis. But so far, the academic literature provides at best ambiguous support in this area. It is therefore my hope that many of you will be motivated to push further in this area, exploring new institutional frameworks that might make it easier to achieve outcomes that can make everyone better off. We clearly need a stronger theoretical approach to something we feel strongly about—having experienced the benefits of international cooperation from within this institution, but only at a pragmatic level. How can we think more analytically about it?
Concluding thoughts
Let me conclude. As I reflect on the financial crisis, I draw two important lessons:
First, the crises of tomorrow are very unlikely to be a repeat of the crises of yesterday. This is why we must avoid becoming too complacent about our beliefs in how the world economy works. We must also remain ever vigilant to the emergence of new vulnerabilities, and not underestimate their power to unleash costly crises. And probably in the past, we didn’t do so enough, having a set of ideas that we believed would be true forever.
And second, as the global economy becomes ever more interconnected, the role of international policy cooperation in preventing crises—and more generally, of reaching globally better outcomes—will continue to grow. But how to organize this cooperation—and how to do so in quiet times, when the momentum is not as strong, is an important question.
At the IMF, we are taking these lessons very much to heart as we support our 187 member countries to meet the challenges of the post-crisis period. And we look to you, the academic community, to be our partner in finding practical solutions to today’s policy challenges.
I wish you a very fruitful exchange of ideas—and hope that they will sow the seeds of more work in this area, and more collaboration between the IMF and the academic community in the months and years to come. Thank you for your kind attention.
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