Managing Spillovers—Striking the Right Balance of Domestic Objectives and External Stability
By Christine Lagarde
Norges Bank 200th Anniversary Symposium on “The Interaction Between Monetary Policy and Financial Stability—Going Forward”, Oslo, Norway
June 16, 2016
As Prepared for Delivery
Ladies and gentlemen – good morning. God morgen!
Deputy Governor Matsen – thank you for your generous introduction and for the opportunity to speak to such a distinguished audience.
I would like to start by congratulating Norway and the Norges Bank on its 200th Anniversary this year! Norway boasts economic institutions that are as solid, sturdy, and well-tested as the Fram – which I had the privilege of visiting yesterday.1
And the Norges Bank, whose age now spans two centuries, is “Exhibit A” on this list! Thank you for the invitation, and I am honored to be here for your birthday party!
I would also like to congratulate Governor Olsen on his reappointment—a testament to his stewardship of this historic institution. It takes a wise man to lead this institution, and this brings me to a Norwegian proverb:
“Wise men learn by other men’s mistakes – fool’s by their own.”
So let us use the opportunity of this round birthday to think about what we have learned from the past, and from the mistakes that were made—whether from us or from others. How can we do better in the future?
This is a big topic and we could spend days on this. I believe you have a TV show that is called “Slow TV.” If I followed that format, I could have entitled my remarks “Norges Bank: 200 years in 200 minutes”!
So let me rather stick to something I know better—one lesson that we at the IMF have drawn from our 70 years’ worth of analyzing global economic developments. (We are still a young institution, mind you!)
The way economic and financial shocks have unfolded since the 2008 crisis made it clear to us that the world is interconnected like never before, in multiple and complex ways. The lesson for us was also clear. We need to better understand how developments in one country can have spillovers – economic, financial, even political – on other countries that can be thousands of miles away.
It used to be that advanced economies were the sources of spillovers. For example, monetary policy in the United States, Europe, and Japan has always had an impact on capital flows to emerging markets. This certainly continues, except that now we also have emerging economies as emitters of spillovers, both regionally and globally. Think of China, Russia or Brazil.
1. Current spillovers
There are currently two such shocks causing spillovers at the global stage, whose implications for the world economy we try to understand.
First, China is in the midst of a welcome transition to a slower but more sustainable growth path. This transition partly explains the cooling of global growth, and especially trade. Our estimates suggest that a 1 percentage point decline in China’s growth could reduce global GDP by about 0.2 percentage points.
This is not trivial, and it contributes to what our Chief Economist Maurice Obstfeld recently said: “the Holy Grail of robust and synchronized global expansion remains elusive” – and that is despite massive monetary stimulus in recent years.
The second spillover comes from the oil market. A slow global recovery, a downward shift in expected demand from China, and ample supply have all contributed to a drop in oil prices by some 70 percent from their peak. And as you know very well, despite a small rebound since late 2015, futures markets suggest that prices are likely to stay low for longer.
How do these spillovers play out in the world economy?
At the global level, the fall in oil prices led to a redistribution of income across countries – from heavy exporters such as Saudi Arabia, Russia and Norway to net importers such as the United States, Germany, Japan, China and India.
Faced with such a drastic fall in prices and rising financial pressures, many of the commodity exporters had to adjust.
Most countries cut government spending sharply and reduced investment, in the energy sector and elsewhere. Exchange rates were allowed to depreciate. Think of the 25 percent real effective depreciation in Brazil or the 15 percent depreciation in Russia.
A few countries had to go further and abandon fixed exchange rates, such as Kazakhstan – a country I just visited – and others should also do so, such as Nigeria. These changes helped reduce the need for excessive fiscal adjustment – by limiting the domestic currency loss of commodity revenues.
At the same time, countries with large financial and policy buffers were in a better position to smooth the adjustment. This is the case in Norway, where the sovereign wealth fund, the Government Pension Fund Global, helped buffer the impact of the oil price downturn on the economy. However, even countries with ample buffers such as Saudi Arabia and Russia required significant adjustment and a rethinking of their fiscal and growth plans.
So clearly the impact on oil exporters was severe—perhaps more than anticipated. But oil exporters represent a much smaller share of global GDP than oil importers, less than 15 percent.
One could therefore have thought that the oil price decline would be “a shot in the arm” for the global economy.2 After all, oil importers would enjoy a “windfall income” and a boost to growth from lower prices. Additional spending by importers would exceed the contraction by exporters, and growth would rebound.
Well, that oil “windfall” turned out to be more like a breeze! It was perhaps most noticeable in the United States, where private consumption has been strong, and to some extent in the Euro area where demand also picked up. But in Japan, consumption remained virtually flat.
So compared with past cycles, lower oil prices have not helped overcome the drag from other factors causing slow growth and asymmetric recoveries in oil importers – such as public and private sector debt overhang, slow credit growth, weak employment and low wage growth, and rising inequality, to name a few.
Moreover, we are seeing a slight widening of global current account imbalances, which had narrowed substantially after 2008. While China’s transformation has been a key contributor to the reduction in imbalances in recent years, other countries went in the opposite direction. In 2015, the external deficit in the U.S. increased while the surpluses in the euro area and Japan have widened.3
These changes reflect the asymmetric recoveries and associated large exchange rate movements across major currencies. If continued, this trend would lead to a further widening of stock imbalances, or growing disparities between creditor and debtor countries, which could raise global risks.
This points to the need for better balancing global demand to reinvigorate global growth and contain external imbalances through active use of policy space.
2. Policy response—balancing domestic and external considerations
Making a case to policy makers that something needs to be done to reduce global imbalances is always a hard sell. Their interests are of course geared towards the domestic economy, and growth usually remains the first priority.
Reflecting this priority, we managed to agree on some principles at the IMF Spring Meetings. First, it was widely accepted that monetary policy can no longer be the only game in town. And second, fiscal and structural policies need to step up to boost aggregate demand and growth potential – to form a three-pronged policy approach in advanced and emerging countries alike.
What is left is to make these principles more concrete, and in the process reconciling domestic objectives and external stability considerations.
In many instances, domestic and external objectives are well aligned. For example, Germany could use more of its fiscal space to close domestic investment gaps, and open up its services markets to boost competition.
In fact, our last World Economic Outlook found that major episodes of services market deregulation, including in Germany in the second half of the 1990s, increased GDP by about 2 percent after five years.4 So fiscal and structural reforms will not only lift private investment and long-term growth. They will also help narrow Germany’s large current account surplus.
What if domestic and external objectives are not aligned? In such cases, understandably, domestic issues should take priority. But countries need to take into account the spillovers from their actions.
Consider the case of Japan. When Abenomics was launched, the international community supported the weak yen – as a prop for demand – until the fiscal and structural arrows were deployed.
Or the case of the Federal Reserve, where concerns about the impact of an increase in interest rates on other countries—mainly emerging markets—and the resulting spillbacks on the United States were an important aspect in policy deliberations. These developments underscore the importance of improving our understanding of linkages – real and financial – across countries, and of macroprudential policies in mitigating the impact of volatility on countries exposed to financial spillovers.5
The emphasis here is on the appropriate mix of domestic policies – a balanced approach that limits the undesirable spillovers and beggar-thy-neighbor effects. And while external considerations can temporarily take a back seat to domestic objectives, policies will need to be reoriented over time to address external stability objectives.
3. Building resilience, staying the course – Norway’s lead
What do these developments imply for Norway, and the Norges Bank?
Being the central banker of a small open economy with large export industries like Norway is no easy feat. Fluctuations in the terms of trade often pose challenges, and developments abroad have a deep impact at home.
From the silver standard, through the hyperinflation episodes of the First World War and again in the 1970s, to the establishment of an inflation targeting regime in 2001, Norway’s monetary policy framework has evolved, adapted, and renewed itself. Today, the Norges Bank is better equipped than ever to tackle current and new challenges.
Equally important have been the fiscal rule and the Government Pension Fund Global – which today stands at nearly US$1 trillion dollars and owns more than 1 percent of the world’s traded equity shares. These fiscal tools have been instrumental in shielding the economy from the vagaries of commodity price changes and cushioning the impact of the downturn.
Together, Norway’s institutions evoke the image of its world champion skiers, navigating the slopes with so much agility, versatility, and skill.
But the world stands not still, and there is more work to be done. Just like Bjorn Daehlie would train hours on end just to gain a fraction of a second on the cross-country slopes in the next performance.
The global context has changed. Medium-term prospects for the global economy remain weak, and low prices and interest rates are likely to persist.
- This means softer demand for Norway’s traditional goods exports, which could make the transition to a new, less oil-dependent growth model harder.
- It also means that the Pension Fund is likely to grow more slowly in the coming years. Future real returns could be well below the 3.7 percent average since 1998. And that could imply rising demands on the Pension Fund itself to provide more of an ongoing fiscal stimulus – which would reduce future returns and provide less incentives to switch to non-oil exports.
- And it would have financial stability implications as well. Household debt remains a concern, and as other countries have learned, it is always better to strengthen the capacity to detect and guard against financial risks in good times, particularly in the banking sector.
I have no doubt that Norway’s institutions are up to the task of managing these challenges, and I would always recommend them to other countries as an example.
But let me also mention another area where Norway leads by example – its leadership as a global citizen, championing the call for peace, free trade, and aiding less fortunate countries.
Clearly, Adam Smith’s principles did not only influence the country’s constitution; it helped forge a holistic and humanistic view of the world as well. A case in point is your generous and determined support to help other countries develop sound institutions and policy frameworks.
Norway has been a long-standing partner and donor to the IMF. It contributes to the IMF’s financial resources and its technical assistance and training programs, through your development aid agency (Norad), your Ministry of Foreign Affairs, and your embassies. When it comes to capacity building, you have been our 11th largest donor, contributing almost US$40 million since 2002.
This work is critical in helping other countries develop the economic frameworks necessary for sound policy making, and I would like to thank you and all Norwegian citizens for your support.
Conclusion
Let me conclude. Henrik Ibsen once said:
“A community is like a ship; everyone ought to be prepared to take the helm.”
The slow and uneven global recovery continues to pose important challenges. We should avoid the emergence of major global imbalances, and countries need to be prepared for stronger economic and financial spillovers than in the past. This means that policies need to strike the right balance between domestic objectives and external stability.
There is a role for everyone here. Everyone should be prepared to take the helm.
Thank you – Takk skal dere ha.
1 The Fram is a Norwegian exploration vessel that sailed, between 1893 and 1912, further north and further south than any other ship. It is the world’s strongest wooden ship.
2 See Olivier Blanchard and Rabah Arezki “Seven Questions About the Recent Oil Slump,” December 2014, and Obstfeld. Milesi-Ferretti, Arezki, Oil Prices and the Global Economy: It’s Complicated, March 2016.
3 The forthcoming External Sector Report will present a multilaterally consistent assessment of external sector positions and policies of the world’s largest economies. See also the 2015 External Sector Report.
4 See April 2016 World Economic Outlook, Chapter 3: Time for a Supply-Side Boost? Macroeconomic Effects of Labor and Product Market Reforms in Advanced Economies.
5 See April 2016 Global Financial Stability Report, Chapter 2: The Growing Importance of Financial Spillovers from Emerging Market Economies.