Prospects for International Economic Cooperation
At Foreign Policy Association, New York
September 15, 2010
As Prepared for Delivery
Market and Policy Failures and the Global Crisis
In retrospect, it seems clear that the speed and severity of the global financial crisis – and the ensuing Great Recession—represented a powerful confluence of both market and policy failures. The crisis erupted when the vulnerabilities and imbalances accumulated during the Great Moderation of the previous two decades – years of sustained global growth, low inflation and burgeoning capital markets – could no longer be contained. The growing vulnerabilities, in turn, reflected a progressive breakdown in market discipline, regulatory flaws, and inconsistent economic policies along several dimensions. As earlier complacency gave way during 2007/2008 to extreme concern, financial and economic responses turned virulent, and the impact spread globally at an unexpected speed.
Of course, the epicenter of the crisis was the financial sector in advanced economies. Elemental failures of market discipline – mainly in the United States and Europe—created fault lines of unanticipated severity. As events demonstrated, the growing globalization that had ushered in a period of unprecedented prosperity also had created transmission channels that spread distress at an unprecedented velocity. Just as financial distress cut a swath through international markets, the fourth quarter of 2008 witnessed a frightening drop in manufactured exports from places that had never heard of the Lehman brothers or had any idea what these heretofore unknown siblings had been doing for a living.
One common factor in this web of failures was a weakness in international cooperation, regarding, among other things, global economic and financial governance. As we can see clearly in hindsight, the supervision and regulation of cross-border financial institutions were weaker and more fragmented than had been recognized generally. Financial safety nets and the frameworks for the resolution of non-viable financial institutions were internationally inconsistent and inadequate. Bilateral, regional and multilateral arrangements to address financing and liquidity needs in periods of stress were too reactive and ultimately ad hoc. Importantly, macroeconomic policies were developed outside of an effective collaborative framework. As a result, substantial differences developed and persisted in growth rates of domestic demand. The counterpart of this development was the build-up of unprecedented international payments imbalances without an effective policy response.
Of course, this is not exactly an uplifting opening for my remarks today. Nonetheless, I am preparing the ground for three positive messages. First, out of this searing experience is emerging a significantly bolstered framework of international cooperation across several relevant areas. Thus, the common threat of an imminent global disaster prompted a dramatic increase in cooperation and set in motion unprecedented and coordinated global action.
Second, the near-term actions growing out of this cooperation are helping to usher in what we expect to be a moderate global recovery. Third, if the new patterns of cooperation can be nurtured, fortified and sustained, the recovery will be strengthened and extended. If so, there will be broad-based benefits to be shared, including among other good things, reductions in unemployment around the world as well as here in the United States, and renewed progress in reducing poverty.
In fact, we can identify already many significant accomplishments that have been facilitated by enhanced international cooperation. The unprecedented anti-crisis measures included the largest-ever coordinated countercyclical budgetary actions, rapid and massive rate cuts by major central banks and their provision of unprecedented sums through currency swap lines to support global market liquidity. In the midst of the crisis, the largest economies acting in concert also provided large increases in the resources available to international financial institutions – including a tripling of the resources available to the IMF, among other effects helping to cushion the poorest countries from the brunt of the crisis.
Moreover, substantial actions have been undertaken to strengthen the global financial safety net, thereby reducing the risks of a new crisis. Finally, there is underway via the newly –formed Group of 20 Leaders Summit process a cooperative effort to enhance the coherence of macroeconomic policy formulation and implementation, with the goal of producing stronger, more sustainable and more balanced international growth. Together, these efforts demonstrate the potential scope for, and potential gains from, strong and sensible international collaboration.
From Crisis to Recovery
Despite setbacks, a solid (albeit sluggish – at least for the advanced economies) global recovery is underway. In the first half of this year, global growth reached an annual rate of about 4-3/4%, a bit stronger than we had projected. As I am sure that you are all aware, emerging economy gains have been particularly strong – with first half growth registering an annual rate of about 7-1/4%—sustained by strong domestic demand and a notable recovery of global trade. Major economies in emerging Asia—including China, India, and Indonesia—remain in the lead, followed by Brazil in Latin America. In advanced economies, the expected transition from inventory rebuilding to business investment is underway, although consumption remains weak and overall growth generally has been subdued—registering an annual rate of about 3% in this year’s first half.
More recent developments suggest that the recovery has slowed somewhat. Thus, second- half global growth is likely to be a bit more sluggish than the 3-3/4% annual rate that we had forecast in our latest World Economic Outlook update. By the way, our new World Economic Outlook (or WEO) will be released in early October. In the United States, inventory accumulation has begun to ease and the boost to GDP growth from public demand has begun to fade, as had been expected. Consumer spending is growing, but its speed is being restrained by weak labor and housing markets. Overall Euro area growth has held up relatively well so far – despite severe strains in some smaller economies – reflecting among other things the unexpectedly strong German expansion, which is being driven importantly by buoyant exports, especially to emerging Asia.
Given the Euro area economy’s heavy reliance on bank credit – in contrast to the much greater U.S. reliance on capital markets for corporate funding—and the still-tight bank lending conditions in Euro area banks – domestic demand gains there remain sluggish overall. The slowdown in some countries also reflects reverberations of the stress in financial markets triggered by concerns about sovereign risks, which have been assuaged (though not entirely eliminated), by unprecedented European policy initiatives, bolstered by IMF program support.
Overall, we continue to expect a multi-speed recovery—with GDP growth remaining somewhat subdued in major advanced economies and relatively strong in most emerging markets. We anticipate the recent slowdown to be temporary, affecting the second half of 2010 and early 2011. Looking to 2011 as a whole, the anticipated transition from a rebound in global trade and inventories toward gradually stronger private demand in advanced economies remains broadly on track, led by the recovery in business investment.
However, the outlook remains unusually uncertain, and downside risks have risen over the course of this year. As growth momentum has slowed, private sector balance sheets in many advanced economies have remained weak, while sovereign, financial, and real-estate-related risks remain elevated. A key risk is that turbulence in public debt markets might precipitate adverse feedback between perceptions of rising sovereign credit risks and the financial sector. The resulting financial strains could spill over to the real economy. Another risk stems from possible renewed weakness in property markets, including in the United States, where public support has played a critical role in supporting housing demand and mortgage securitization.
Timing the exit from accommodative monetary and fiscal policies will be determined by individual country circumstances. In general, however, we view current monetary and budget policy settings to be broadly appropriate with regard to our current base case expectations. However, a key challenge in most advanced economies will be the formulation of credible plans for substantial fiscal deficit reduction for the medium-term. Of course, if the current recovery were to falter in some economies, more near-term policy support might be required. Thus, fiscal consolidation might need to be delayed in some cases if private demand were to weaken again. Just to avoid any misunderstanding, however, our base case expectation is for a sustained recovery.
Need for Collective Action
Given the nature of the various challenges facing policy makers—first in order to secure the recovery, and second to establish a robust medium-term path for the global economy—recent developments have made it clear that a collaborative approach to policy action would maximize the chances for success.
First, sustaining the recovery will require two complementary rebalancing moves:
• Internal rebalancing in advanced economies, with stronger private demand accompanying fiscal consolidation. This would allow the private sector to retake its role as the main engine of growth while making it possible to rein in the burgeoning of public debt caused by the crisis.
• External rebalancing, with an increase in net exports in current account deficit countries, such as the United States, and a decrease in net exports in surplus countries, notably emerging Asia. This would ensure the adequacy of global demand as consumers in deficit economies rebuild their savings and governments contain spending. It would also raise the standard of living in the surplus economies and prevent a reemergence of global imbalances.
Success in these rebalancing efforts also will require further action to repair and reform the financial sector. Among other things, help is still required to restore the credit flows needed to support the transition to stronger private demand. Incomplete progress in addressing the legacies of the crisis—including bank funding concerns and the resolution of weak banks—together with regulatory uncertainty has left the system with residual vulnerabilities. Additional efforts also will be required to reduce bank refinancing risks, strengthen balance sheets, and reform regulatory frameworks. Exits from extraordinary financial system support will need to be carefully sequenced while funding risks remain high.
Second, IMF analysis demonstrates that the goal of securing stronger, sustainable and more balanced growth would be strengthened by a collaborative approach to macroeconomic policy decisions. Just as the force of collective action in early 2009 was critical in avoiding a financial meltdown and a potential economic debacle, establishing coherent policies in the recovery will be important for minimizing downside risks and putting the global recovery on a sustainable and more balanced footing—as well as ensuring vigorous economic performance over the medium term.
Recognizing the case for policy coherence and cooperation, G-20 Leaders at their Pittsburgh Summit last year launched their “Framework for Strong, Sustainable and Balanced Growth” – to be implemented via an unprecedented Mutual Assessment Process, or MAP. For its part, IMF staff was asked to provide technical and analytical support, with inputs from other international organizations.
So far, the MAP has elicited strong “buy-in” from G-20 members. In the first stage of the process, all G-20 members shared with each other and with IMF staff their policy plans and economic projections for the next 3–5 years. Taken at face value, these frameworks collectively pointed toward achieving the Framework’s goals of strong, sustainable and balanced growth. However, given the underlying policy plans, the projections appeared to be relatively optimistic and were subject to notable downside risks.
The principal conclusion that was drawn from analyzing the initial G-20 policy frameworks was that additional efforts across the membership would be needed to achieve their shared objectives. To highlight the issues, IMF staff produced two alternative scenarios.
• A downside scenario quantified the implications of the key risks to the authorities’ projections if they were to materialize.
• An upside scenario suggested actions that could improve the outlook and bring countries closer to their shared objectives. Specifically, it assessed the impact of three mutually-reinforcing policy approaches: (i) “growth-friendly” and credible fiscal consolidation in major advanced economies, beginning in 2011 and going beyond the countries’ submitted medium-term plans; (ii) policies aimed at bolstering domestic demand in emerging economies with large external surpluses; and (iii) structural reforms in labor and product markets across the G-20 countries aimed at boosting supply potential and reducing unemployment. The upside scenario demonstrated that appropriate collective action could make everyone better off, while minimizing the risks of the downside scenario occurring.1
At their June 2010 Toronto Summit, G-20 Leaders reaffirmed their commitment to the Framework process, agreeing to undertake “concerted actions to sustain the recovery, create jobs and to achieve stronger, more sustainable and more balanced growth.” Thus, in the second stage of the Mutual Assessment Process—that currently is underway—G-20 members are identifying policies they will undertake in order to achieve a more ambitious outcome—closer to that of the upside scenario. These country-level policies will form the basis for a Comprehensive Action Plan that will be articulated by Leaders at their Seoul Summit this November.
However, macroeconomic policy collaboration is not the only area where strengthened international cooperation can yield superior outcomes. In addition to addressing the underlying economic challenges, three more “architectural issues” also are ripe for further international cooperation – and would help build a more robust international system for the future:
• The international financial system needs to be made more robust. An ambitious and vigorous program of financial system repair and reform is underway, and is sorely needed. While agreement was reached last weekend by the Basel Committee on Banking Supervision on a reform package on bank capital standards, the result is necessarily a compromise, if a workable one. At the same time, many issues remain on the agenda, including implementation issues, as well as macro-prudential elements such as dealing with risk posed by systemic institutions, and a cyclical calibration of the capital requirements. Strengthening supervision also represents a critical element in the reform agenda.
• While the international economy’s resilience certainly can be enhanced, realism and prudence compels us to view future institutional failures and even crises as more or less inevitable. Hence, a need remains to strengthen the global financial safety net. Building on progress made following the depths of the crisis, the Fund’s Executive Board last week took another step forward by enhancing its country insurance facilities and extending their reach to a broader set of countries that are following sound policies and possess solid economic fundamentals. For countries with both very strong policies and economic fundamentals, our flagship insurance option—the Flexible Credit Line (FCL)—has been made more adaptable. And, for countries with moderate vulnerabilities, the Fund now offers a new form of contingent protection through the newly-authorized Precautionary Credit Line (PCL).
• Nonetheless, more can and should be done in this area. Good policies no doubt represent the first line of defense. However, as history and the recent crisis have shown, there are times when broad financial market shifts can swamp economies and create potentially destructive systemic strains. To address these risks, the Fund will explore options for improving its crisis prevention facilities, further complementing its traditional crisis resolution tools. Among other things, we are looking to develop greater synergies in terms of lending and surveillance activities with key regional financing arrangements, and are also considering the creation of a Global Stabilization Mechanism—a framework that would allow proactive crisis prevention measures to be undertaken during a systemic crisis.
• In addition to the efforts I have described, intense efforts are underway to reach agreement on a set of governance reforms at the IMF itself. The overarching goal is to insure that international institutions – in this case focusing on the IMF – adequately reflect the shifting economic weight implied by the sustained dynamism exhibited in recent years by many emerging economies. With reform objectives set at the Pittsburgh G20 Summit, and endorsed by Finance Ministers and central bank Governors in the IMF’s own International Monetary and Financial Committee, progress is anticipated during the upcoming October IMF Annual Meetings and to the November Seoul G-20 Summit. Quota reform – governing both the relative voting shares of all 187 IMF member countries and the overall size of the Fund’s quota pool—is only one aspect. A broader package of governance reforms is being debated in order to enhance the effectiveness of international cooperation through Fund activities. Fund staff and management are working closely with the Fund’s member authorities’ efforts to reach agreements. This task is complex and very challenging, and success would represent a new concrete step toward the international cooperation that could contribute to renewed global progress.
Conclusion
The recent crisis highlighted the need for cooperation—when the implications of failure were brought into stark relief. However, the true test of whether the lessons of the crisis have been learned will become clearer as the crisis recedes into the past.
Today, key challenges remain before us:
• To sustain and build a global recovery;
• To secure the basis for strong, sustainable and balanced growth;
• To build a more robust global economic and financial infrastructure; and
• To strengthen global governance.
My principal messages today have been that progress has been achieved in all these areas, but that it is incomplete. At the same time, the international community – working in the new context of the G-20 Leaders process, as well as within pre-existing venues – has pledged to make new progress, even in the coming months. The first tests will come quickly – at the IMF Annual Meetings in October and the G-20 Seoul Leaders Summit in early November.
So there are real reasons for optimism about prospects for enhanced, effective global cooperation. But at the end of the day, it is the support of informed and interested citizens like yourself that will make a difference in encouraging political authorities to show the needed commitment, and to make the needed effort. My IMF colleagues and I are confident that in this case, the benefits will accrue to all.
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