A year ago, the world economy fell into a deep recession. Now, happily, we see financial stabilisation and economic recovery. But we must not declare victory. The world could still make two mistakes: first, we might withdraw stimulus too soon; second, we might lose the opportunity for reform. We must avoid both dangers. That is the lesson I learnt at the annual meetings of the International Monetary Fund and World Bank in Istanbul. So where are we and where do we need to go? Think of this in terms of five ‘r’s: rescue; recovery; rebalancing; regulation; and reform.
The rescue was unprecedented in scale and scope. It had to be: the world economy went over a cliff. At the beginning of 2009, the annualised fall in a quarterly moving average of world industrial output reached 25 per cent (see charts below). The fall in world trade was even more extreme.
In response, the authorities socialised most financial liabilities, launched unprecedented monetary easing and ran fiscal deficits never before seen in peacetime. In the high-income countries, support for the financial sector – via capital injections, guarantees, asset purchases and liquidity provision – was 29 per cent of 2008 gross domestic product (see chart). In its World Economic Outlook, the IMF forecasts the fiscal deficit of these countries at 9 per cent of GDP in 2009. The rise envisaged in public debt compares to that of a big war.
“It worked”, as the leaders of the Group of 20 leading high-income and emerging countries claimed after their summit in Pittsburgh. One indication is the upward revision of the IMF’s forecasts since July: world output is forecast to shrink “only” 1.1 per cent this year and then grow 3.1 per cent next year. This is 0.3 and 0.6 percentage points better than forecast in July. In the 12 months from the fourth quarter of 2009, high-income economies are forecast to expand 1.7 per cent and those of emerging Asia 7.8 per cent, with China up 9.2 per cent.
We must not forget what such a recovery would mean: few economies are likely to see a fall in unemployment or in excess capacity over the next year. Moreover, the recovery is hugely dependent on the surge in government spending and the inventory cycle, particularly in the US (see chart). As the IMF stresses, “the main risk is that private demand in advanced economies remains very weak”.
Despite the recovery in confidence, the financial system remains damaged (see chart). Private sector deleveraging has barely begun. The rise in savings rates in countries such as the US and UK may also prove permanent. So growth might weaken when the inventory bounce and fiscal boost have worked through. Early withdrawal of stimulus is likely to be a huge error.
Yet expecting countries with external deficits and geared private sectors to provide much of the demand boost is also very risky. That could well turn today’s private sector debt crisis into tomorrow’s public debt and currency crises. This is why a third ‘r’ – rebalancing – is so important. The world needs the big surplus countries to sustain a higher rate of growth in demand than in potential output, to reduce their surpluses. That is not yet happening. Current account “imbalances” have fallen this year, but largely because of the fall in oil prices. Moreover, the IMF expects these imbalances to widen from next year. This is less rebalancing than the world needs if the recovery is to be sustained and healthy.
Beyond these big medium-term concerns are two longer-term issues: regulation of the financial sector and reform of the international monetary system. Both are now on the agenda. But on both action is likely to fall far short of what is needed.
On financial re-regulation, policymakers face contradictory pressures: in the short run, they are desperate to get credit flowing; but in the long term, they wish to prevent another crisis. The meeting of the Institute for International Finance, the association of the global financial industry, made clear that the industry is well aware of – and determined to exploit – this dilemma. Even Joseph Ackermann, one of the industry’s most thoughtful leaders and the IIF’s chairman, argued that “official regulatory reforms must be balanced, and the trade-offs involving possibly lower global growth and less job creation need to be carefully considered”.
In short: thanks for your money; now please go away. This is all too predictable. But fundamental change is essential. Doing what the bankers want is also politically poisonous. No bonuses should be paid until banks reach adequate levels of capital. Better still, as Andrew Smithers of London-based Smithers & Co has argued, let us force banks to raise the needed capital and if they cannot, let governments provide it.
In the longer run, at least three further changes are needed: a resolution regime for all financial institutions, with costs falling on creditors; the movement of virtually all trades into organised clearing houses or exchanges; and systems of remuneration which ensure that the management of rescued institutions always loses heavily.
Finally, there is the challenge of global reform, particularly reform of the global monetary system. Dominique Strauss-Kahn, IMF managing director, raised this issue when he argued for making the Fund “a global lender of last resort”. Experience has underlined two linked concerns: first, many emerging economies run current account surpluses and accumulate stocks of foreign currency reserves, to lower the risk of currency and financial crises; second, the reliance on the currency of one dominant country as the principal source of reserves creates vulnerability at the heart of the global economy.
Mr Strauss-Kahn argues, rightly, that the solution is collective insurance, via a bigger IMF. On a temporary basis, via the so-called new arrangement to borrow (NAB) and additional issuance of special drawing rights, loanable resources have been tripled to $750bn and an additional $283bn has been allocated as SDRs, $110bn of which will go to emerging and developing countries. This is good, but is not enough. The NAB’s resources are also not enduring. In addition, failures of the global monetary system have to be addressed. They played a big part in this crisis. We do not want a repeat.
This is not a time for a return to business as usual. We have survived this crisis. But we could not cope with another, possibly bigger and yet more dangerous one in a few years. Let us now show posterity we are able to learn from history.