The Global Policy Actions Needed to Stay Ahead of the Crisis

By Christine Lagarde

Managing Director, International Monetary Fund

Economic Club of New York, New York, April 10, 2013

As prepared for delivery

Introduction: Status of the global economy

Good afternoon. Let me begin by thanking the Economic Club of New York—and especially chairman Roger Ferguson and president Jan Hopkins—for inviting me today. I know that Wendell Wilkie—a presidential candidate back in 1940once described the Economic Club as “the foremost non-partisan forum in this country”. When it comes to the cutting edge of economic policy, I believe the same is true today. You provide an invaluable public service, and I am delighted to be here.

Next week, the IMF holds its Spring Meetings, when we welcome economic policymakers from 188 countries—our global membership—to Washington. We will release our latest economic forecasts at that time.

I will not provide those numbers today; but I will provide some sense of the major issues, here in New York.

The big question, of course, is: where does the global economy stand? Five years after Lehman, is the world finally getting back on a positive path? I wish I could give you a simple answer but, unfortunately, the truth is a bit more complicated tan that, and looks more like a mosaic.

The good news is that after a particularly volatile period, financial conditions are showing signs of improvement. Thanks to the actions of policymakers, the economic world no longer looks quite as dangerous as it did six months ago.

Yet we do not expect global growth to be much higher this year than last. We are seeing new risks as well as old risks. In far too many countries, improvements in financial markets have not translated into improvements in the real economy—and in the lives of people.

The differences between regions are also starker than ever. We are now seeing the emergence of a “three-speedglobal economy—those countries that are doing well, those that are on the mend, and those that still have some distance to travel.

These three groups face different challenges, largely interconnected, but they share the need to put in place policies that will repair the consequences of the crisis and prevent its recurrence.

Walt Whitman put it so well when he said: “Keep your face always toward the sunshine, and shadows will fall behind you.”

So I would like to talk about two things today:

  • First, the policy requirements in the three groups of countries needed to stay ahead of the crisis.

  • Second, the overarching issues that transcend these different groups, and what they need to do together to stay ahead of the crisis.

I. Priorities for the “three-speed” global economy

Let me begin with the priorities for the three different groups.

(a) The firstspeedgroup includes the countries that are doing well.

This group includes, essentially, the emerging markets and developing countries. Because many had grappled with crises in the past, they were well prepared, and entered the crisis from positions of strength—with sound policies under their belts. Think East Asia, for example.

In fact, for the past half decade, the emerging markets and developing economies have led the world’s recoveryaccounting for a remarkable three-quarters of global growth. After a slight slowdown last year, they are bouncing back again. Today, developing Asia and Sub-Saharan Africa are the two fastest-growing regions of the world. These countries will legitimately want to consolidate their success.

At the same time, many emerging markets are looking at the advanced countries with some serious concern. Many are worrying about the potential fallout from exceptionally loose monetary policy, especially from unconventional easing.

Let me emphasize that, in present circumstances, it makes sense for monetary policy to do the heavy lifting in this recovery by remaining accommodative. We know that inflation expectations are well anchored today, giving central banks greater leeway to support growth.

But experience also tells us that this can have unintended consequences. Low interest rates push people to take on more risksome of which justified, some of which not.

Across the emerging economies, policymakers worry that exceptionally loose monetary policy will affect exchange rates and capital flows, and threaten financial stability through high asset prices and rapid credit growth. The greatest worry is that just likewhat goes up comes down”, “what comes in goes out”—a sudden reversal of large and volatile capital flows that can bring down the economy with it.

Right now, these risks appear under control. Capital is flowing to emerging markets mainly because of good policies and good prospects in these markets.

But we must be alert to any warning signs. Corporations in emerging markets, for example, are taking on more debt and foreign exchange exposure. Over the past five years, foreign currency borrowing by firms in emerging markets has risen by about 50 percent. Over the past year, bank credit has increased by 13 percent in Latin America and 11 percent in Asia.

When the tide turns, and interest rates pick up again, these hidden dangers will be exposed to the cold light of day.

So emerging markets will need to boost their defenses. This includes reconstituting fiscal policy space that eroded during the crisis as well as stepping up banking regulation and supervision. The right macroprudential policies obviously depend on different circumstances. They will include limiting credit growth in rapidly-expanding areas, imposing capital requirements that move with the cycle, reinforcing financial markets, and closely monitoring foreign exchange exposures.

The advanced economies also bear some responsibility here, in terms of delivering a better fiscal policy and more financial repair—and thus relieving some of the burden on monetary policy.

With the right set of policies on both sides of the capital flow equation, the risks can be managed—and the emerging markets and developing countries can expect to continue their forward momentum in the “first speedgroup of economies.

(b) Let us turn to the second group of the three speeds”—countries on the mend.

This group of countries consists of those that have come to grips with some fundamental policy issues. This includes the United States, but also other countries like Sweden and Switzerland, for example.

Let me dwell on the United States for a moment: the crisis began here, a result of financial excess. Since then, the United States has made rapid and substantial progress in repairing its financial system, as well as the household debt situation. This is paying off: credit conditions, housing markets, and employment have begun to tilt up. We are seeing steady growth underpinned by solid private demand.

This does not mean that everything is settled. Far from it. An outstanding issue is that public finances appear unbalanced. Adjustment is too aggressive in the short term, and too timid in the medium term. This adds to uncertainty and casts a shadow on the recovery.

Yes, the fiscal cliff has been avoided. But this year, fiscal adjustment is still outsized, at 1¾ percent of GDP. Sequestration alone—if not reversed—could cut a half percent of GDP from growth. This risks throwing away needed growth, especially at a time when too many people are still out of work.

It is also an extremely blunt instrument, imposing deep cuts in many vital programs—including those that help the most vulnerable—while leaving untouched the key drivers of long-term spending.

Turning to these longer-term issues: yes, progress has been made, with the deficit falling over 5 percentage points of GDP since 2009. Despite this reduction, it is still among the highest of the advanced economies. In fact, government debt is expected to hit 108 percent of GDP this year. Without policy action, the trajectory is unsustainable.

At this point in the recovery, it is more important than ever to put in place a credible, medium-term roadmap to bring down the debt—a balanced plan made up of savings in entitlement spending plus additional revenues.

Such a plan would support the recovery in private demand. This is the major policy challenge facing the United States today and it must be met. Otherwise, the substantial gains that have been made can be too easily lost.

(c) Let us now turn to the “third speedgroup of the global economy—the countries that still have some distance to travel. These include the Euro Area and Japan.

Starting with the Euro Area, European policymakers have accomplished a lot over the past year or so—including the European Stability Mechanism, the ECB’s Outright Monetary Transactions, the single supervisory mechanism, and the agreement to help relieve the debt burden of Greece. We should applaud this—it is not easy for 17 countries to agree to and implement such major policy initiatives in such a relatively short time.

At the same time there is still a lot to do. Especially in the periphery, many banks are still in an early stage of repairnot enough capital and too many bad loans on their books. Even outside the periphery, there is a need to shrink balance sheets, reduce reliance on wholesale funding, and improve business models.

Because of insufficient financial repair, monetary policy is “spinning its wheels”—meaning that low interest rates are not translating into affordable credit for people who need it. The plumbing is clogged up, and we are seeing more financial fragmentation. Across the European periphery, credit has contracted by 5 percent since the onset of the crisis, hitting small and medium-sized enterprises particularly hard.

So the priority must be to continue to clean up the banking system by recapitalizing, restructuring, or—where necessaryshutting down banks.

In an economic and monetary union, financial problems are common problems. So the Euro Area needs more collective policy solutions. One option is direct recapitalization by the European Stability Mechanism of troubled banks that have systemic implications.

Beyond this, the Euro Area needs a real banking union to strengthen the foundations of monetary union. This means complementing the single supervisory mechanism with a single resolution authority, and deposit insurance backed by a common fiscal backstop. Only then can the poisoned chord between weak banks and weak sovereigns be forcefully cut. Only then can monetary policy be fully effective. Only then can financial stability be fully assured.

The Euro Area countries are prominent among those that still have some distance to travel. So is Japan. The priority here, however, is to finally break free of the deflation trap and restore economic vitality. In this vein, the recently-announced framework of ambitious monetary easinggeared toward achieving a higher inflation target—is a positive step. Japan needs to rely more on monetary policy to kickstart growth.

For this to succeed, however, Japan must also move ahead in other areas—including in fiscal policy, which looks increasingly unsustainable. Japan’s public debt is now approaching 245 percent of GDP. As an urgent priority, therefore, Japan needs a clear and credible plan to lower public debt over the medium term. It also needs comprehensive structural reforms to shift the economy into higher gear.


So these are the major policy challenges that need to be met to stay ahead of the crisis, for each group of countries in the “three-speed global economy”.

II. Global priorities to stay ahead of the crisis

There is another set of overarching issues that affects them all. These issues have been with us since the beginning of the crisis, they are familiar, but have not yet been fully resolved. There are three of them as well: financial sector reform; more balanced global demand; and more emphasis on growth, jobs, and equity. Let me turn to these issues, to theseold risks”.

(a) Financial sector reform

The bottom line is that we need a global financial system that supports stability and growth.
Until now, this has been lacking. In too many cases—from the United States in 2008 to Cyprus today—we have seen what happens when a banking sector chooses the quick buck over the lasting benefit, backing a business model that ultimately destabilizes the economy.

We simply cannot have pre-crisis banking in a post-crisis world. We need reform, even in the face of intense pushback from an industry sometimes reluctant to abandon lucrative lines of business.

Global policymakers have certainly made significant progress on more stringent capital and liquidity requirements and capital surcharges for global megabanks, as well as clear standards for supervision and resolution.

To stay ahead of the crisis, we need to see more progress in other important dimensions. What do I mean? For a start, the “oversize banking model of too-big-to-fail is more dangerous than ever. We must get to the root of the problem with comprehensive and clear regulation, more intensive and intrusive supervision, as well as frameworks for orderly failure and resolution—including across borders, and with authorities empowered to oversee the process.

In terms of other issues: derivatives are still the dark matter of the financial system—as of last September, only one in ten credit default swaps were cleared through central counterparties. Shadow banking is still a shady corner toward which risk appears to be gravitating. This is true in advanced as well as in emerging economies.

Financial sector reform efforts must also be coordinated internationally. We are already seeing countries pulling in different directions in some areas, such as in calculating the riskiness of assets and curbing banking excesses. We need more focus on consistent global regulation and implementation, including in key areas such as bank resolution.

So: completing financial sector reform is the first overarching issue to be faced.

(b) More balanced global demand

The second issue: more balanced global demand. For too long, the pattern of global growth has been a high-wire act between regions with large current account surpluses and those with large current account deficits. The good news is that a sense of balance is returning. However, too much of it is one-sided, and comes from lower demand in deficit countries.

So there is a need for higher demand in surplus regions. This means different things for different countries. For countries in Northern Europe, like Germany, it means doing more to boost investment. For China, it means doing more to boost consumption and moving further toward a services-oriented consumer-based economy—a path upon which it has already embarked.

In addition, China’s rebalancing strategy depends crucially on its financial sector. Reform in this field serves numerous goalssupporting more balanced growth, more inclusive growth, and a safer financial system that helps the real economy, especially the dynamic private sector. Priorities here include continued interest rate liberalization, improving risk management, and strengthening regulation and supervision of shadow banking.

(c) Growth, jobs, and equity

The third issue: all countries need to emphasize more growth, jobs—and more equity. In other words, more attention to the issues that really matter to people. This is something we take very seriously at the IMF.

With over 200 million people out of work today, job creation is an urgent priority. A high level of employment is the best guarantee of a vibrant economy and a healthy society. Without this, we risk a wilderness of wasted potential and ruined ambition—especially for a generation of young people.

The best way to create jobs is through growth. This must come first, with the right balance of demand-side and supply-side policies. But policymakers can also deploy labor market policies to spur job creation more directly, while keeping fiscal policy sustainable. Options include education and training programs, hiring and wage subsidies, public works programs, child care subsidies, and lower taxes on labor.

Besides more growth and jobs, there must be equity and inclusion.

Equity matters because a more balanced distribution of income leads to more sustained growth and greater economic stability, underpinned by stronger bonds of social trust. Let’s face it: inequality is too high in too many countries, and has been growing in most countries during the crisis.

Equity also matters because, as tough times continue, we see signs of adjustment fatigue and rising social tensions. This is not primarily because of the adjustment itselfpeople understand that they cannot live beyond their means indefinitely. It is because of perceived unfairness in the burden of adjustment.

Just as the pains of adjustment must be shared, so should the gains from growth. This matters for the people in crisis countries bearing a heavy burden. For the people in the Arab transition countries seeking a new departure based on dignity and justice. For the two and a half billion people struggling to survive on less than $2 a day.

There is no magic bullet here, but there are still options. Most urgently, we should protect people most affected by crisis and make sure adjustment is as fair as possible—by protecting basic social services, assuring progressivity in taxation, and combating tax evasion.

Subsidy reform can also help. Take energy subsidies, for example. Not only do they hurt the planet, they help the rich at the expense of the poor. The IMF has estimated that these subsidies, including tax subsidies, ate up almost $2 trillion in 2011—a whopping 2½ percent of global GDP. Clearly, these are resources that could have been put to much better use—to improve the economy and improve people’s lives.


Let me conclude. This crisis has been long, bitter, and hard. The priority now is to take advantage of any financial breathing space, and put it to good use. This is such a moment. We cannot afford to let up.

As Rainer Maria Rilke put it, “The future enters into us, in order to transform itself in us, long before it happens.

We know the future we want. We know the path to get there. The task before us now is to act, to make that future a reality, to get ahead—and stay ahead—of the crisis.

Thank you.


The Use and Abuse of Monetary History

Barry Eichengreen

10 April 2013

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BERKELEYImagine two central banks. One is hyperactive, responding aggressively to events. While it certainly cannot be accused of ignoring current developments, its policies are widely criticized as storing up problems for the future.
The other central bank is unflappable. It remains calm in the face of events, seeking at all cost to avoid doing anything that might be construed as encouraging excessive risk-taking or creating even a whiff of inflation.
What I have just described is no mere hypothetical, of course. It is, in fact, a capsule depiction of the United States Federal Reserve and the European Central Bank.
One popular explanation for the two banks’ different approaches is that they stem from their societies’ respective historical experiences. The banks’ institutional personalities reflect the role of collective memory in shaping how officials conceptualize the problems that they face.
The Great Depression of the 1930’s, when the Fed stood idly by as the economy collapsed, is the molding event seared into the consciousness of every American central banker. As a result, the Fed responds aggressively when it perceives even a limited risk of another depression.
By contrast, the defining event shaping European monetary policy is the hyperinflation of the 1920’s, filtered through the experience of the 1970’s and 1980’s, when central banks were enlisted once again to finance budget deficits – and again with inflationary consequences. Indeed, delegating national monetary policies to a Europe-wide central bank was intended to solve precisely this problem.
It is not only in central banking, of course, that we see the role of historical experience in shaping policymaking. President Lyndon Johnson, when deciding to escalate US intervention in Vietnam, drew an analogy with Munich, when the failure to respond to Hitler’s aggression had catastrophic consequences. A quarter-century later, President George H.W. Bush, considering how best to roll back Iraq’s invasion of Kuwait, drew an analogy with Vietnam, where the absence of an exit strategy had caused US forces to get bogged down.
But a key conclusion of research on foreign policy is that decision-makers all too often fail to test their analogies for “fitness.” They fail to ask whether there is, in fact, a close correspondence between historical circumstances and current facts.

They invoke specific analogies not so much because they resemble current conditions, but because they are seared into the public’s consciousness. As a result, analogical reasoning both shapes and distorts policy. It misleads decision-makers, as it did both Johnson and Bush.
The same dangers arise for monetary policy. For the Fed, it is important to ask whether the 1930’s, when its premature policy tightening precipitated a double-dip recession, really is the best historical analogy to consider when contemplating how to time the exit from its current accommodating stance. Certainly, the Great Depression is not the only alternative on offer.
The Fed might also consider policy in 1924-1927, when low interest rates fueled stock-market and real-estate bubbles, or 2003-2005, when interest rates were held down in the face of serious financial imbalances. At a minimum, the Fed might develop a “portfolio” of analogies, test them for fitness, and distill their lessons, as President John F. Kennedy famously did when weighing his options during the Cuban missile crisis in 1962.
Similarly, the ECB might consider not only how monetary accommodation allowed governments to run large budget deficits in the 1920’s, but also how central bankers’ failure to respond to the financial crisis of the 1930’s fed political extremism and undermined support for responsible government. Again, rigorous analysis requires testing these historical analogies for fitness with current circumstances.
Anyone who does so will find it hard to defend the ECB and its stubborn inaction in the face of events. There is exactly zero evidence in Europe today that inflation is just around the corner. And, if current European governments are not committed to austerity and fiscal consolidation, then which governments are?
When I consider the European economy, the ECB’s failure to provide more monetary support for economic growth appears to be directly analogous to Europe’s disastrous monetary policies in the 1930’s. The political consequences could be similarly devastating. Europeans should ponder why the inflationary 1920’s, rather than the politically catastrophic 1930’s, have become the historical lodestar for current monetary policy.
On the other hand, when I contemplate the US economy, I conclude that recovery from the Great Depression, and not 1924-1927 or 2003-2005, is the episode that most closely resembles current circumstances. Only in the 1930’s were interest rates near zero. Only in the 1930’s was the economy digging itself out from a major financial crisis.
Then again, perhaps it is to be expected that I find the analogy with the 1930’s compelling. That was the defining episode for American monetary policy. And I am, after all, an American.

Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund. His most recent book is Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System.