The Global Policy Actions Needed to Stay Ahead of the Crisis ---- Christine Lagarde

http://www.imf.org/external/np/speeches/2013/041013.htm

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 1940—once 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 than 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-speed” global 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 first “speed” group 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 recovery—accounting 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 risk—some 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 like “what 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 speed” group 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 speed” group 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 repair—not 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 necessary—shutting 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 easing—geared 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 these “old 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 goals—supporting 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 itself—people 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.

Conclusion

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.