NEWS

The economic downturn and beyond

In an exclusive interview with Kathimerini, the managing director of the International Monetary Fund, Dominique Strauss-Kahn, warns that a recovery from the global economic crisis is not guaranteed and that even if it is achieved, unemployment will continue to rise for the next two years. Strauss-Kahn is also worried about a move toward protectionism and believes that an international response is needed. As he stresses, the fiscal and monetary policies followed to get countries out of the crisis also present their own dangers but he does not think that the time has come for governments to stop supporting their countries’ economies. However, Strauss-Kahn believes that countries like Greece, which have high public debt, need to come up soon with a reliable plan to reduce their deficits. He also believes that if the appropriate measures are taken and the world overcomes the crisis, there will be better cooperation and a better regulated financial system in the future. The recovery is now expected to take hold in the first semester of 2010. What are the major risks to this scenario? We have to keep working hard to ensure that a durable recovery will indeed take place in the first semester of 2010. But even with recovery, unemployment will continue to rise well into 2010 and probably into 2011 in most advanced economies. Therefore, it is important to take forceful actions upfront. Possibly the biggest danger is complacency, leading to unresolved banking problems. The core problem with banks (capital deficiency, troubled assets) is still very much with us; many securitization markets remain closed, or open only due to extraordinary state intervention, and this continues to weigh on the capacity of the financial system to provide credit. If banking problems are not addressed, systemic risk might well return. On the political side, public skepticism about perceived bail-outs could undercut support for financial restructuring and so postpone the crisis. Risks to the outlook remain on the downside and will remain there while the financial sector undergoes repair. The main short-run risk is that the recovery stalls. This can be triggered by a number of adverse developments. Premature exit from accommodative monetary and fiscal policy is a risk, if a policy-induced rebound is mistaken for a sustained recovery. Progress in repairing financial balance sheets might be undercut by corporate bankruptcies, unemployment and higher-than-expected delinquencies on residential mortgages and commercial real estate. And in this precarious position, shocks that might otherwise be absorbed, such as a resurgence of swine flu or heightened geopolitical tensions, might destabilize the global economy. Another key concern is that higher oil prices could hinder economic recovery. Monetary and fiscal policy themselves present risks. We could witness inflation risk, the risk that central banks might have to tighten more than envisaged to deal with rising inflationary pressures. This could arise if potential output falls more than expected or if the large build-up of reserves at central banks spurs a surge in credit growth. On the fiscal side, the large increase in public debt has already raised concerns in financial markets. A further risk is the rise in trade and financial protection, which could gain traction as unemployment rises. At the IMF, have you reached any conclusions about the root causes of the crisis? Our initial views suggest that the root of market failure was overoptimism, bred by a long period of high growth, low real interest rates and historically low volatility but also policy mistakes and failures, specifically in these fields: financial regulation, which was not fully equipped to detect some risk concentrations and flawed incentives behind the recent financial innovation boom; macroeconomic policies, which did not respond sufficiently to the build-up of systemic risks in the financial system and in housing markets; and the global architecture, in which fragmented surveillance, particularly of the financial sector, compounded the inability to see growing vulnerabilities and links. Would a new, global reserve currency help address global imbalances? The benefit of a global currency reserve has been raised in the past and merits continuous studying and reflection. These discussions arise from general interest in strengthening the international economic and financial system but, by itself, a global reserve currency will not solve global imbalances. Furthermore, the political economy of getting to a global currency, particularly of obtaining a transfer of sovereignty from countries to a multilateral institution, would make it a far-away prospect. We should be realistic in our expectations, while encouraging further research, analysis and debate on the issue. Back in December, there was a call at the G20 for a new financial architecture for the future. Are you satisfied with the progress of this exercise so far? What are your expectations of the forthcoming G20 in September? Good progress has indeed been achieved. The crisis presented an unprecedented challenge that called for, and has in many ways already produced, an unprecedented response. As I mentioned, countries have acted together in ways that have been innovative and effective, including through the G20 summits. These meetings were both substantive and symbolic, with important commitments on the part of G20 industrialized and emerging market countries to cooperate more closely on macroeconomic and financial sector policies. The IMF has found itself at the center of the new international agenda. In particular, it has been recognized broadly that systemic changes are needed if we are to maintain the benefits of an open and integrated global economy, ensure that these benefits are broadly shared and limit the risk of future crises. Many of the IMF reforms have already been implemented. For instance, pledges for loans and notes now total about US $411.5 billion, approaching the goal of supplementing Fund resources by up to $500 billion set by the G20. Our members have also approved a general allocation of Special Drawing Rights (SDRs) equivalent to $250 billion, to provide liquidity to the global economic system by supplementing foreign exchange reserves. We have also announced an overhaul of our lending and conditionality framework, including introduction of a new Flexible Credit Line, which provides large-scale, up-front financing with no policy conditions to countries with a sustained track record of very strong policies. And, very importantly, we have gone beyond the G20 call for doubling the Fund’s concessional lending to the world’s poorest countries. In addition to the mobilization of additional resources, the IMF’s Executive Board recently backed an overhaul of its financial instruments vis-a-vis its low-income members, geared to accomplish more flexibility to their diverse needs. If current plans are implemented as anticipated, the post-crisis world is likely to be one characterized by enhanced multilateralism, greater policy coordination and a more effectively regulated financial system. I certainly hope that more steps will be taken in this direction at the G20 meeting in September and in our annual meetings in Istanbul. Is there a new economic paradigm that you see emerging as a better way to deal with such global problems in the future? Global efforts have focused largely on the crisis at hand but many reforms under way also aim at the post-crisis world. That said, no set of institutional changes eliminate business cycles or periods of financial sector stress. Moreover, economic and financial sector policies will remain primarily the business of national governments. Nevertheless, it is reasonable to hope that the ongoing changes to the global financial architecture, including to the IMF, can reduce the frequency and depth of future crises. If that can be accomplished, we will have gone a good distance toward ensuring that the benefits of our increasingly open and integrated global economy can be preserved and extended. Do you see the need for a change in the role and the policy tools of the IMF as a result of the crisis in order to deal with such global problems in the future? I think that the reforms that we have undertaken will give us the tools and the flexibility to deal with global problems in the future. The IMF will monitor countries’ policy implementation, including sharpening its early warning capabilities in concert with the Financial Stability Board. Of course, the IMF’s effectiveness also depends on its legitimacy among its global membership, which is why we also need to make progress in enhancing our governance structure and important work is continuing in this area. It is also important to underscore that policymakers continue to implement the needed reforms even as the immediate threat of crisis abates. That will help ensure that such crises are avoided in the first place. Do you share the concern about the rising tides of protectionism? Yes, although not traditional protectionism: increasing tariffs and similar policies. Most governments have understood well the lesson from the past, that this just made things worse. But you may have protectionism coming through the back door, especially in the financial sector. To give you an example, when governments provide some new resources or recapitalization of banks, they may add some comment saying that the money should stay at home. Or you may have in different stimulus packages some comment or amendment saying that this money should be used to buy national products – and similar distortions. There is a risk that this kind of protectionism may arise. The risk of a «beggar your neighbor» policy is still high and I think it is part of our job to explain that a global crisis requires a global response. No domestic or national solution will fix a global problem. When will be the right time to start tightening our fiscal belts? Is it the same for all countries? As I said, this depends to some extent on the countries we are considering. For many, it is not time to exit. That should come only as and when market conditions permit and the recovery is firmly established. Then, credible and coherent exit strategies will be needed to unwind substantial state interventions in an orderly fashion. This will require coherent sequencing and clear communication by both fiscal and monetary authorities. Specific exit plans will need to be tailored to the various measures, provide assurances on achieving medium-term policy goals, while avoiding the risk of a premature withdrawal of support. Multilateral coordination should help mitigate possible cross-border distortions during exit. For those countries, like Greece, where the fiscal position is weak and deteriorating further, and the external deficit is large, policies are needed to bolster confidence in the reduction of these imbalances and the sustainability of future development. However, some countries with excessive public sector debt levels need to start implementing a credible fiscal consolidation plan soon, to address market concerns about their fiscal sustainability. Greece is clearly in this group. There is a widespread fear among economists that small, relatively closed economies like Greece might find it particularly hard to return to previous rates of strong growth. Is there a way out? Recent rates of growth in Greece were very high and contained some one-time elements such as catching up with the euro-area average and historically low interest rates after joining the euro area. Looking forward, the aging of the population will also gradually slow output growth (as it will in trading partners too), so somewhat slower growth may be expected as a normal process. But that is not to say that Greece is without options to maximize growth and the development of its economy. Policies need to reduce imbalances that are now standing in the way of healthy and sustainable growth. Here, we are thinking of the large and persistent fiscal deficits and debt, the very high external current account deficits and deteriorating international investment position but also severe structural rigidities. Indeed, one of the major challenges for Greece to resume strong growth is to boost its competitiveness. To that end, Greece needs to undertake comprehensive structural reforms without delay. This will require the government and social partners to forge buy-in and stronger ownership of the reform agenda on three fronts. First, public administration should be streamlined and made more transparent. Second, product and service markets need to be further liberalized. And third, labor reforms should aim at lower unit labor costs and higher employment rates, possibly supported in tripartite agreements between employers, unions and the public sector. In short, Greece needs to pull together as a country, because competition from other countries will continue to be fierce. Let me also say at this point that we have been dismayed by the terrible wildfires that have raged through several parts of the country in recent weeks and that we commend very much the efforts of the firefighters and citizens of Greece to get the blazes under control.