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Given the scale of the financial distress, a protracted process of deleveraging and restructuring is unavoidable. In short, it has become obvious that the financial sector in the United States and elsewhere is in the midst of a historic reordering that will alter market and institutional structures. At this point, anticipating the outcome is highly speculative, but a return to rapid credit growth appears to be a long way off.
The Global Outlook: A Gradual Recovery
Given these challenges, one could reasonably expect that we would be pessimistic about the global outlook and the scope for recovery. For sure, the further tightening of financial conditions in light of recent events will have some negative implications for global economic activity, not least because it is likely to diminish the scope for a rapid recovery of credit creation. However, several factors provide a degree of reassurance that a severe downturn can be avoided.
First, as noted earlier, oil prices have come down sharply in recent weeks. This should reverse a significant portion of the adverse terms-of-trade effects arising from the more than 60 percent increase in oil prices during 2008 and the erosion in purchasing power and real wages being felt by most advanced economies. In the United States, if oil prices remain at current levels, the implied boost to real disposable income will rival the value of the income tax rebates. Indeed, in our projections, we expect a modest rebound in consumption in both the United States and euro area over the course of 2009.
Second, it is plausible to anticipate that the U.S. housing market will find a bottom in 2009. Already, the inventory overhang is diminishing, while affordability measures are returning to levels that appear much more consistent with past experience. The recent US Treasury support for the GSEs was intended to allow these agencies to expand their balance sheets through 2009, while direct Treasury purchases of the GSEs mortgages securities should help to keep mortgage costs down. As a consequence, we expect residential investment to find a floor. This will reduce the considerable drag-amounting to ¾ percent of GDP over the past two years-of the housing sector on economic activity. At the same time, the eventual stabilization of house prices should help restrain mortgage-related losses and contribute to restoring financial institutions to health.
Third, while financial conditions have tightened in both the United States and in Europe, it does not mean that an economic recovery is thereby excluded. In the United States, for example, corporate finances in general remain relatively healthy. Productivity gains have helped to sustain profits. Time-limited investment tax credits will encourage corporate capital expenditures in the coming months. Moreover, recent IMF analysis suggests that a slowdown in credit intermediation does not necessarily impede economic recovery.
Finally, relatively robust emerging market growth, led by strong domestic demand in several of these economies, has helped boost U.S. exports. Going forward, we expect net exports to support growth in the United States as the effects of the earlier declines in the value of the dollar take hold with a lag. Of course, the dollar has strengthened in recent months. Nonetheless, Fund analysis indicates that the US currency is still somewhat on the strong side relative to medium-term fundamentals. At the same time, the limited adjustment in the currencies of several economies with pegged exchange rate regimes and large current account surpluses has not been adequately supportive of global adjustment while preserving growth.
Against this background, we project global growth to come in around 4 percent in 2008 and somewhat under 4 percent in 2009 on an annual average basis. However, the dynamics are portrayed more clearly when growth rates are examined on a fourth quarter over fourth quarter basis. Using this metric, global growth would slow from 4¾ percent in 2007 to near 3 percent in 2008 before recovering to around four percent in 2009.
The challenges facing the global economy and financial system are clear, and downside risks to the outlook have increased notably. The overarching risk revolves around the feedback loop between continuing strains in financial markets and slowing economic activity. Despite aggressive policy actions aimed at alleviating liquidity strains and preventing systemic events, markets remain under severe stress. There is a clear risk that financial conditions could deteriorate further and more aggressive attempts by financial institutions to deleverage balance sheets could imply severe problems of credit availability. There also is a clear risk that emerging market economies, that have so far been relatively insulated from the financial turmoil, could be subject to large reversals of capital flows, with serious implications for economic activity.
But the critical issue is how we deal with these challenges and risks. The remainder of my remarks will focus on policies to address the challenges that I have just outlined. Let me emphasize, however, that the confluence of shocks has made policymaking more difficult and resolving the current turmoil on a durable basis will require creative solutions across a range of policy instruments.
Policies: Finding our Footing
Monetary and budget policies are critical, but these provide only a first and second line of defense against the deleterious impact of a financial crisis. The use of public funds to safeguard the financial system that we have labelled the third line of defense may become imperative. It is appropriate that this option be considered in a broad, coherent and proactive manner.
The first line of defense lies with monetary authorities, both in terms of liquidity provision to the financial sector and in setting policy interest rates. Monetary policy can play a critical role in helping individual economies find their footing, but the scope for policy easing ultimately will depend on each country’s cyclical position.
In advanced economies, we expect the slowdown in activity to help contain inflation going forward. Weakening domestic demand, increasing output gaps and sluggish labor markets should limit pressures on underlying inflation. Moreover, the recent sharp decline in oil prices should help alleviate short-term pressures on headline inflation. Hence, we see monetary policy as broadly appropriate at this time across most advanced economies. Outside the United States, given the downside risks to growth and the ongoing strains of the financial crisis, there could be scope to lower rates in the euro area and the United Kingdom if activity slows and inflation moderates as we expect.
In many emerging economies, with the shifting balance of risks between inflation and growth, there is greater scope for countries with moderating inflation and policy credibility to take a wait and see approach. That said, serious inflation risks persist in countries where growth remains strong and where, given lags in pass-through, food and energy price increases are still in the pipeline. For these countries, monetary policy should have a tightening bias.
Fiscal policy-the second line of defense-has played a role in the United States already and automatic stabilizers are appropriately providing support as growth slows in other advanced economies. In many emerging economies, budgetary policy will have to play a supportive role to monetary policy in helping to bring down inflation.
Fiscal policy is broadly appropriate across the advanced economies, but room for maneuver is limited given the need for medium-term fiscal consolidation in many of these countries. However, support for the financial sector inevitably will involve budgetary costs that must be taken into account in considering policy alternatives.
In emerging economies where inflation remains a problem, fiscal policy should play a more supportive role in restraining demand growth and easing inflation pressures. In particular, greater restraint on spending growth would be helpful as a complement to tighter monetary policy.
Direct intervention-the third line of defense-has and must be considered so long as there are systemic risks to the financial system. And we must keep in mind that, although the situation is far from ideal, there are also a variety of other policy options that can be used, including further direct support to housing markets.
In this regard, the Fund welcomed the recent actions by the U.S. authorities to support Fannie Mae and Freddie Mac. These actions represented a significant step-and a key lesson from past financial crises (notably in Japan and Scandinavia) is that direct public intervention should be of a large scale, as piecemeal efforts of this nature often are not effective.
The measures taken should bolster the GSE’s balance sheets and stabilize the funding of mortgages. They should also substantially reduce downside risks to the U.S. growth outlook related to shortages of housing finance, although by themselves are unlikely to turn around the U.S. housing market. Over the longer term, a deep restructuring of the GSEs remains essential to restore market discipline, minimize fiscal costs, and limit systemic risks for the future. Ultimately the conflict of private ownership and public policy objectives within the GSEs’ former business model must be resolved.
Even after the dramatic events of this past week, it would not be surprising if some additional financial institutions will not survive in their present form. Nor will market structures or instruments remain unaltered. In fact, it seems clear that the overall size of the financial sector will shrink in many markets. There is no inevitability to any over-expanding sector, at least not in relative terms. In these circumstances, the key is to strike the right balance between limiting moral hazard and safeguarding the financial system’s effectiveness. This task is by no means an easy one, but the consequences-either in the short- or longer-term-would be severe if the pendulum swings too far in either direction.
Notwithstanding the recent use of innovative and unconventional measures, more may be needed. The implication is that a more systematic approach may be required to deal with such basic issues as the disposition of distressed assets, the degree of protection offered to depositors, and the scale and scope of liquidity support that is offered to institutions and markets.
The fact of globalized financial markets means that policy interventions need to be globally coherent and consistent in order to be effective. Although I am cautiously optimistic that the global economy will continue to be resilient in the face of significant headwinds, this does not imply that the policy challenges and tradeoffs are not daunting. At the IMF, we stand ready to assist our members in confronting these exceptional challenges, in understanding the critical policy tradeoffs, and in navigating successfully through the turbulent waters ahead.
Speech by First Deputy Managing Director John Lipsky, International Monetary Fund, At the Center for Strategic and International Studies Washington D.C., September 18, 2008
Source: IMF