Keynote speech, Chatham House City Series Conference: “Deleveraging the West: The Impact on Global Growth”
November 12, 2012
Royal Institute of International Affairs, Chatham House, London
As prepared for delivery
When the G20 Leaders met here in London in the Spring of 2009 and took decisions that turned back the financial panic at its high water mark, they had two simple, understandable objectives: i) to resolve the crisis; and ii) to make sure it doesn’t happen again. Unfortunately this agenda is still with us, despite the progress that has been made, because in fact “this time is different” and this crisis is proving very hard to end. Let me talk about why this is, and then take stock of how much has been done and how much remains to be done, and how we should go about it.
Progress has been hard in part because the measures called for under each agenda item to some extent undermine the other agenda item. The first objective, exiting the crisis requires strong enough demand to restore growth and jobs. At the same time, the second objective, ensuring sustainability and laying the foundation for a stronger global economy, requires deleveraging in many advanced economies, which will dampen demand, particularly if it happens simultaneously in many sectors in many countries. In particular:
- In many countries, households need to work off debt, in order to restore their financial position and be ready to cope with the uncertain financial future they now see before them. Doing so will leave them stronger and will support more sustainable spending down the road. Yet, as Keynes warned with his “paradox of thrift,” in the short-run repairing household balance sheets means higher saving, lower consumption, and other things equal an economic slowdown.
- Meanwhile banks need to deleverage, secure more stable funding sources, and build higher capital buffers in order to bolster their balance sheets and future resilience. Banks can and should reduce leverage by increasing the level of capital on their balance sheets—and they have been doing this. But in difficult market conditions banks also de-lever by reducing assets. If banks cut back assets by tightening their lending, credit to the private sector will decline, hurting those that are most dependent on bank lending (i.e., SMEs and households), which also undercuts recovery.
- In the face of those pressures on households and banks, the standard prescription for the public sector is to be countercyclical. We saw some countries respond counter-cyclically early in this crisis. Budget deficits and public debt rose as countries supported the economy both providing demand and in some cases relieving the private sector debt burden and financial stress via bank recapitalization. But the high public sector indebtedness in advanced economies, adds a constraint, and requires major, sustained consolidation over the medium term if countries are to restore the soundness of their finances, rebuild fiscal space, and lay a foundation for sustained long-term growth.
- Even with the long run budget constraint, if only one country or region were experiencing these phenomena amidst a vibrant global economy, we might expect external demand, perhaps bolstered by currency adjustment, to allow all three parties, households, banks, and public sectors, to de-lever at once without dire growth consequences. But in the current setting, where so many countries find themselves facing similar circumstances, what we have seen is that fiscal consolidation alongside private sector deleveraging, has dampened demand, and the near-term effect on activity has been larger than anticipated in several countries.
To resolve this conundrum, policymakers need the right pace of consolidation in the short term, effective and credible commitments over the medium term time frame, and a willingness to adjust as needed along the way. Deleveraging is necessary, but it should be implemented at a speed and in a way that minimizes the impact on growth.
Let me say a few words about how we see fiscal and financial policy issues.
As for fiscal policy,
- Where financing conditions permit, fiscal consolidation should be gradual and sustained, guided by structural targets. In case of large negative shocks or growth disappointments, the pace of consolidation should be smoothed in countries that can afford it.
- Fiscal adjustment must be anchored by concrete and ambitious medium-term consolidation plans. The adjustment should be of quality and as growth-friendly as possible. Robust fiscal frameworks would support the credibility of adjustment plans.
- Access to funding at reasonable costs is essential to allow European periphery economies to adjust, as well as facilitate balance sheet repair and support growth.
Turning to financial policy, it is crucial to strike a proper balance between the necessary strengthening of the resilience of the financial system and the need to cushion the impact of the adjustment on economic activity.
- Most importantly, the speed and sequencing of financial reform matter for growth. More stringent lending standards for example, will affect availability of credit. Therefore, it is crucial to strike a proper balance between the necessary strengthening of the financial system via robust implementation, while cushioning the impact of the adjustment on activity with policies polices geared towards supporting growth.
- So, to the extent possible, bank leverage should be cut by raising capital levels. Viable banks may need to be restructured, while non-viable institutions should be resolved, potentially including the bailing-in of creditors, respecting the seniority of investors.
- Where recapitalization of banks threatens public debt sustainability, direct equity injections from the ESM into banks will be instrumental in cutting adverse bank-sovereign loops.
- Meanwhile, central banks should continue providing liquidity support for banks and should stand ready to do more to support activity, if needed.
Fortunately, other parts of the policy agenda are mutually reinforcing, and should go forward steadfastly.
- Structural reforms to boost productivity and restore competitiveness in external deficit countries will also raise these economies’ growth potential. While structural policies will differ in their impacts on demand, our analysis shows that reforms of product and labor markets could make a positive contribution, even in the short to medium term.
- At the same time, decisive progress toward further integration in the euro area (banking union, fiscal union) would improve financial conditions and confidence, leading to higher growth, and in turn facilitating fiscal adjustment and other structural reforms.
How far along are we?
A lot of progress has been achieved, but a lot remains to be done in each of the following areas.
Considerable fiscal consolidation has already occurred, but many advanced economies still have a long way to go.
- Market concerns remain heightened about policy adjustment in periphery countries, which will still take many years to complete.
- At the moment, the U.S. lacks agreement on a concrete and ambitious medium-term fiscal consolidation plan, and Japan’s plan needs to be strengthened further despite the recent welcome approval of a timetable for doubling the consumption tax rate.
- In many countries, it is important to move early to reduce the growth of aging-related expenditures. While some measures have been enacted in Europe to reduce retirement costs, more can be done in all advanced economies, particularly to lower health-related spending.
As for bank deleveraging,
- The recapitalization exercise launched by the EBA in October 2011 has helped strengthen the capital position of many European banks up to now. However, looking forward, further deleveraging will be needed to high funding costs, weaker economic outlook, and new regulations.
- Further rebuilding capital levels is especially needed in periphery countries, where the sharp deteriorations of the outlook could test the adequacy of capital buffers. For this, external support may be instrumental to avoid an even deeper credit crunch.
Financial sector reform
Pre-crisis financial regulation and supervision failed to prevent the unhealthy buildup of leverage and mispricing and these shortcomings need to be addressed.
- The financial regulatory reform agenda has been advanced but implementation is still in early stages and it is hard to be confident that the global financial system is appreciably safer than before the crisis.
- Key areas of attention for further progress include cross-border resolution and supervision, the too-important-to-fail issue, consistent implementation of the reforms in the over-the-counter derivatives market, and closing critical information gaps.
Euro area architecture
- The firewall of the euro area has been strengthened with the activation of the ESM and the introduction of OMT. Uncertainty however, remains on the timely recourse to ESM and OMT for countries that need it.
- Critical decisions also remain to be taken about the future contours of EMU (including key elements of a banking union) and making the pan-European firewall more flexible—to help solidify bank balance sheets.
- A banking union, which I mentioned earlier, is indispensable for smooth functioning of integrated financial markets in EMU and should rest on: a single supervisory-regulatory framework; a pan euro area resolution mechanism with common backstops; and a pan euro area deposit guarantee scheme. Some building blocks are being developed, but the reform momentum must continue.
- Greater fiscal integration is also needed to backstop a banking union, help prevent idiosyncratic shocks from becoming systemic; and constrain imprudent policies.
What are the implications of these policies for growth?
Last summer, the global economy was like a bicycle that was slowing and beginning to wobble. In recent months, we have seen what may be the beginning of a stabilization. On one hand, data show that the global economic recovery remains weak, mainly because of the ongoing deleveraging across sectors in so many advanced countries. On the other hand, the decisions and steps that have already been taken are creating some positive momentum and have surely boosted market expectations that policies will be supportive of growth and consolidation. But the forces supporting recovery will only predominate if policymakers take action and remove the remaining uncertainties.
- In the euro area, implementation challenges remain large and future EMU architecture is still taking shape, with the roadmap toward a banking union and greater fiscal integration yet to be fully agreed.
- In the United States, if timely action is not taken to avoid the fiscal cliff and raise the debt ceiling, fiscal policy could tighten by over 4 percent of GDP in 2013, pushing the country into a recession with large international spillovers. The lack of a strong medium-term fiscal adjustment plan also weighs on business confidence.
- In Japan, political impasse over budget funding and the lack of a sufficiently strong medium-term fiscal adjustment plan (notwithstanding the recent approval of a timetable for consumption tax increase) also contribute to uncertainty.
Global output is projected to expand only modestly, by 3.3 percent in 2012 and 3.6 percent in 2013. Even that is however predicated on two critical assumptions. The first is that policies are implemented decisively in the euro area to gradually restore confidence and ease financial conditions. The second assumption is that U.S. policy makers will effectively avoid the fiscal cliff and raise the debt ceiling. Absent such actions, the world could slide into another downturn, with deep recession in the euro area periphery, and contraction or stagnation in the core and other advanced economies. This requires very careful policy steering.
To conclude, a few words on what this all means for the rest of the world, the role of the Fund, and the importance of global collaboration.
At the outset, I mentioned that no country could count on global growth to relieve their deleveraging dilemma. But that does not mean that global cooperation can play no role. The international community cannot afford to ignore any margin that could help boost global growth and reduce the risk of prolonged crisis. In fact, collective action can help and is sorely needed to support global demand, ensure a healthier global allocation of this demand and to avoid the re-emergence of vulnerabilities in the future. Everyone needs to do their part.
- Deficit economies need to continue their fiscal consolidation and private sector deleveraging in a sustainable way, while implementing structural reforms to improve competitiveness, including in euro area periphery.
- At the same time, global growth needs to be supported by stronger demand from surplus economies. That demand can be promoted by boosting investment in advanced surplus economies, broadening social safety nets in key emerging economies and, where appropriate, cutting back on reserve accumulation and allowing more exchange rate flexibility.
- Importantly, these adjustments would be in the individual interests of countries concerned (surplus and deficit economies alike) while effectively lowering global imbalances and related vulnerabilities.
We at the IMF can also contribute to the process by further strengthening our surveillance. We have launched “spillover reports” for the five most systemic economies—China, the Euro area, Japan, the United Kingdom and the United States—to assess the impact of each country/region policies on the rest of the world. In addition, the IMF Board approved in July a new Integrated Surveillance Decision, which aims to better integrate bilateral and multilateral surveillance.
Collective action is also needed to make the global financial system safer. Risks related to delayed or inconsistent implementation across economies could create opportunities for regulatory arbitrage, gaps, or conflicts in regulation. So could differences in approach, as are emerging in the Volcker, Vickers and Liikanen proposals to deal with the structure of banks. Collective and harmonized action is needed to avoid undermining financial stability and ultimately harming members’ growth objectives.
A spirit of collective action is no less important now then when the G-20 met here in London in April of 2009. Indeed the commitment those twenty countries made to cooperate to achieve strong, sustained and balanced growth, remains key to putting an end to this crisis and laying a foundation for more robust global economy and financial system in the future.