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TRADE AND DEVELOPMENT REPORT 2011:
Post-Crisis Policy Challenges
in the World EconomyVaibhav Gupta
MIB, DoC, DSE, DU
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Main messages Economic recovery is losing steam,
particularly in advanced economies
A shift from fiscal stimulus towards fiscal tightening at this time is self-defeating – fiscal space is a largely endogenous variable
Comprehensive financial reform is needed more than ever – unambitious efforts initiated after the crisis have failed
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Global economic recovery is slowing down, with strong downside risks
2.6
8.6
1.7
0.3
5.4 5.4
-2.1
-3.6
-6.7
2.5
3.9
2.5
4.1
7.4
3.1
1.8
4.4
6.3
8.0
4.0
-8
-6
-4
-2
0
2
4
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World Developed countries South-East Europe and CIS Developing countries
2007 2008 2009 2010 2011 (forecast)
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“Two-speed” recovery pattern continues
Note: Linear trends correspond to 2002–2007.
Real GDP at market prices, 2002–2011 (Index numbers, 2002 = 100)
Fiscal Aspects of the Financial Crisis Governments’ Fiscal Policy more viewed as a
problem than solution- 2009. Policy driven fiscal stimulus packages and
affect on fiscal balances and public debt through several channels:Reduced tax RevenuesIncreasing Social Expenditure(Developed
Economies)Abrupt fall in commodity prices(Exports Economies)Currency depreciation and high interest rates
spreadsGovernment bailing out ailing institutions(Developed)
which converted former private debt to public debt.
So , the CRISIS clearly was not the outcome of excessive public expenditure on public sector deficits; rather it was the cause of fiscal deficits and / or high public-debt-to-GDP ratios.
Fiscal Tightening from Fiscal Stimulus
Some economies have already started this, some are planning, to gain confidence of financial markets.
Although it is clear that crisis was the result of financial market failure, little has been learned about placing too much confidence in the judgment of financial actors including “rating agencies”.
Worst seems to be over– but policymakers and large body of public opinion are again putting trust in the same agencies
Fiscal Tightening from Fiscal Stimulus
Fiscal tightening appears to be premature in any case in many countries, where private demand has not yet recovered on a self sustaining basis.
Could be self –defeating Weakens the recoveryHampers improvement in public revenuesIncreases fiscal costs related to recession and
bailouts.Hence, by hindering growth , such a policy
would fail to achieve fiscal consolidation.
Lawson Doctrine Contradiction
Primary deficits caused by discretionary fiscal policies were a much smaller contribution to higher debt ratios than the slower (or negative ) GDP growth and banking crisis.
Therefore any policy that seeks to reduce public debt should avoid curbing GDP growth; without growth, any fiscal consolidation is highly unlikely to succeed .
These findings challenge the influential “Lawson Doctrine”, that financial crises are caused by excessive public sector borrowing, and that private sector debt never poses a problem because it is the outcome of optimal saving and investment decisions
Talking of US
US need to invest: Investment should come in Job Skills and Infrastructure. Makes the scene more competitive.
Declining Social Mobility, lacking in public finance in preschool and teachers’ union.
They have been long demonizing governments. Need to stop.
Reagen himself once said, “ Government does not create problem, Government is the problem”.
Most dynamic economies of the world are promoting market reforms India, China, Brazil, why not US.
and the world
Age of global dissatisfaction Partying hard is fun, but it is often followed by
even harder hangover. Special case : Argentina(2001 crisis: $100B
default)2002-2003: 5 presidents in 2 weeksIncumbent Cristina re-elected.Huge subsidiariesDoctored numbers of InflationDevalued currency
Greece can soon follow in Argentina’s footsteps
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Developing countries cannot lead the global recovery
They have insufficient weight, relatively low absorptive capacity and cannot issue international currencies
Most large emerging economies face demanding domestic adjustment needs which require significant domestic resources
They also face significant external risks because of continued economic weakness in developed economies and the lack of significant reforms in international financial markets – they are vulnerable to decline in trade volume and sharply fluctuating primary commodity prices
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Global imbalances remain a risk to sustained economic recovery
Post-crisis unwinding has been short-lived
Country-specific evolution depends on whether domestic demand (BRIC) or net exports (Germany, Japan) drive recovery
Exchange-rate movements have sometimes enlarged imbalances -1500
-1000
-500
0
500
1000
1500
2005 2006 2007 2008 2009 2010 2011
Germany
Japan
Fuel-exporting countries
China
Other developing andtransition economies
European Union excl.Germany
United States
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Premature fiscal tighteningis counterproductive
The best strategy for reducing public debt ratios is to promote growth and maintain low interest rates
Fiscal space is a largely endogenous variable Fiscal retrenchment is likely to be self defeating, as it
affects GDP growth and reduces fiscal revenues ‘Functional finance’: changing the composition of
revenues and expenditure can further extent fiscal stimulus and maximize multiplier effects
Fiscal expansion tends to be most effective if higher spending takes precedence over tax cuts spending targets infrastructure and social transfers tax cuts target lower income groups
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Developing countries’ post crisis increase in public debt was relatively small
Ratio of public debt to GDP, selected income groups, 1970–2010 (Median, in per cent)
IMF-sponsored programmes systematically underestimate their negative impact on GDP growth and
fiscal balances
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Proactive incomes policy is a key element of growth-friendly macroeconomic policies
Wages should grow in line with productivity growth (plus an inflation target) to pave the way for a steady expansion of domestic demand as a basis for expanding investment while containing cost-push inflation risks
An individual country may strengthen its international competitiveness through wage compression – but a simultaneous pursuit of this strategy by many countries causes deflationary pressure
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Financial deregulation was one of the main factors leading to the global crisis Financial deregulation:
Led to a large, opaque and undercapitalized “shadow banking system”
Concentrated the traditional banking segment in a few “too big to fail” (and “too powerful to regulate”) institutions
Reduced diversity of financial system and increased systemic risk
While government regulation has weakened, its lender-of-last-resort support to the financial system has increased, and even extends to the shadow banking system
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Financial reform agenda remains uncompleted
Strong re-regulation is urgently needed. It must:
Be tighter with the “too-big-to-fail” institutionsCover the “shadow banking” and avoid regulatory arbitrageIncorporate a macro-prudential dimension, with anti-cyclical
capital requirements and capital controls
In addition, the financial system must be restructured
Re-regulation alone will not orient credit to real investment or make it accessible to small and medium-sized firms
Banking restructuring should aim at more diverse financial systems, with a bigger role for public and cooperative institutions
Giant institutions must be sized downThe activities of commercial and investment banking should
be clearly separated, in order to reduce the risk of contagion
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Commodity prices have recovered amidst high volatility
Monthly evolution of selected commodity prices, January 2002–May 2011
(Price indices, 2000 = 100)
Many explanations are available for recent commodity price movements Changes in fundamentals
Demand: rapid income growth in emerging economies (intensity of use; dietary habits); biofuels
Supply: increased production cost; earlier low rates of investment
Increased participation of financial investors who treat commodities as an asset classIndex investors (passive, long positions in range of
commodities)Money managers (active, short and long positions
in specific or range of commodities)
Financial investment continues to riseAUM/global GDP ratio doubled in 2005–07 and rose 4-fold in
2008–10Commodity investment, assets under management, 2005–2011 ($bn)
0
50
100
150
200
250
300
350
400
450
2005 2006 2007 2008 2009 2010-1stquarter
2010-2ndquarter
2010-3rdquarter
2010-4thquarter
2011-1stquarter
2011-2ndquarter
Index investment Other investment
Why does financialization matter? Financialization risks impairing
appropriate functioning of commodity exchanges
Uncertainty (price trends disconnected from fundamentals; high volatility) deters investment and supply growth
Financialized commodity markets may cause pre-mature macroeconomic tightening and declining demand
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Policy recommendations to improve commodity market functioning
Increase transparency in physical and derivatives markets
Arrange for internationally coordinated tighter regulation of financial investors
Consider occasional direct intervention to avert price collapses and deflate price bubbles
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Exchange rates have become disconnected from macroeconomic fundamentals
Real effective exchange rate, selected countries, January 2000–May 2011(Index numbers, 2005 = 100, CPI based)
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Leaving currencies entirely to market forces entails considerable risks for both the global financial system and the multilateral trading system Instead, a rules-based managed floating can deliver
Sufficient stability of real exchange rate to enhance international trade and support fixed investment in the tradable sector
Sufficient flexibility of exchange rate to accommodate differences in cross-country developments of unit labour costs or inflation
Such a system could be based in two approaches:
Adjustment of nominal exchange rates to inflation differentials – emphasizes need to avoid trade imbalances
Adjustment of nominal exchange rates to interest rate differentials – emphasizes limiting currency speculation
Rules-based managed floating may be practiced unilaterally, regionally or (preferably) multilaterally
