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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

6

8

10

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 economiesEuropean Union excl.GermanyUnited 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 imbalancesAdjustment of nominal exchange rates to interest rate differentials

– emphasizes limiting currency speculation Rules-based managed floating may be practiced

unilaterally, regionally or (preferably) multilaterally

Thank you!gupvaibhav@gmail.com

(vaibhavgnnugupta.wordpress.com)(guptavaibhav.wordpress.com)