Author: Uri Dadush
Originally published by the Carnegie Endowment for International Peace
The Great Financial Crisis is far from over, but a stimulus-triggered recovery is now taking hold. The contours of the post-crisis economy are already emerging—from the sharply rising public debt levels in most industrial countries to the severely impaired balance sheets of banks and households in countries at the epicenter of the banking disaster, including the United States, the UK, and several smaller European countries. At the same time, China, India, Brazil, and many other emerging markets, which were badly affected at first, demonstrated remarkable resilience in the face of the crisis and have confirmed both their attractiveness as long-term investment destinations and their growing economic and political clout.
The upcoming G20 summit, which will bring together leaders of the largest developing and industrial economies, was born of the crisis, and is the best available option to deal with the post-crisis world. Although the G20 assembly is bigger than necessary, it is nevertheless a big improvement on the G8, which is not representative of today’s global economy, and on any UN-style universal assemblies, which are far too large to be effective.
In an effort to lower expectations, the stated purpose of the upcoming summit is not to break new ground but to verify progress on previous commitments. Nevertheless, the G20 leaders in Pittsburgh will have to confront four major challenges: they will have to evaluate and shape the sustainability of the recovery; ensure that a relapse into crisis is avoided as government support is withdrawn; draw lessons from this crisis in order to avoid future ones; and finally, set a future agenda.
Challenge One: What Kind of Recovery?
It is becoming increasingly evident that the global economy stabilized and then began to recover early in the second quarter of this year. The recovery first took hold in China (where fundamentals and stimulus were the strongest), spread to Japan and the rest of Asia, and, in a relatively autonomous fashion, began a few months later in Germany, France, the rest of Europe, and lastly in the United States (where fundamentals were the weakest and the crisis originated).
Data on the production and trade of goods best reflects the remarkable amplitude and global nature of this cycle.
At first, as panic spread and credit tightened, households around the world deferred any purchases that could be delayed, from houses to cars to TV sets, and firms furiously slashed inventories and capital spending. With crucial support from government measures, the cycle is now reversing, and the speed of the short-term production and trade recovery may be just as surprising as its downturn was. Growing consumer spending, rising housing prices, stabilizing inventories, and the reemergence of capital goods orders provide crucial signs that demand is returning.
But even if a V-shaped recovery materializes this quarter and the next, the recovery is likely to remain vulnerable to many possible shocks at least over the next year or two: it will take time to rebuild the balance sheets of banks and to repair those of households in countries where consumers were most overstretched and the housing bubble was most dramatic. Similarly, it will take time for certain countries to reduce their unsustainable current account deficits and surpluses. Final demand and the health of financial institutions continue to rely on government support measures, and because of trade and financial linkages, this is true throughout the world—even in countries at the margin of the crisis.
Challenge Two: When to Withdraw Stimulus
Government support in the wake of the crisis took three forms: fiscal, monetary, and financial institution rescue. Withdrawal of fiscal stimulus is the least urgent and most straightforward of the three. It is least urgent because the size of the discretionary stimuli—typically 2 percent of GDP this year and next—accounts for only a small part of the crisis-driven surge in government deficits and debt levels, which are mainly due to falling tax revenues and bank rescue plans. It is most straightforward because most of the fiscal stimulus programs are temporary by design and will end by the end of next year. Attempts to claw back discretionary spending are likely to be impractical, and they may, contrary to their goal, actually increase fiscal deficits if confidence falls and the recession lengthens as a result.
Although monetary policy is not technically on the agenda of G20 leaders (since central banks are independent), it has once again proven to be by far the most powerful weapon for counter-cyclical policy, and thus cannot be ignored. Withdrawal of monetary stimulus is not urgent, since core inflation has yet to rise anywhere and housing and asset prices, whose continued recovery is needed to rebuild balance sheets, remain very low compared to the pre-crisis period. However, given the long and variable lags in monetary policy’s effect on the economy, the large tightening needed for policy to return to neutral cannot be postponed indefinitely. Otherwise, serious inflation risk will emerge as the economy recovers. On the other hand, tightening too early—when unemployment is still rising sharply—could seriously hurt confidence and devastate the most interest-sensitive sectors, which are also currently the most depressed. In addition, it could hurt banks whose balance sheets are slowly recovering as they profit from a steep yield curve (paying little to short-term depositors but charging high interest rates for medium- and long-term loans).
Some of the stimulus will automatically disappear as banks make less use of central bank liquidity facilities, but most tightening measures, including sales of securities and hikes in policy rates, will require explicit decisions. Tighter monetary policy may cause a sharp rise in long-term interest rates and stress the recovery of economies with large budget deficits. As a result, central banks in those countries will face the greatest political pressure to delay tightening. The right moment for tightening will thus vary across countries, and is a call best left to independent central bankers. But the G20 leaders can insist on caution and coordination in the timelines to minimize potential effects on confidence, including those associated with large exchange rate shifts.
Withdrawal of measures in support of the banks is the most delicate and complicated issue, and rash action could end up being extraordinarily expensive if it leads to relapse. Authorities cannot withdraw their bank borrowing and increased deposit guarantees until they are entirely confident that the system is healthy again. Yet it must be done sooner rather than later, not only because trillions of dollars of contingent liabilities ultimately rest on taxpayers and government rescue massively distorts competition, but also because such measures build moral hazard into the system. Given the many large banks that have been ravaged by the crisis, safely withdrawing support may take years and could be delayed by any number of possible shocks, such as souring commercial real estate loans in the United States.
Challenge Three: How to Avoid the Same Crisis in the Future
The Great Financial Crisis holds three main lessons for policy makers: better risk management and financial sector regulatory oversight must be introduced, macroeconomic policies must go beyond inflation and growth targets and must also take into account housing and financial bubbles, and a well-resourced lender of last resort in the shape of the International Monetary Fund must exist. Only on the last of these items have the G20 countries made serious progress, though the legitimacy and governance issues raised against the Fund by its developing country clients remain largely unaddressed; IMF quotas and voting power will be on the agenda in Pittsburgh.
While the issue of executive compensation has drawn much attention, it is not clear what the G20 can or should do in this area beyond highlighting the need for long-term performance incentives. On the other hand, the case for coordinating financial regulation regimes, including capital requirements, in highly integrated international capital markets is very strong. This must be done not only to avoid regulatory arbitrage, but also to protect countries against banking crises that have huge effects on them but arise where they have no jurisdiction.
The inclusion of developing countries in the Financial Sector Board, which will advise these reforms, is a step in the right direction but—given the profoundly invasive nature of financial regulation, the information advantage of local authorities, and the considerable political influence of the financial industry—country preferences will almost certainly determine regulations in the end. As a result, the G20, through the IMF and the Financial Sector Board, can support analysis and diagnostics, nudge countries in the right direction, and provide a political umbrella for change. However, expectations beyond that are unrealistic; the ball remains in the national authorities’ court.
The best that can be expected from this process is that banks will police themselves, at least as long as memories of the crisis are fresh, and that some countries will succeed in tightening regulations, perhaps drawing on lessons from the tougher risk management approaches and relatively small banking losses in Spain, Italy, Japan, India, and Brazil. In other countries, however, many current weaknesses are likely to persist, and current government rescue efforts may aggravate the inclination to take risks, especially by banks deeming themselves “too big to fail.”
Asking central banks to take on a more active role in preventing future crises is an easy lesson to draw but a difficult one to act on without incurring large consequences. For example, giving central banks regulatory oversight of the financial system, as proposed by the U.S. administration to Congress, or expecting monetary policy to address asset bubbles, would inevitably draw them deeper into the political arena and further call their independent status into question.
Challenge Four: What is the Long-term Agenda for the G20?
To dispel the uncertainty surrounding the G20’s role as a forum and its relation to the G8, leaders should recognize it as the new forum on economic issues. As it grows in importance, the issue of its membership, particularly the under-representation of Africa and the over-representation of Europe, will need to be confronted, but it is not an immediate problem.
The crisis will remain at the forefront for now, but in future meetings, G20 leaders should turn to some vital, longer-term issues of international coordination that have consistently eluded world leaders operating in other less representative (e.g., the G8) or ineffectual (e.g., the UN) forums.
The following are three important examples which go beyond the current crisis. First, the leaders must adopt a set of principles on climate change and, as the Center for Global Development has proposed recently, determine a division of labor among the various agencies; hopefully this would build on progress made at the universal Copenhagen meeting. Second, as set out in a Carnegie policy brief published this week, they must initiate a process for WTO reform in order to make the negotiation process leaner, as well as more flexible and responsive to the needs of groups of countries. Third, the assembly should develop a framework to govern international migration and remittances, including the fair treatment of migrants in both sending and receiving countries, competition in the money transfer industry, and principles for negotiating worker mobility agreements at the regional and multilateral level.
If, as an outcome of the crisis, the G20 can begin to tackle these and other crucial issues of international coordination—on which progress has been elusive in other contexts—then the Chinese saying, “Out of crisis comes opportunity” will ring true.
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