By David Lipton
First Deputy Managing Director, IMF
National Association for Business Economics
Washington, D.C.
March 8, 2016
Let me start by thanking the National Association for Business Economics and Tom Beers for inviting me to speak to you today.
At the recent G20 meeting in Shanghai, countries recognized the challenges facing the world economy, acknowledged that the recovery remains too weak and uneven, and recognized the downside risks. The meeting’s message provided some reassurance that countries stand ready to act if necessary. Today I want to make the case for action now.
The IMF’s latest reading of the global economy shows once again a weakening baseline. Moreover, risks have increased further, with volatile financial markets and low commodity prices creating fresh concerns about the health of the global economy.
These concerns are partly being fed by a perception that policymakers in many economies have run out of ammunition or lost the resolve to deploy it. For the sake of the global economy, it is imperative that advanced and developing countries dispel this dangerous notion by reviving the bold spirit of action and cooperation that characterized the early years of the recovery effort.
What is needed is a three-pronged approach through monetary and fiscal policies, as well as structural reforms to strengthen the baseline and guard against the risks. In addition, collective global action should play a supporting role in helping leverage individual country action and seeking to make the international monetary system more stable and hence supportive of growth.
1. Global Economic Outlook
What do we know so far?
The weak recovery is taking place in the context of unresolved legacies. In many parts of Europe, for instance, sovereign and private sector balance sheets remain highly leveraged and banks’ non-performing loans high. In the US, aging-related spending pressures and unfulfilled infrastructure needs diminish economic prospects. And in Japan, deflation is putting the recovery at risk.
At the same time, we are witnessing an emergence of new risks. The global economic slowdown is hurting bank balance sheets and financing conditions have tightened considerably. In emerging markets, excess capacity is being unwound through sharp declines in capital spending, while rising private debt, often denominated in foreign currency, is increasing risks to banks and sovereign balance sheets.
Concerns about the global outlook have weighed heavily on world financial markets. The decline in equity price indices in 2016 so far this year has averaged over 6 percent, implying a loss of global market capitalization of over US$ 6 trillion (or 8.5 percent of global GDP). This is roughly half the US$ 12.3 trillion loss incurred in the most acute phase of the global financial crisis. Some Asian markets, such as in China and Japan, have been particularly hard hit, with losses of over 20 percent since the beginning of the year. Meanwhile, emerging market currencies have weakened, while their sovereign credit spreads have continued to widen—in Latin America and Africa by over 300 basis points over the past year.
What may be most disconcerting is that the rise in global risk aversion is leading to a sharp retrenchment in global capital and trade flows. Last year, for example, emerging markets saw about $200 billion in net capital outflows, compared with $125 billion in net capital inflows in 2014. Trade flows meanwhile are being dragged down by weak export and import growth in large emerging markets such as China, as well as Russia and Brazil, which have been under considerable stress.
Furthermore, inflation has fallen to historical lows. Headline inflation in advanced economies in 2015, at 0.3 percent, was the lowest since the financial crisis, and in emerging markets core inflation remains well below central bank targets.
Why should we be concerned about these developments?
First, because protracted low global demand, and adverse feedback loops between the real economy and markets may generate additional deflationary pressures, putting us at risk of secular stagnation. Second, and equally relevant, is that labor supply and labor productivity growth have fallen considerably over the past decade, further aggravating these adverse dynamics.
While some aspects of the weak recovery are clear, we and many others in the policy world and in the markets are still debating and analyzing the role and the severity of several key transitions now underway:
How will China’s transition—with the deceleration in export oriented manufacturing activity and a pickup in sectors satisfying household demand —alter patterns of global trade and investment?
Will the transition to lower oil and commodity prices be a plus, as predicted, or a minus? The expected pickup in consumption in commodity importers has been weaker than expected, possibly reflecting continued deleveraging in some of these economies and a limited pass-through of price declines to consumers. At the same time, declining prices have reduced investment in extractive industries, pushed some producers to or beyond the edge of profitability, and weighed on growth prospects for commodity exporting countries.
Will geopolitical tensions, the related refugee crisis, and global epidemics further increase uncertainty and weigh on economic activity?
With all these uncertainties, even our latest baseline for global growth may no longer be applicable. In any case, the downside risks are clearly much more pronounced than before, and the case for more forceful and concerted policy action, has become more compelling.
2. Policy priorities
Let me turn to three realities of the present situation.
(i) The inescapable task of building resilience in emerging markets
Emerging markets face the task of reducing vulnerabilities where those have built up, and rebuilding resilience to deal with what may come.
Commodity exporters need to recognize that commodity prices may well be permanently lower. Fiscal buffers can help smooth the adjustment to lower commodity prices, but it will be important to plan for more resilient fiscal models by upgrading the efficiency of spending, strengthening fiscal institutions, and increasing non-commodity revenues.
Exchange rate flexibility, where feasible, should be used to cushion the impact of adverse shocks these countries are facing. Macro prudential tools should also be employed to mitigate risks, for instance by raising provisioning requirements on risky loans, and ensuring adequate safeguards are in place to cover banks’ foreign exchange exposures.
While many commodity importers have benefited from reduced inflation, monetary easing may be constrained by tighter external financing conditions, and in some cases, still high inflationary expectations. In many cases, these countries will be well served by strengthening public and private sector balance sheets by pressing ahead, for instance, with energy subsidy reforms and addressing corporate sector vulnerabilities.
(ii) Only positive sum policies will strengthen global growth
History has taught us a few things not to do. We need to avoid negative sum and zero sum economic policies. We know that restrictive policies on trade and capital flows are suboptimal and in the long run will make all countries worse off. And we know that competitive devaluations are a zero sum game, since they merely switch demand from one country to another.
To avoid this, countries should bolster aggregate demand, not just attract it from abroad. That does not mean abandoning accommodative monetary policy where inflation is too low and slack is too high, just because it has been pushed to extremes. Premature withdrawal of monetary support would not only undermine policy credibility, it would risk precipitating the very outcome we all wish to avoid. It would lower aggregate demand and increase the degree of slack in the global economy. As a result, the world could fall into deflation, whose vicious and self-reinforcing dynamics―in the form of higher real interest rates, falling nominal GDP, worsening public debt ratios, and rising unemployment―are notoriously difficult to combat once they become entrenched.
However, with negative policy rates taking hold in some countries, the scope for monetary policy to boost domestic demand further is limited, so its remaining potency may lie mainly in weakening currencies and attracting demand from the rest of the world in a way we should avoid.
Therefore, fiscal policy has to take a more prominent place in the policy mix. Here I am thinking of two aspects: first, making fiscal policies more growth-friendly, by changing the composition of budgets; second, countries with fiscal space should use it to boost infrastructure investment, for example. This is particularly the case in advanced economies given, as I said a moment ago, that the need to build resilience in emerging markets will in many cases require sustained adjustments that will likely prove pro-cyclical. So, the burden to lift growth falls more squarely on advanced economies.
Let me develop the case for thinking again about fiscal policy. We know that infrastructure investment can be particularly beneficial, not only because it is deeply needed in some advanced economies, but as it has positive spillover effects to the rest of the economy. Raising wages and tax cuts to promote spending can also be effective, particularly in countries that have current account surpluses. These need to be carefully designed and directed to those that are most likely to spend the proceeds. Measures to reduce debt bias in favor of equity through tax incentives can also be effective in promoting growth, while reducing leverage.
Of course, given the highly uncertain outlook we need to balance risks to public debt against those to growth. Such a risk management approach argues for a dynamic assessment of the potential use of fiscal policy: what will be the evolution of debt and GDP along the present trajectory, accounting for risks of further slowdown and stagnation versus what risks will be avoided and growth ensured with a more forceful approach. We see valuable potential for pre-empting risks and spurring growth at this critical stage of the global recovery. Combined with monetary accommodation supporting continued low interest rates as well as the beneficial impact on growth, the near term impact on debt would be manageable in some advanced economies, as well as selectively within the G-20.
(iii) Without structural reform long run growth prospects will be inadequate
In tandem with demand-side policies, we need to strengthen supply. Both advanced and emerging market economies have to redouble their efforts to raise potential output through structural reforms.
We know that structural reforms are often times politically difficult to implement and can take time to produce results. Moreover some reforms may idle resources for a transitional period and temporarily add to slack when that is undesirable. It is therefore important to prioritize reforms, while tailoring efforts to country circumstances.
With this in mind, we have found that lowering barriers to entry in product and services markets can be particularly effective as they deliver gains already in the short run. Furthermore, fiscal structural reforms in labor markets, such as reductions in labor tax wedges, can be particularly effective during periods of economic slack, as they usually entail some degree of fiscal stimulus.
More is also needed to foster innovation—by removing barriers to competition, cutting red tape, enhancing labor mobility, and investing more in education and research. This is key to raising entrepreneurship, productivity and potential output. For the same reason, technological sharing need to be encouraged by, for instance, removing barriers to foreign direct investment.
These are just some examples where we think progress is urgently needed. Other key areas include further integrating capital markets, reforming state owned enterprises, enhancing corporate governance and transparency, improving public investment efficiency and removing impediments to private investment.
A three-pronged approach
So, in sum, a three-pronged approach of monetary, fiscal, and structural policies is needed. Together with bank repair, where needed, and with proper targeting on infrastructure, this approach would create jobs, and likely reduce public debt-to-GDP ratios in the medium term by stimulating nominal GDP, and supporting credit and financial stability. By strengthening the global outlook, such coordinated action would speed up healing in the banking sector and forestall contingent liabilities for governments that loom in the face of inaction. It would also have substantial positive spillovers to vulnerable emerging economies, including commodity exporters that may not be able to participate directly in the fiscal expansion.
3. Need for a global approach to action
Acting collectively to leverage impact
In addition to country action, concerted action is required to go from zero sum to positive sum and avoid secular stagnation. I am thinking here, for instance, of promoting better trade integration through multilateral trade initiatives. The Trans-Pacific Partnership is a significant and welcome initiative but further trade integration is needed on a global basis. The challenge now is to establish a clear path forward for the multilateral trade system, post-Doha, to advance integration at a global level.
Collective efforts are also needed to further strengthen the global financial system. New financing mechanisms to address risks by commodity exporters and emerging markets that have strong fundamentals but are susceptible to shocks are needed. Broadening the web of central bank swap lines to include a wider range of well managed advanced and emerging markets could fill an important void, while reducing the need for emerging markets to hold excess reserves. This capital could be put to better use for much-needed investments in infrastructure, education and health.
At the IMF, we will need to revisit how we can help strengthen and broaden our global precautionary financing instruments so that they can work for all. We will also be taking another look at policies to address financial account risks, including macro-prudential and capital flow management measures. Moreover, the regulatory reform agenda needs to be completed, including strengthening regulation and supervision of financial activities outside the banking sector.
4. Conclusion
These are the key messages that I wanted to convey to you all today. Global economic recovery continues, but we are clearly at a delicate juncture, where risk of economic derailment has grown. Again, I think that at the recent G20 meetings in China there was broad recognition of these risks and priorities.
Now is the time to decisively support economic activity and put the global economy on a sounder footing. This requires some tough choices, with advanced economies in particular needing to step up to the plate through the three-pronged approach I have described, as well as measures to make the global financial system more efficient and resilient.
Winston Churchill said, “I never worry about action, but only inaction.” This is one of those moments where action—concerted action— is needed
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