Policy Responses to the Global Economic Crisis
Losses of this magnitude have significant wealth effects on consumption and savings. Indeed, the current global crisis is not limited to the financial sector and is now affecting real economic sectors. Industrial production in the first quarter of 2009 fell 23 percent in Eastern Europe, 62 percent in Japan, and 42 percent in Germany, at seasonally adjusted, annualized rates (SAAR). Globally, industrial production declined by 28 percent in the first quarter following a 22 percent fall in the final quarter of 2008, before easing to a pace of contraction of 19 percent in April (on a rolling quarterly, SAAR basis). During the first quarter of 2009, for East Asian economies, such as China and Japan, exports declined by 50 percent or more, and 43 percent in Korea. This year we will encounter the largest trade contraction since 1929. Commentators, papers, and reports3 have compared the nature and intensity of the present global recession with past episodes such as the Great Depression of the 1930s and the Japanese Recession of the 1990s:
- Like the Great Depression, the current crisis originated from the U.S. financial system. The size and interconnectivity of the U.S. economy facilitated the contagion of the crisis, following the bankruptcy of Lehman Brothers.
- Unlike the bank runs of the 1930s, this financial crisis involved complex financial instruments, harder to re-price, and globally disseminated in the balance sheets of a variety of financial institutions. This created new channels for rapid transmission. The boom was bound to turn to bust. And in mid-2007 this process began with the crisis unfolding in the subprime mortgage market in the U.S. The drop in the value of the off-balance sheet assets pushed many financial institutions into insolvency. Even worse, the financial innovations of the past decade—many of which had been sold on the promise that they would diversify and minimize risk—turned out to be the transmission mechanism for instability. The (relatively small) subprime mortgage crisis thus became a full-fledged global financial crisis.
- The pre-crisis global build-up of capacity in the real economy, specifically in the housing and manufacturing sectors, will result in excess capacity even after the global economy starts recovering. As households respond to the sudden loss of wealth, by reducing consumption, and the deleveraging of the financial sector reduces the funds available for investment, aggregate demand will decline. The capacity utilization rate of the manufacturing sector was 69.1 percent in the U.S. in March, 2009, the lowest since statistics began to be collected in 1967. In Germany it was 72 percent and in Japan 65 percent—all record lows for recent decades. Once excess capacity appears, the economy gets trapped in a vicious cycle, it becomes hard for firms to find viable investment opportunities, investment demand declines, and some firms are forced into bankruptcy. This, in turn, threatens the income and job security of workers, who then try to reduce spending, and so on.
- Finally, small, open developing economies typically use currency depreciation and the resulting export-driven growth to come out of a crisis. However, this is impossible in a globally depressed environment. Policy instruments in both developed and developing countries are likely to be less effective without coordination. And unless we deal with the excess capacity, we will all experience a protracted crisis.
Beginning in mid-March 2009 amid signs of a recovery in the United States, and confidence that no further major financial sector collapses were in the works, markets began to strengthen and capital flows to developing countries picked up. Equity flows to developing countries in the first two months of the second quarter exceeded the total for the first quarter, while bank lending and bond issuance both accelerated. Partly as a result, returns on emerging market assets surged. Since mid-March developing country markets are up 33 percent as compared with only 19 percent for high-income countries. Nevertheless, markets remain well below pre-crisis highs. Equity markets, often considered an early indicator of recovery, are pointing firmly to a pick-up, especially in the United States and in a number of developing East Asian economies. These developments are consistent with a turning point in the crisis. The prognosis for Europe and Japan, however, is less upbeat. Although surveys show that consumer and business confidence are improving, economic statistics continue to deteriorate.
Much uncertainty remains. Global output is now expected to shrink by 2.9 percent in 2009, the first contraction since World War II; world trade is likely to contract by 10 percent in 2009; and unemployment will soar in industrial countries, as high-income countries reel from an unprecedented asset market bust.
The policy responses
In contrast to the Great Depression, rapid and comprehensive monetary authority interventions helped to avert a global financial collapse at the end of 2008. The broad nature and size of interventions—in most cases expanding the public sector balance sheet, has been unprecedented in modern times. The size of interventions in the financial sectors during 2008–2009 was large, totaling on average for advanced economies about 50 percent of their purchasing power parity (PPP) weighted GDPs. Yet despite capital injections, special liquidity facilities, monetary easing, provision of guarantees, stress-testing, and the announcement of financial restructuring plans, the status of financial sector balance sheet repair is still uncertain.
In addition to support to the financial sector, the global economy is facing an unprecedented problem of coordination. Addressing the crisis requires a broad, decisive, and globally coordinated policy action in the form of a fiscal stimulus that goes beyond national boundaries. In most cases,G20 countries have adopted—in addition to support of their financial sectors—fiscal stimulus measures that reached 0.5 percent of their average GDP in 2008, 2 percent in 2009 and 1.5 percent in 2010. A particular emphasis was placed on discretionary spending on infrastructure, given its higher multiplier effects.
Conversely, there is much more certainty about the damage done to the development efforts and prospects of developing countries, where the room for policy maneuvers is smaller. The GDP growth rate in developing countries in 2009 is forecast to drop to 1.2 percent, a sharp decline from 8.1 percent in 2007 and 5.9 percent in 2008. This decline alone will cause more than 30 million workers to lose their jobs according to the United Nations International Labor Organization and, of course, poverty will rise. In fact, if we do nothing, this situation could turn into the worst case scenario. With the crisis taking its toll, it is estimated that total foreign direct investment (FDI) and private capital flows will decline from $1.2 trillion in 2007 to $363 billion this year. As a result of declining exports and reduced capital inflows, developing countries may encounter a financing gap of between $352 billion and $635 billion. Moreover, remittances are likely to fall by 7.3 percent in 2009 to a level of $305 billion. Estimates for 2009 suggest that lower economic growth rates would trap 53 million more people in poverty—those living on less than $1.25 a day—than was expected prior to the crisis. If the $2 a day poverty line is used, 65 million will stay trapped. If the recession is protracted, more and more people will fail to get out of poverty.
Contrary to the predominant view during 2003–2007, when some saw a “decoupling” of business cycles between industrialized and emerging economies, the post-Lehman, end-2008 acute turmoil still produced contagion effects from developed to all developing countries. The short-term consequences of the global financial crisis have been extensive, including: the sudden halting of financial flows (from markets); the limited room for additional concessional aid by donors; the fall in remittances due to rising unemployment of unskilled workers; global trade contraction; increased need for budgetary resources to contain the dramatic poverty impact of this global crisis; the ensuing credit crunches (including trade-financing); the abrupt fall in commodity prices for many exporters; the consequent exchange rate volatility due, inter alia, to portfolio composition shifts; massive deleveraging; and abrupt profit repatriation.
The longer-term implications of the global financial crisis for developing countries are more difficult to discern. The relative stability of developing country yields since the beginning of the year suggests that the borrowing costs for these countries may not rise by as much as feared. That said, capital flows are much lower than in the past, and are not expected to return to pre-crisis levels anytime soon. As a result, financing of both private and government sector investment is likely to be more difficult for some time, with implications for longer term potential output.
Developing countries have been affected in varying degrees by the transmission of the global financial crisis depending on their level of integration in global financial markets and their specific external dependency, for example, on external financing by capital markets, on exports, on aid, on expatriate labor income, and so forth. It is noteworthy that several developing countries are navigating this crisis better than previous episodes. Having translated the lessons of previous crises into robust policy frameworks and stronger fundamentals, they are now capable of implementing countercyclical policies, whereas in the past (for example, during the Mexican, East Asian, and Russian crises), the need for immediate stabilization led inevitably to contractionary policy frameworks to rebuild confidence and credibility.
Policy challenges ahead
Despite some preliminary discussions about exit options, for the time being the primary policy challenges concern the need for interventions to sustain global demand and policy coordination. On the one hand, developed countries are focused on repairing their financial sectors, stimulating the real economy, and trying their best to coordinate fiscal and monetary policy initiatives. Many are using the expansion of their public sector balance sheets, but also need to pay attention to their credit ratings and medium- and long-term loan (MLT) debt sustainability. On the other hand, we have: (a) middle-income countries that have both excess capacity in the production and export of manufactured consumer goods (to high-income countries) as well as with the need to import capital goods; and (b) low-income countries that have excess capacity in the production of commodities. In both middle income countries and low-income countries, there is evidence that investment in infrastructure has lagged due to a number of chronic problems such as past and present fiscal constraints, quality of governance, technical capacity to identify sound projects, political economy issues, and so forth. Hence, while there is uneven room for fiscal maneuvering in developing countries, the crisis should, nevertheless, be an opportunity to identify targeted investment that would increase future productivity and position these countries to be more competitive in the aftermath of the crisis. Infrastructure seems a logical sector in which sound projects could produce high returns and multiplier effects.
In 1998, because of the East Asian financial crisis, China encountered a situation very similar to the current one. The Chinese government adopted a fiscal stimulus package in 1998–2002 to remove bottlenecks in infrastructure. In 1997 China had only 4,700 kilometers of highway, by 2002 this had increased more than five times to 25,000 kilometers. The transportation capacity improved greatly as did port facilities and the electricity grid. With that kind of fiscal stimulus, China maintained its average annual growth rate at 7.8 percent. More importantly, after the crisis the growth rate accelerated. Between 1979 and 2002, the average annual growth rate in China was 9.6 percent. And between 2003 and 2008, the growth rate actually increased from 9.6 percent to 10.8 percent. This growth was made possible by investment targeted to freeing-up bottlenecks, that is, those sectors constraining growth in the economy. As a result, though government debt as a percentage of GDP initially rose from about 30 percent of GDP to 36 percent in 2002 it then declined as growth increased. By 2006-2007, government debt had fallen to 20 percent of GDP.
The lesson to take from China’s experience is that, if the return is high enough to generate higher growth, sufficient revenues can be generated to pay for the costs of the fiscal stimulus itself. That is, the project may be “self sustainable.” Whereas opportunities for growth-promoting fiscal stimuli may be mostly exhausted in developed economies, in developing countries, by contrast, opportunities for investments that help break through bottlenecks to growth tend to abound. Although some fraction of fiscal resources must be injected in developed countries that are at the epicenter of the current crisis, the main policy objective should be to create demand as quickly and efficiently as possible. This can be done by channeling investment to where it can be most effectively utilized: by investing in eliminating bottlenecks to growth in the developing world. Lack of infrastructure in many developing countries, both domestic and regional, is the main bottleneck to growth. Increasing investments in infrastructure can raise the productivity of the private sector, improve the business environment, and generate high economic returns. This must be supported with increased financing and underpinned by improvements in the efficiency and effectiveness of public spending.
Policy makers also need to prevent future crises in the financial sector. We know that this global financial crisis was caused in part by failures of the pre-crisis regulatory and supervision framework, especially in the G7. After the crisis, many reports and proposals are calling for a strengthening of prudential regulation, a more accurate evaluation of risk, and a tightening of accounting standards. The pre-crisis regulatory framework allowed distortions in banks’ behavior and the financial intermediation process and did not control financial pro-cyclicality. There were strong incentives to bypass required capital regulations by shifting loans off banks’ balance sheets. Furthermore, the risk models did not take into account “extreme events” and mispriced risk, and there was lax governance in the financial sector industry, including in its internal, short-term based compensation rules. Looking ahead, some of the areas for reform include: changes in compensation schemes in the financial industry with more emphasis on evaluating long-term performance and results; better supervision of excessive leverage and asset quality; comprehensive registration of all financial transactions, including over-the-counter (OTC) operations (especially for highly leveraged agents and derivative markets); reassessment of the role and oversight of rating agencies; and better capital requirements rules (Basel II) that can smooth business cycle fluctuations by reducing pro-cyclicality.
The current crisis is the first “synchronized” crisis in almost eight decades and as a result, dealing with it is beyond the capability of any single country. Instead, decisive and concerted actions are needed by the international community as a whole. In particular, there is a need for a global, coordinated fiscal stimulus. For example, in the spirit of building our common global future, developed countries need to consider, in addition to their domestic efforts, using part of their resources to make investments in developing countries. This will not only help the latter, but also the former. It would support short-term recovery, but also help lay the foundation for a sustainable, inclusive growth in the longer run.
Conclusion
While we are observing (as of July 2009) some “green shoots” pointing to a bottoming-out of the crisis, it is too soon to speak of a recovery that includes stabilization of mature economies and resumption of strong growth in developing countries. We can, however, identify some key forces that are likely to shape any future recovery and growth path.
The post-crisis global growth pattern may be slower than in the pre-crisis period, in part because of the need to rebalance growth in the global economy and reduce excessive current account imbalances. This correction will take many forms (and some time), including changes in private consumption in the U.S. and surplus countries, movements of relative prices (for example, energy, minerals, food, and so forth), and better control of the financial industry through lower leverage ratios and simpler financial products, all potentially contributing to a lower trend growth for the next cycle. Also, at some point, current stimulus policies (both monetary and fiscal) will need to be unwound. That will reduce the momentum of global growth to some extent and will have to be carefully timed to avoid both the dangers of inflationary pressure and a premature shock to aggregate demand. A rise in protectionist pressures would take a toll on trade and growth. Finally, investment may be dampened for some time by the need to absorb the high excess capacity that currently exists in the world economy.
The implications are clear for developing countries: those who will have tailored their fiscal stimulus well, removed bottlenecks to growth, and invested adequately in human and physical capital within the limits of their fiscal room for maneuver, will be naturally better-off and ready to begin a new and more robust growth cycle based on their comparative advantages in the global economy. For the IFIs, helping this process unfold through lending and technical assistance while also building global public goods will be a challenging agenda for the next few years.
Justin Yifu Lin is Senior Vice President and Chief Economist of the World Bank.
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The post-crisis global growth pattern may be slower than in the pre-crisis period, in part because of the need to rebalance growth in the global economy.
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