Ignazio Visco: Challenges to international cooperation in the wake of the
global crisis
Speech by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, at The Italian
Chamber of Commerce and Industry for the UK XXXI Annual Conference "A New Approach
for Global Economic and Social Growth", London, 16 October 2009.
* * *
1. The unfolding of the crisis
1.1 Origins
Whether the global crisis that has hit the world economy so severely since August 2007 was
rooted in macroeconomic causes is an open question. To be sure, the trigger and proximate
causes of the crisis were essentially financial, originating in a specific segment of the US
financial system, i.e. the subprime mortgage market. Nevertheless, I believe that financial
excesses could not have developed to the extent they did if the macroeconomic environment
had not been characterised by large saving-investment imbalances, very low interest rates
and asset price misalignments. These factors helped create the conditions in which financial
innovations and regulatory failures caused serious dysfunctions in the US and global
financial system. The general climate of excessive optimism that those macroeconomic
conditions supported certainly contributed, with risk managers and supervisors allowing
financial vulnerabilities to grow basically unchecked.
Signals of macroeconomic stress, which interacted with financial system flaws to create very
serious fragilities, had been manifest at least since the late 1990s. The most evident were
the dramatic fall in the saving rate of American households, from around 7 per cent in the
early 1990s to near zero in 2005-2007, and the persistence and significant widening of the
US external deficit (from 1.6 per cent of GDP in 1997 to 6 per cent in 2006), against growing
surpluses in a number of emerging economies, in particular China (from 1.3 to 11 per cent of
GDP between 2002 and 2007) and the oil exporting countries.
Focussing on the role of policies in sustaining this pattern of highly unbalanced growth and
on how they reacted to the various shocks - geopolitical, technological and economic - to
the global economy, two factors appear to have played a major role.1 The first was the great
increase in US and global liquidity, in part owing to the generally accommodating US
monetary policy stance. This accompanied a protracted expansion of consumer spending
financed by growing household indebtedness. At the same time, low interest rates triggered
a search for yield that squeezed risk premiums on whole classes of assets and so tended to
make financial conditions even more favourable for a broad range of borrowers. Abundant
liquidity and credit expansion, as well as regulatory failures in some markets, helped feed an
uncommonly synchronised global boom in house prices.
The second element was the decision by China and other rapidly growing emerging
economies to peg their currencies to the dollar as a way of supporting their essentially
export-led growth model. Not only did this imply basically importing the generally easy US
monetary stance; most importantly, it produced an enormous accumulation of official
reserves (from $168 billion to $1.9 trillion in China between 2000 and 2008, 40 per cent of
the increase in the world as a whole), perhaps as a self-insurance response in the wake of
the Asian crisis of 1997-98. Largely invested in US financial and monetary instruments, these
reserves helped to finance the massive US deficit in the current account of the balance of
payments and to maintain very low interest rates along the whole length of the yield curve.
Both of these policies were attractive in the short term but unsustainable in the long run. In
fact, when global supply encountered bottlenecks in the form of shortages of primary
commodities and as inflationary pressures started to materialize, the Federal Reserve
progressively tightened monetary policy, and house prices started to fall. At that point, the
serious risk exposures that had been built up within the financial system suddenly became
apparent, precipitating the turmoil. The relevance of this broad set of interrelated factors -
macroeconomic as well as financial - in creating a crisis of these proportions is evident in the
way the crisis was so rapidly propagated across financial markets and then to the real
economy, not just in the industrialised world but globally. It was the unbalanced world
consumption patterns that transformed what might otherwise have been a very serious but
limited episode of financial turmoil into a fully-fledged global economic crisis, with plunging
world trade and output. When the United States stopped serving as "consumer of last resort"
the whole world suffered from insufficient aggregate demand precisely because of the
unbalanced consumption patterns.
1.2 The real economic consequences
The crisis has left deep scars. In the advanced economies the IMF projects the
unemployment rate to reach 9.3 per cent in 2010, almost 4 percentage points above the low
point registered in 2007; the shortfall in GDP, relative to potential, is projected to reach 4 per
cent this year and to remain just slightly below this level in 2010.2 But predicting the exact
dimensions of this slack is complicated, since the crisis is also likely to affect potential output
in various ways that are difficult to quantify.
Past experience shows that the repercussions of financial crises in terms of lost output are
both significant and sustained: the IMF has estimated that seven years after the start of a
major crisis gross domestic product is still, on average, ten percentage points below where it
would have been had it continued on the previous trend. However, growth paths after the
initial output decline have differed widely in historical experiences: while in some cases
output gradually returned toward the pre-crisis trend, in others the gap widened over time. It
is probably still too early to tell which type of adjustment pattern will prevail this time.
While there is consensus on the fact that the level of potential output in advanced countries
is likely to be reduced permanently as a result of lower investment and structural
unemployment, estimates of the size of this loss vary widely, around 3 to 5 per cent. What
will happen to its future growth rate is even more uncertain. Both the IMF and the OECD
have assumed so far that, as a first approximation, it should be unaffected. However, one
could argue that we may be at the beginning of a major structural change, certainly in the
financial sector and perhaps in the economy as a whole: uncertainties over the recovery of
demand and the process of deleveraging in the financial sector could hamper not only
investment but also the accumulation of human capital and innovation, with likely negative
effects on potential output growth.
1.3 Policy responses and the outlook
Policy makers' response was generalized and remarkably well coordinated. Official interest
rates were lowered rapidly; in many countries they are still near zero. Central banks injected
liquidity in unprecedented quantities, extending the range of their instruments for action. The
severity of the crisis has created a vast international consensus on the need to accompany
monetary action with fiscal expansion. For the G-20 economies, crisis-related discretionary
fiscal measures are estimated at about 2 per cent of GDP in 2009 and 1.5 per cent in 2010,
over the 2007 baseline. To this, we should add the substantial cost of various measures -
capital injections, guarantees on bank liabilities, relief of impaired assets, liquidity and bank
funding support - enacted in most countries to sustain the banking systems.
This powerful response averted the danger of a systemic collapse and helped to restore
market confidence and bring back a more "normal" risk appetite. The cost of money market
funding has come down considerably and worry over the health of the banking system has
been allayed. Corporate risk spreads have narrowed to levels close to those prevailing
before the bankruptcy of Lehman Brothers in September 2008.
Recently, the global economy has begun to grow again, but the recovery appears to be
sluggish, uneven and highly dependent on policy support. According to the IMF central
forecast, after contracting by 1 per cent in 2009 global activity should return to growth of 3
per cent in 2010 thanks to a modest upturn in the advanced economies and more vigorous
expansion in the emerging and developing countries. By way of comparison, the average
world economic growth rate between 2002 and 2007 was around 5 per cent. It is important to
stress that there is considerable uncertainty around this scenario, and forecasters' current
views about the strength of the recovery span a wide range. For example, while private
forecasters expect US GDP growth to reach around 21⁄2-3 per cent in 2010, the IMF is
projecting only 11⁄2 per cent growth.
One may wonder why we are still considering the predictions of economic forecasters after
their dismal recent performance, which surprised even Her Majesty the Queen. We should
not forget that forecasting activity permits the consistent organisation of our ideas and
hypotheses about the most plausible path of the main economic aggregates. This is
particularly useful to analysing the effects of policy actions, which usually come with
timelags and through many channels. It goes without saying that economic forecasters are not
fortune-tellers, and their projections always come with explicit or implicit probabilistic ranges
of possible outcomes. But it is also true - to quote the great social scientist Herbert Simon -
that unless the phenomena to be predicted "are sufficiently regular that they can simply be
extrapolated ... our predictions will generally be only as good as our theories".3 Some
occasions are particularly marked both by the lack of sufficient regularity in the data
observed and by difficulty in properly using our theories to anticipate the non-linear
consequences of economic and financial decisions. This calls for special care, better
discussion of alternatives and greater consideration of the possibly severe consequences of
what may be seen, ex ante, as rare events. But modesty in our evaluation of economic
projections should only be seen as a call for more transparency and better analysis, not as a
refusal to use quantitative assessments based on an informed and probabilistic reading of
the available evidence.
Anyway, the general view of the latest official projections is very cautious and correctly
postulates that the support deriving from the fiscal stimulus and inventory rebuilding cannot
last forever. Beyond the short term, it still remains to be seen how soon and how far private
demand - consumption and investment - can take up the slack and give rise to a
selfsustaining recovery.
In fact, in much of the industrial world private consumption is still stagnating at best, and its
weakness appears even more significant if one excludes the effects of temporary measures,
such as the various "cash for clunkers" schemes in the United States and in the major
continental European countries, or the reduction of the VAT in the United Kingdom. To the
extent that subsidies have merely brought part of households' planned expenditure forward,
once these programmes expire consumption may lapse again. With anaemic demand
prospects and with banks still curbing credit as they deleverage, investment too is bound to
be sluggish at best for some time. And without a pick-up in the pace of investment it is hard
to imagine any return to a healthy growth path.
The main risk is that rising unemployment rates will undermine household confidence and
depress spending. As long as jobs are still being lost, there is plenty of potential for
destabilizing feedbacks. Lower employment can trigger more mortgage defaults and put
additional stress on key financial institutions. In other words, as long as the employment
picture continues to worsen, the risk that things could deteriorate again remains great.
2. Challenges for international cooperation
2.1 Repairing the financial system
One of the main challenges is to complete the repair of the financial system so that it can
support the return to sustained and stable growth. As the financial markets appear to be
regaining confidence, it is important that the reform momentum not be lost. The decisions of
the G-20 summit in Pittsburgh point to a renewed effort to overcome the deep flaws that
affected the financial environment prior to the eruption of the crisis.
Although the question of capital requirements for banks is certainly most prominent, it should
be considered only part of the solution. To discourage excessive leverage, the quantity and
quality of bank capital should be raised. But it is also of paramount importance that the
perimeter of regulation be extended to cover all systemically important institutions.
Regulatory systems must be harmonised to limit the potentially disruptive repercussions of
regulatory arbitrage. In this context, the prudential framework should be designed to prevent
the pro-cyclical accumulation of financial vulnerabilities during booms and sharp
deleveraging during crises.
There is also widespread recognition of the need to reform corporate governance in the
financial sector, so as to align executive compensation with long-term performance and
ensure greater transparency. All these measures should help deal with the threat posed by
institutions "too big or too interconnected to fail". Better mechanisms should be devised to
limit the costs of failure, but widely shared solutions are still to be found. Resolution plans
and a stronger capitalisation may mitigate but will not eliminate the financial fallout of the
bankruptcy of one of these institutions and the related moral hazard.
2.2 Rebalancing the sources of global growth
Whatever shape the future financial system may take, it is urgent to rebalance the sources of
global growth. At present, the main priority of monetary and fiscal policies in all the advanced
and in many emerging countries is still to support economic recovery by compensating for
the weakness of private demand and countering the effects of financial deleveraging. As a
result of the crisis and the strong policy response, the public finances have deteriorated
notably. Under current policies, budget deficits in the advanced countries are projected to
remain very large and gross public debt may rise over the next five years above 110 per cent
of GDP, from 80 per cent before the crisis.
If maintained for too long, the substantial fiscal and monetary stimulus enacted during the
past year could become a new source of instability. So the most challenging task for
economic policy is timing what are now called "exit strategies", i.e., when and how to phase
out these exceptional measures. This involves striking a delicate balance. As the recovery of
final demand is likely to be lacklustre for some time, support should not be withdrawn
prematurely. At the same time, credible exit strategies are crucial to reassure the markets as
to the commitment to price stability and a return to sound and sustainable public finances.
Central banks have already made it clear that they have the tools necessary to withdraw
excess liquidity, and are determined to do so as soon as conditions warrant. The most
delicate challenge is to choose the appropriate timing and speed for exiting from
"unconventional" measures and for raising interest rates. In this process, the strength and
durability of the recovery will have to be taken into account, as well as the progress toward
financial system repair.
In designing the appropriate fiscal policy response, it is important to take expectations into
account. The economic slowdown partly reflects the pessimistic expectations of economic
agents. A well-designed and well-targeted fiscal plan can help the recovery by boosting the
confidence of households and businesses. Also the financial markets' reaction to any given
level of public debt is powerfully influenced by their expectations on future fiscal behaviour.
Accompanying the fiscal stimulus with credible action to right the public finances in the
medium term can limit the rise in interest rates stemming from a temporary upsurge in debt.
This strategy is particularly important for countries with high debt or a weak reputation for
fiscal rectitude.
The problem, particularly at the present juncture, is how to make this commitment to
medium-term consolidation credible while preserving the necessary flexibility in the short
term. On the one hand, the commitment to a long-term objective may not be credible without
an indication of how to get there. On the other hand, because the shape and strength of the
economic recovery are so uncertain right now, and because the premature end to fiscal
stimulus could easily derail it, governments may find it difficult to stick to pre-announced
fiscal targets.
Going forward, the need to move towards more sustainable fiscal positions will require tough
policy choices in a number of countries. Although the challenges posed by the projected rise
in health and pension costs connected to population ageing have been well known for some
time, with substantial comparative assessments produced by the European Commission, the
IMF and the OECD,4 the fiscal costs of the crisis have now sharply reduced the margins for
manoeuvre, and addressing those challenges can no longer be postponed. Governments
need to commit credibly, now, to curb the future growth of those entitlement programs; this
could provide space for a more gradual removal of fiscal support. However, the manner in
which the eventual consolidation is carried out will also be important. If the mix of
expenditure cuts and (probably unavoidable) tax increases could be engineered so as to
minimize the adverse impact on medium-term growth, the consolidation would be less
painful. For instance, as much as possible the penalization of growth-enhancing
expenditures, such as R&D investment, education and overall human capital formation,
should be avoided.
Over the medium term, the crucial factor for sustained growth is a better balance in global
demand. The rise in US private-sector saving and the sharp fall in investment, partly offset by
a larger public sector deficit, appear to have cut the US current account deficit from 5.3 per
cent of GDP in 2007 to 2.6 per cent in 2009, as projected by the IMF. The Chinese surplus
has also been reduced, from 11 to about 8 per cent. However, most of these corrections are
due to cyclical, not structural, factors.
If the recovery is driven by demand in the surplus countries - not only emerging Asia, but
also Japan and some European countries - then some real correction of imbalances is
possible. A major rebalancing of world demand from deficit to surplus countries presupposes
coherent movements in exchange rates. I do not intend to pinpoint exactly where exchange
rates should be. After all, no one knows what is the correct or "fair" value of a currency. But
the risk of a disorderly adjustment in exchange rates has to be averted. I think the solution is
unlikely to consist either in asking countries with dollar-peg regimes to shift abruptly to a fully
flexible regime or in the quest for the "holy grail" of a single world currency - which would
require very high flexibility in the markets for goods and services in all the national
economies. As the rebalancing of world demand proceeds, reasonable solutions based on
intermediate regimes, such as target zones or bands and currency baskets, should not be
dismissed out of hand.
There is now a growing awareness of the importance of rebalancing, as the Pittsburgh
summit acknowledged. However, it is still not evident how (and whether) any given country
will in fact implement such shared understanding. If the current situation does not change,
shifts in saving and investment will not be able to correct global imbalances, thus feeding the
expectation of significant exchange rate adjustments and triggering potentially disorderly
movements.
2.3 The increasing role of international cooperation
In the last few months several fundamental changes in the IMF's modus operandi have been
agreed, as well as an increase in its financial size. First, the Fund's lending framework has
been reformed radically. In particular: (a) conditionality has been simplified and tailored to the
varying strengths of countries' policies and fundamentals; the IMF will rely more on pre-set
qualification criteria (ex-ante conditionality) and less on traditional (ex post) conditionality as
the basis for access to its resources; (b) a new Flexible Credit Line (FCL) has been
introduced, for countries with very strong fundamentals, policies, and track records of policy
implementation. Countries eligible to the FCL are granted large and upfront access to Fund
resources, within limits to be assessed on a case-by-case basis and with no ongoing (ex
post) conditions; (c) the traditional stand-by lending arrangements have been made more
flexible, to enable high access on a precautionary basis for members that do not qualify for
the FCL; (d) non-concessional loan access limits for countries have been doubled (to 200
and 600 per cent of quota on an annual and cumulative basis, respectively), in order to
bolster countries' confidence that adequate resources would be available to meet their
financing needs.
Second, and perhaps more important, the Fund's lending capacity has been trebled from the
pre-crisis level, from $250 billion to $750 billion. A number of advanced and emerging
countries have volunteered to lend new resources for more than $500 billion, through
bilateral loans and IMF notes purchase agreements.
On the whole, the IMF's lending toolkit has been re-oriented from crisis resolution to crisis
prevention, and the substantial increase in financial capacity has enhanced its credibility as a
multilateral insurance mechanism. The FCL plays a special role in this new framework. Its
success so far (as in the cases of Mexico, Poland and Colombia) bears witness of a radical
shift in the sentiment of the potential beneficiaries.
Third, a decision has been taken to allocate new Special Drawing Rights (SDRs) equivalent
to $250 billion, two fifths of which to emerging and developing countries. SDRs are a means
for IMF members to obtain freely usable currencies from other members, and they therefore
help to increase countries' international reserves.
One purpose of these reforms is to convince emerging countries to abandon the quest for
self-insurance through the massive accumulation of official reserves against potential crises
and go over instead to a mutually accepted system of multilateral insurance provided by
international financial institutions. In recent years, many emerging market economies have
relied upon reserves for their precautionary needs. Some countries, especially those running
persistently large current account surpluses, have accumulated reserves far above any
reasonable benchmark.
However, large reserve holdings can generate costs both for individual countries and for the
world economy as a whole. For an individual country, the issuance of domestic debt aimed at
absorbing excess liquidity from abroad carries a fiscal cost if the domestic interest rate is
higher than the return on official reserve assets; furthermore, and perhaps more importantly,
the country risks large capital losses if, sooner or later, its currency is revalued. More
generally, large reserve holdings entail a misallocation of resources that could have been
more efficiently invested domestically. From a global standpoint, the accumulation of
reserves in some countries has been the counterpart of the external deficits run by others,
which have been a key co-driver of the crisis, the global recession, and the collapse of world
trade.
Does this imply that the IMF can act as international lender of last resort and provide full
coverage of the potential needs of its members? I do not believe that time is ripe for such a
bold move. While the IMF is now well-equipped to mitigate the economic disruption from
sudden stops in capital flows and from the perceived need for excessive (and expensive)
official reserves, I am convinced that sound macro-financial policies at the country level
remain essential to strong, sustainable and balanced global growth. In an interdependent
world these policies should take into account, as much as possible, the spillovers to the
global economy.
Here is where the IMF's surveillance function can play a decisive role. In the recent past the
Fund has failed to get major countries to steer their domestic policies towards reducing their
large external imbalances. To be sure, this was an extremely difficult task, since the logic of
surveillance rests on the postulate that policy makers should cede a measure of sovereignty
in the interest of international cooperation. Unfortunately, this happened only in a very small
part.
Going forward, the global crisis might have had the beneficial effect of forcing policy makers
to think outside the box, i.e. to act cooperatively to rebalance world demand and steer the
global financial system. This is a very big challenge, and one should not cultivate
exaggerated expectations. However, we should acknowledge that, in this respect, in less
than a year the G-20 and the Financial Stability Board have become the new protagonists:
the first, as a sort of world economic "steering committee", which availing itself of the IMF's
analysis and advice can enhance international cooperation on all fronts and help achieve
balanced and sustainable growth; the second - enlarged and institutionalized from its
predecessor, the Financial Stability Forum - to make substantive progress in the key task of
setting out financial and regulatory standards that will also involve the Basel committees, as
well as the Fund.
3. Structural reforms to sustain growth
3.1 Structural reforms in times of crisis
Rebalancing cannot be achieved without sound structural economic policies. The joint
statement released at the G-20 summit in Pittsburgh acknowledges that a strong recovery
will necessitate "macroeconomic policies that promote adequate and balanced global
demand as well as decisive progress on structural reforms that foster private domestic
demand, narrow the global development gap, and strengthen long-run growth potential."
In the aftermath of the economic crisis, pro-growth structural reforms may be held back. As
the main focus of policy-making during the recession has been demand support, the issue of
structural reform may well be downplayed or even set aside. In part this may reflect political
reasons: insofar as reforms have short-term costs, the political appetite for them could be
low. But this would be a lost opportunity.
The reform action must not be halted by more urgent needs linked to the current crisis. It
must continue to remove the obstacles to growth that lie in low levels of competition and
several rigidities in product and labour markets. A constant monitoring of the progress in
each country should provide an important stimulus for action. This is the aim of the OECD
program Going for Growth, launched in 2005, which provides a sort of structural surveillance
on OECD member countries. A possible extension outside the OECD membership could be
a significant step forward.
The nature of the present crisis demands a general review of financial regulation around the
world. Specifically, there is a need to broaden the perimeter of regulation and to adopt new
rules. After the years in which markets were presumed to be self-regulating and public rules
were abolished or greatly relaxed, the financial landscape will now have to be reshaped with
more pervasive regulation, both domestically and internationally. This is a necessary step
toward ensuring a functioning financial system and fostering the return of confidence to the
credit markets.
There is a risk, understandable, that for some time regulation of financial markets might turn
out, ex post, to be even too heavy. We should be careful not to extend this pro-regulation
attitude to other product and service markets where some regulatory easing is needed. Were
not this the case, the outcome would be to weaken competition and increase monopolistic
rents, favoured by administrative burdens and inefficiencies. Innovation and the evolution of
productivity would be impaired in the long run, with negative consequences for economic
growth.
However, policy action must be carefully designed to avoid flawed structural interventions or
measures that could jeopardise the benefits of recent reforms. The early retirement schemes
introduced in many European countries were intended to foster youth employment, but after
a good many years most of them proved to be failures. Similarly, incentive schemes targeted
to specific sectors risk creating a dangerous dependence on public support and should
accordingly be phased out quickly.
3.2 Support to domestic demand in emerging economies
In most economies with external surpluses, it is crucial to establish the conditions for
expanding private consumption and investment. Take China, for instance. In 2008 the
Chinese current account surplus of 10 per cent of GDP was equivalent to about a third of the
total surplus of Asia (including Japan) and the major oil exporting countries. Gross domestic
saving amounted to 50 per cent of GDP. Such high saving (half of it generated by the
business sector) together with very low household consumption (35 per cent of GDP, half the
ratio for the United States) are striking by international standards. Underlying these figures
are very substantial reinvested earnings and the high household propensity to save (on
average 25 per cent of disposable income), mainly out of precautionary motives.
Lack of basic social services - health care, education and pension benefits - for a rapidly
ageing population, together with credit constraints, has greatly increased the need for
selfinsurance. At the same time, an output structure intensely skewed towards capital-intensive
industries, the underdeveloped state of financial markets and privileged access to bank
lending by large state-owned enterprises are all factors inducing firms to finance investment
largely out of retained earnings. In this context, demand-side reforms are needed to reduce
precautionary saving, while supply-side measures should aim at shifting output composition
more towards labour-intensive activities, chiefly in the service sectors.
As for social services, the recent health care reform is a step in the right direction, although
the share of the anti-crisis stimulus package allocated to overall social welfare programs is
small indeed compared to that going to infrastructure and other public investments (0.5 and
11 per cent of GDP respectively).
The service sector would benefit greatly from financial system reforms to stimulate credit to
small and medium-sized enterprises, which until now have been severely constrained.
This could prompt the emergence of a large middle class and lead to a better distribution of
income, thereby increasing the overall propensity to consume.
3.3 Reforms to boost growth in the advanced economies
The Chinese case, and that of the emerging countries in Asia generally, differs from other
countries running an external surplus or a small deficit. For Japan and some European
countries, such as Germany and Italy, where the scope for fiscal manoeuvre is limited,
structural reforms should be directed at the sectors where heavy regulation limits
competition, hindering innovation and productivity growth. The deregulation of the
telecommunications market in the 1980s and 1990s helped to spark the formation of new
companies and the introduction of new products, thereby raising demand. Something similar
could be done for professional services and retail trade, which are still characterised by
relatively pervasive regulation. These are reforms that would not be difficult to implement and
would entail potentially very large gains in potential output.
We are probably going to experience what many commentators are already calling a "jobless
recovery". In fact, unemployment is rising all over the advanced world: in the United States
the rate is expected to hit double digits within the next few months and to stay there
throughout much of 2010. The fiscal and monetary stimulus have saved a lot of jobs, but it is
widely recognized that extra effort is needed to help employment to recover quickly.
What is particularly disturb