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TRADE AND DEVELOPMENT REPORT 2011:
Post-Crisis Policy Challenges
in the World Economy
Vaibhav Gupta
MIB, DoC, DSE, DU
1
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
2
Global economic recovery is slowing down, with
strong downside risks
10
8.6
8.0
7.4
8
6.3
5.4
6
4.0
2
4.1 4.4
3.9
4
5.4
3.1
2.6
2.5
2.5
1.8
1.7
0.3
0
-2
-2.1
-4
-3.6
-6
-6.7
-8
World
Developed countries
2007
2008
2009
South-East Europe and CIS
2010
2011 (forecast)
Developing countries
3
“Two-speed” recovery pattern continues
Real GDP at market prices, 2002–2011 (Index numbers, 2002 = 100)
Note: Linear trends correspond to 2002–2007.
4
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 Revenues
 Increasing Social Expenditure(Developed
Economies)
 Abrupt fall in commodity prices(Exports Economies)
 Currency depreciation and high interest rates
spreads
 Government 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 recovery
 Hampers improvement in public revenues
 Increases 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 weeks
Incumbent Cristina re-elected.
Huge subsidiaries
Doctored numbers of Inflation
Devalued currency
Greece can soon follow in Argentina’s
footsteps
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
12
Global imbalances remain a risk to
sustained economic recovery

Post-crisis unwinding
has been short-lived
1500
Germany
1000

Country-specific
evolution depends on
whether domestic
demand (BRIC) or net
exports (Germany,
Japan) drive recovery
Japan
500
Fuel-exporting countries
China
0
Other developing and
transition economies
European Union excl.
Germany
United States
-500

Exchange-rate
movements have
sometimes enlarged
imbalances
-1000
-1500
2005 2006 2007 2008 2009 2010 2011
13
Premature fiscal tightening
is 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
14
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)
15
IMF-sponsored programmes systematically underestimate their
negative impact on GDP growth and fiscal balances
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
17
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-oflast-resort support to the financial system has increased,
and even extends to the shadow banking system
18
Financial reform agenda remains uncompleted

Strong re-regulation is urgently needed. It must:
 Be tighter with the “too-big-to-fail” institutions
 Cover the “shadow banking” and avoid regulatory arbitrage
 Incorporate 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 down
 The activities of commercial and investment banking should be
clearly separated, in order to reduce the risk of contagion
19
Commodity prices have recovered amidst
high volatility
Monthly evolution of selected commodity prices, January 2002–May 2011
(Price indices, 2000 = 100)
20
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 class
 Index 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 rise
AUM/global GDP ratio doubled in 2005–07 and rose 4-fold in 2008–10
Commodity investment, assets under management, 2005–2011 ($bn)
450
400
350
300
250
200
150
100
50
0
2005
2006
2007
2008
2009
Index investment
2010-1st 2010-2nd 2010-3rd 2010-4th 2011-1st 2011-2nd
quarter quarter quarter quarter quarter quarter
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
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)
25
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 imbalances
 Adjustment of nominal exchange rates to interest rate differentials
– emphasizes limiting currency speculation

Rules-based managed floating may be practiced
unilaterally, regionally or (preferably) multilaterally
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Thank you!
[email protected]
(vaibhavgnnugupta.wordpress.com)
(guptavaibhav.wordpress.com)