Yılmaz Akyüz, guest blogger
After three years of recovery the world economy still remains highly fragile. The short-term outlook is for contraction in several advanced economies (AEs) in Europe. Growth in others, including the US, is weak and erratic. But more importantly, medium term prospects are bleak almost everywhere.
There is considerable tension in financial markets. Asset and commodity prices, risk spreads, capital flows and exchange rates are highly susceptible to sudden swings. Currently the Achilles Heel of the international economy is the eurozone (EZ). Consequently, the way the EZ crisis is handled is a major concern for DEs.
Contrary to a popular view entertained until recently, developing economies (DEs) are not decoupled from AEs. They now face significant downside risks, including dampened export prospects and unstable capital flows and commodity prices. As noted by the IMF “even absent another European crisis, most advanced economies still face major breaks on growth. And the risk of another crisis is still very much present and could well affect both advanced and emerging economies.”
There can be little doubt that the crisis has posed difficult policy challenges for AEs. But there have also been shortcomings in their policy responses. First, there is a failure to maintain adequate demand by reconciling the need for short-term fiscal stimulus with a credible programme for long-term consolidation, leading to a return to self-defeating fiscal orthodoxy and austerity in the EZ, the UK and even the US.
Second, public interventions have failed to alleviate the debt overhang and stop retrenchment at the expense of employment and growth. The US TARP has rescued big banks without preventing foreclosures or increasing lending. In the EZ long-term refinancing operations have provided little relief to debtors. Banks remain highly fragile. Last summer the EZ resisted mandatory capitalisation despite calls from the IMF, but it is now finding them undercapitalized. They are shrinking their balance sheets by selling assets and cutting credit, impairing the access of DEs to trade financing.
Third, deep cuts in interest rates and quantitative easing have not been very effective in addressing over-indebtedness and reversing spending cuts, but have led to problems for DEs in macroeconomic and exchange rate management. The surge in short-term capital flows have shifted exchange rates and trade not only between the North and the South but also among DEs, creating tensions in the trading system. The matter has been taken to the WTO by one of the most affected DEs for discussion in a seminar held at the end of March. Questions have been raised on the coherence between international trading and financial systems, the impact of exchange rates on trade concessions and the rationale and scope to deploy WTO disciplines, reaffirming once again the urgent need to reform the international monetary system in order to avoid beggar-my-neighbour policies and protectionism.
The IMF lacks effective surveillance to bring discipline and elicit responsible behaviour on the part of reserve-issuing countries. With the surge in destabilizing capital flows, it has abandoned willy-nilly its orthodoxy and has offered a framework to DEs for managing inflows, including capital controls as a last resort and temporary measure. This is rightly rejected by DEs, in an effort to retain their policy autonomy in managing capital flows and avoid new obligations. The Fund has paid no attention to policies in source countries, including measures to stem speculative outflows of the kind that the US used in the 1960s when it suited them.
The risk-return configuration that has sustained short-term capital flows to DEs cannot last indefinitely. They have already shown a high degree of volatility since last summer, and there are now signs of flight to safety. The immediate threat is not a hike in interest rates in AEs, but the deepening of the EZ crisis, triggering a rapid exit, very much like the collapse of Lehman Brothers.
Default by Greece has been averted for the moment, but now Spain is facing similar pressures and Italy is vulnerable. Bailouts for these would require much larger funds and their austerity would create a much bigger impact. Spanish problems have little to do with fiscal irresponsibility, but excessive private debt built during the housing bubble, financed by core banks. Wrong diagnosis and recipes by the EC and ECB are now worrying even the IMF. With unemployment at 25%, foreclosures rising and the economy shrinking, Spain is not expected to succeed in meeting deficit targets and financial obligations.
This is the main reason for the recent initiative to double IMF resources. This makes the Fund highly leveraged, particularly because of the failure to review quotas in time. The 2009 UN Conference on the World Financial and Economic Crisis and its Impact on Development agreed that the next quota review should “be completed no later than January 2011”. An agreement was reached in the IMF in 2010 to shift votes and two seats to DEs and double the quotas, to become effective by October 2012. Less than half of G20 members have ratified it so far. The US, Germany and its current chair, Mexico, are not among them. The package is unlikely to be ratified on time by the required percentage of votes and members.
In any case there is no justification for the EZ to draw on the IMF. Unlike DEs, the EZ can issue unlimited international liquidity. The moral hazard argument used against intra-EZ bailouts also applies to IMF bailouts. More importantly, the financial integrity of the IMF may be put at risk by large-scale lending. In the event of a default by its borrowers, the IMF has no de jure preferential creditor status. By lending to the IMF to lend to the EZ periphery rather than lending to the periphery directly, the EZ is effectively shifting the default risk to IMF shareholders, including its poor members. Thus, the IMF should only lend to the EZ periphery subject to significantly increased efforts by the EZ to bail in private creditors and to supplement and use its own rescue fund.
Finally, despite recurrent sovereign debt difficulties, the international community has not been able to introduce orderly debt workout mechanisms. The attempt made at the IMF in the early years of the 2000s to establish a Sovereign Debt Restructuring Mechanism was blocked by some major AEs. The UN Conference agreed “to explore the need and feasibility of a more structured framework” for debt workouts. It has since then gained further importance with the EZ crisis. The Financial Stability Board has included bail-in as one of the key attributes of effective resolution regimes and the EC has formulated a bail-in proposal, but the issue is not placed squarely on the IMF agenda.
In conclusion, the world economy is no less fragile today than it was on the eve of the 2009 Conference. And DEs are just as exposed to downside risks from AEs as they were then, but their policy space has narrowed in the interim. There can be little doubt that there is a lot DEs could do to strengthen their own fundamentals and reduce dependence on foreign markets, capital and commodities to gain greater autonomy. But they cannot be expected to put their house in order when AEs falter and the global financial architecture continues to suffer from systemic shortcomings.
These difficulties continue unabated despite agreements reached at the 2009 Conference on the crisis on “decisive and coordinated action to address its causes, mitigate its impact”, to “avoid possible adverse impacts” of stimulus measures on DEs, and to “reform and strengthen international financial system and architecture”. The task remains unfinished. The UN is often said to have no competence in these matters. However, the International Financial Institutions and ad hoc groupings such as G7 or G20 have proved totally ineffective in resolving these matters. Thus, they need to be pursued with greater determination and commitment in the UN.
This article is based on a presentation made at the UNGA High Level Thematic Debate on the State of the World Economy, New York, 18 May 2012.
Yılmaz Akyüz is the Chief Economist at the South Centre in Geneva, Switzerland.
The Triple Crisis blog invites your comments. Please share your thoughts below.