2011 In Review: Four Hard Truths

By Olivier Blanchard

(Versions in  عربي中文, EspañolFrançaisРусский, 日本語)

What a difference a year makes …

We started 2011 in recovery mode, admittedly weak and unbalanced, but nevertheless there was hope. The issues appeared more tractable: how to deal with excessive housing debt in the United States, how to deal with adjustment in countries at the periphery of the Euro area, how to handle volatile capital inflows to emerging economies, and how to improve financial sector regulation.

It was a long agenda, but one that appeared within reach.

Yet, as the year draws to a close, the recovery in many advanced economies is at a standstill, with some investors even exploring the implications of a potential breakup of the euro zone, and the real possibility that conditions may be worse than we saw in 2008.

I draw four main lessons from what has happened.

•        First, post the 2008-09 crisis, the world economy is pregnant with multiple equilibria—self-fulfilling outcomes of pessimism or optimism, with major macroeconomic implications.

Multiple equilibria are not new. We have known for a long time about self-fulfilling bank runs; this is why deposit insurance was created. Self-fulfilling attacks against pegged exchange rates are the stuff of textbooks. And we learned early on in the crisis that wholesale funding could have the same effects, and that runs could affect banks and non-banks alike. This is what led central banks to provide liquidity to a much larger set of financial institutions.

What has become clearer this year is that liquidity problems, and associated runs, can also affect governments. Like banks, government liabilities are much more liquid than their assets—largely future tax receipts. If investors believe they are solvent, they can borrow at a riskless rate; if investors start having doubts, and require a higher rate, the high rate may well lead to default. The higher the level of debt, the smaller the distance between solvency and default, and the smaller the distance between the interest rate associated with solvency and the interest rate associated with default.  Italy is the current poster child, but we should be under no illusion: in the post-crisis environment of high government debt and worried investors, many governments are exposed. Without adequate liquidity provision to ensure that interest rates remain reasonable, the danger is there.

•       Second, incomplete or partial policy measures can make things worse.

We saw how perceptions often got worse after high-level meetings promised a solution, but delivered only half of one. Or when plans announced with fanfare turned out to be insufficient or hit practical obstacles.

The reason, I believe, is that these meetings and plans revealed the limits of policy, typically because of disagreements across countries. Before the fact, investors could not be certain, but put some probability on the ability of players to deliver. The high-profile attempts made it clear that delivery simply could not be fully achieved, at least not then.  Clearly, the proverb, “Better to have tried and failed, than not to have tried at all,” does not always apply.

•        Third, financial investors are schizophrenic about fiscal consolidation and growth.

They react positively to news of fiscal consolidation, but then react negatively later, when consolidation leads to lower growth—which it often does. Some preliminary estimates that the IMF is working on suggest that it does not take large multipliers for the joint effects of fiscal consolidation and the implied lower growth to lead in the end to an increase, not a decrease, in risk spreads on government bonds.  To the extent that governments feel they have to respond to markets, they may be induced to consolidate too fast, even from the narrow point of view of debt sustainability.

I should be clear here. Substantial fiscal consolidation is needed, and debt levels must decrease. But it should be, in the words of Angela Merkel, a marathon rather than a sprint. It will take more than two decades to return to prudent levels of debt.  There is a proverb that actually applies here too: “slow and steady wins the race.”

•         Fourth, perception molds reality.

Right or wrong, conceptual frames change with events. And once they have changed, there is no going back. For example, nothing much happened in Italy over the summer. But, once Italy was perceived as at risk, this perception did not go away. And perceptions matter: once the “real money’’ investors have left a market, they do not come back overnight.

A further example: not much happened to change the economic situation in the Euro zone in the second half of the year. But once markets and commentators started to mention the possible breakup of Euro, the perception remained and it also will not easily go away.  Many financial investors are busy constructing strategies in case it happens.

Put these four factors together, and you can explain why the year ends much worse than it started.

Is all hope lost? No, but putting the recovery back on track will be harder than it was a year ago. It will take credible but realistic fiscal consolidation plans. It will take liquidity provision to avoid multiple equilibria. It will take plans that are not only announced, but implemented. And it will take much more effective collaboration among all involved.

I am hopeful it will happen. The alternative is just too unattractive.

Published on iMFdirect blog.

Olivier Blanchard is Economic Counsellor and Chief Economist at the International Monetary Fund.

57 Responses

  1. [...] of the IMF warns against the effects of excessive fiscal restraint. I had already cited a speech by Olivier Blanchard, IMF Chief Economist, who argued that debt consolidation is a marathon, not a sprint. So the [...]

  2. [...] Cottarelli VOX piece is available here.   See here for a related and much discussed blog post by Olivier [...]

  3. [...] its voodoo priests to the country who applied (and continue to do so with minor modifications, see here) the naivest recipe of all: make the Greeks poor by artificially bringing wages down so that the [...]

  4. [...] market behavior is much more complex than this, at least in the current crisis. For sure, markets don’t like large debt and fiscal deficits, but [...]

  5. Oops, Mr. Blanchard’s first lesson just dropped in to say hello. Better start thinking about the unthinkable, it’s about to happen.

    The following snippet from ZeroHedge:

    “While we are sure Mitt Romney would not care to comment, private equity firm KKR’s Henry McVey is strongly suggesting investors should avoid European sovereigns in his 2012 Outlook. While his reasoning is not unique, it does lay out a fundamental fact for real money investors as he still does not feel that Core or Periphery offer value. Specifically noting that “fiscal austerity among European nations is likely to lead to lower-than-expected growth, which would ultimately increase the debt-to-GDP ratios of several countries in the coming quarters”, the head of KKR’s asset allocation group sees a slowdown in Europe as core macro risk worth hedging.”

    LOL, good luck growing your way out of this whirlpool. Hope everybody has stocked up on their gold.

  6. [...] of the austerity cure imposed by Germany and the ECB to the EMU. If market participants join the IMF (actually, ‘only’ the IMF chief economist, Olivier Blanchard), the OECD, and an [...]

  7. [...] academic economist, and currently also Chief Economist at the International Monetary Fund. He sees today’s current big problems primarily due [...]

  8. A: I think the problem that we have, which has been talked about now for a couple of weeks, is there are high expectations in the market. I think we are going to have a situation where next Wednesday, hopefully, there will be announcement in terms of debt forgiveness and bank recapitalization. But I am afraid we are not in the end-game. The end-game is ultimately that we need to have fiscal consolidation in Europe and ultimately Germany has to stand behind that.

  9. One of the key questions is pace. Will it really work to take it “slow and steady” to win the race? Will an incoming generation of people really be willing to suffer paying off the debts of the past for another couple of decades? Without social unrest? Really? That’s a big bet, particularly when the debt was incurred without any good excuse or moral justification like – for instance – having to fight a proper war.

    The plain fact at the moment is that there is so much debt that it really can’t all be paid (actual sovereign debt, bank debt, unfunded pension liabilities, etc., etc., etc.) Someone will be stiffed.

    The current proposal is that the next generation should be stiffed by spreading the resolution of this crisis out over the next several decades…leaving the people who caused and/or benefited from all the borrowing intact and screwing a bunch of people who had nothing to do with it.

    Ouch….and risky.

    • The blog post makes it clear that dragging this out to a happy ending is not going to happen. Blanchard says himself that reduced spending further inhibits growth, which in turn further exacerbates the problems with the bond vigilantes. Even if this were not so and there was a will to take on the issue of spending, Blanchard says you’d need a complete political consensus and a will to carry it through FOR TWENTY YEARS. It’s clear even he doesn’t believe it, but refuses to consider the alternatives, total systemic collapse or devaluation.

      Playing this out for twenty years is the party line, something intended to keep the sheep quiet while they ready for a global devaluation. They are going to tie their fiat to the SDR, tie the SDR to gold, ramp gold prices by engaging in gold purchases, and print like crazy. In countries with a common currency like the Euro, the member nations will have to issue their own domestic currencies for use alongside the Euro in a system similar to the old bi-metallic standard in the U.S. pre 1873.

      Global derivatives are exploding. We experienced a 15% increase in the last 6 months alone, bringing the total to $707 trillion in a world with a global GDP of only $65 trillion. The United States is quietly monetizing its debt while its trading partners dump their treasuries. Soon, sometime before spring when JPM position limits kick in and Frank Dodd goes into effect, and there’s still time to save Obama, they are going to announce a bank holiday and make their move. When they do, everybody holding their paper will take a haircut. Anybody holding what central banks hold, that being gold, will increase their wealth, because gold, in the form of the SDR, is going to be the money by which nations settle their trade.

  10. I must say, I have to eat some crow here, because I thought my very rough comments would never get past the moderation gatekeepers, but they did. So I have to tip the hat to Olivier and this site, you are top notch.

    I have read his words, over and over again, and I can’t change my opinion that Olivier Blanchard, the Chief Economist of the IMF, has almost no faith that we can pull this off. The blog amounts to a half-hearted prayer that if political leaders act in perfect concert, and they follow through on all their promises, and we add no further debt, we can crawl out of the quicksand IN 20 YEARS!

    That scenario has zero chance of happening, and Oliver knows it. I have become a fan lately, and I know he’s no snake oil salesman, he knows what he is doing.

    It must be a very lonely existence to be an economist at this point in time.

  11. [...] of crisis inevitably leads to more recession and not necessarily to a decrease in bond yields. IMF’s Chief Economist Olivier Blanchard has backed this view by declaring that ‘some preliminary estimates that the IMF is working on suggest that it does not [...]

  12. [...] like those in place ahead of the 2008 meltdown. Here’s IMF Chief Economist Olivier Blanchard on this point: We started 2011 in recovery mode, admittedly weak and unbalanced, but nevertheless there was hope. [...]

  13. OK, Oliver, let’s see if I have this right:

    1. If government debt gets too big, the difference between the rates you have to give and the rates that will break you gets smaller and smaller until you collapse.

    2. Unfortunately, the bond vigilantes are a bunch of scardy cats, and once they know you are in trouble, the perception makes the reality. Worse, any fiscal discipline is bound to lead to lower growth, makes things scarier.

    3. If we don’t substantially lower our spending and debt, we will implode.

    4. To avoid imploding we have to print through our liquidity provision.

    5. Don’t worry, even though debt–the very central problem I have identified in this speech–is INCREASING, we promise we won’t devalue, we’ll just grow our way out of this over the next 20 years. LOL!!!!

    The end is priceless, so I’ll quote it:

    “It will take plans that are not only announced, but implemented. (regardless of silly things like laws) And it will take much more effective collaboration among all involved.” (i.e., everything has to go perfectly)

    “I am hopeful it will happen. The alternative is just too unattractive.” (i.e., Even I don’t believe it.)

    HERE YOU HAVE IT FOLKS, THE CHIEF ECONOMIST OF THE IMF DENIES DEVALUATION IS IN THE CARDS, AND WE ALL KNOW WHAT HAPPENS WHEN BANKERS AND THEIR MINIONS START DENYING THINGS.

    Prediction for 2012: Before May all central banks that count peg to the SDR, and the SDR is in turn pegged to gold. Then we all devalue together, and ramp up gold prices to the sky as we print like there is no tomorrow announcing price targets to return us to pre-deflationary levels ala Bernanke’s 11/21/2002 and 10/31/2003 speeches.

  14. [...] like those in place ahead of the 2008 meltdown. Here’s IMF Chief Economist Olivier Blanchard on this point: We started 2011 in recovery mode, admittedly weak and unbalanced, but nevertheless there was hope. [...]

  15. [...] spent a few minutes reading this account of Olivier Blanchard (OB) on what went wrong in 2011. OB claims to have the four reasons [...]

  16. Sachin hit the nail on the head – as did other responders.

  17. Why are you guys playing the psychiatrist for the United States and misleading the world?
    The United States got into the recession because of excessive greed by politicians, industrialists, bureaucrats, and the fat pay checks given to the top CEOs by the big financial corporations. After quite a long while, the U.S. government realized that they are in a real mess; money starts flowing into the BRIC nations (the world’s biggest and most populous third world countries) and now suddenly they start to shine. Dollars flow into these economies and they get inflated and they become bubbles (again due to excessive greed).

  18. The fourth point raises the issue of the role of the media and its army of “analysts” who use fear tactics, propaganda and other tools of the trade to sensationalize the truth in order to attract readers and hence, advertising revenue. I am not opposed to free speech, just to the abuse of this right, insofar as irresponsible journalism exists. Those with the facts and the respobsibility to maintain stability, such as the central banks, have to step-up their publicity (much like Ben Bernanke’s approach) to counter the detrimental and destabilizing effects of irresponsible journalism.

  19. IMF has a supervisory role in the world economy and does continuous audit of the big and small countries. If the crisis still happened, it has to accept some responsibilty. It can stop a loan to Pakistan for not meeting certain conditions but goes on doling out billions of dollars to failing European nations.

    • Thank you Sat Goel for having a soft corner for my country as well, although I personally believe that everyone should fulfill their agreed commitments.

      Merry Christmas and Happy New year

      Javed Mir
      Lahore 25.12.2011

  20. [...] Olivier Blanchard, l’économiste en chef du FMI, suggère que ce pourrait être les cas dans un nouveau poste sur son blog. Il ne dit pas cela en tant de mots, mais il est facile de le comprendre quand il dit que les demi-mesures répétées qui échouent ne font qu'aggraver la situation et amener les gens à perdre confiance en leurs dirigeants et de leur capacité à  tourner le bateau de l'économie européenne loin des écueils pour savoir où il va maintenant. [...]

  21. The lesson from the Four Lessons derived by Olivier Blanchard leads us to the conclusion that IMF with available expertise should also constantly monitor the emerging economies to help them in anticipating before-the-event risks and to avoid subsequent financial crises. During this period of human history because of interconnectedness, spillover contagions are almost impossible to avert. Timely assistance by the IMF’s technical training facilities can produce the desired results.

  22. [...] - 2011 In Review: Four Hard Truths. [...]

  23. I totally agree, we need to work together more!

  24. [...] week (December 21, 2011) – the IMF Chief Economist’s (Olivier Blanchard) blog – 2011 In Review: Four Hard Truths – was also in search of the [...]

  25. [...] reglementarea sectorului financiar", scrie economistul sef al FMI, Olivier Blanchard, pe blogul Fondului Citeste [...]

  26. [...] Olivier Blanchard’s post yesterday on the IMF blog has caused quite a few ripples. (Read Duncan’s brilliant response for a much more thorough explanation of its significance than I’m going to try here). The point that’s aroused most comments is – Third, financial investors are schizophrenic about fiscal consolidation and growth.They react positively to news of fiscal consolidation, but then react negatively later, when consolidation leads to lower growth—which it often does. Some preliminary estimates that the IMF is working on suggest that it does not take large multipliers for the joint effects of fiscal consolidation and the implied lower growth to lead in the end to an increase, not a decrease, in risk spreads on government bonds. To the extent that governments feel they have to respond to markets, they may be induced to consolidate too fast, even from the narrow point of view of debt sustainability. [...]

  27. [...] the IMF’s official blog pointed out four lessons from 2011 that will hopefully guide IMF policy going forward. One particular point [...]

  28. Our policymakers have done their utmost to make matters worse:

    1) The dogmatic and überhawkish ECB have refused to help its member countries by cutting rates, implementing QE and acting as a lender of last resort. Instead they have hiked rates and insisted on debt-deflationary self defeating austerity.

    2) The European politicians have not understood that they need to focus on getting aggregate demand back to more normal levels and getting nominal GDP back to where it should be. Instead they have been implementing austerity measures that have further depressed aggregate demand and made the slump worse. Unemployment in many countries are at unacceptable levels, but yet they have no urgency to fix the problem it sems.

    3) The European Banking Authority have acted in a highly pro-cclical manner and hiked solvency rules in the middle of a slump and a banking crisis. They should of course have waited until the recovery was well established and then gradually have demanded higher tier 1 one ratios etc. Now they have created a credit crunch that will make unemployment and growth worse and the slump deeper than neccessary.

    It has been very painful indeed to stand by an see our so called “leaders” committing one grave policy error after another and never even giving one single sign that they understand what implications their actions are having on growth, deficits, unemployment etc.

    Is it just bad luck that we happened to have small minded leaders like Trichet, Merkel etc just at a time when we needed really good, competent leaders instead?

  29. [...] 2011 In Review: Four Hard Truths « iMFdirect – The IMF Blog [...]

  30. Good observations, but one that is most troubling, especially coming from an IMF official

    “It will take more than two decades to return to prudent levels of debt.”

    This is the height of madness. To accept this timeframe requires the willful suspension of disbelief, that is, you would have to believe that future governments will hold themselves to commitments made by current legislators. All of the evidence in the West is to the contrary. Future governments, encouraged by their constituents, will never ahere to long term austerity measures. Investors know this, and therefore they will not relent until painful measures are implemented in the near term. The bond vigilantes need tangible evidence of real adjustment measures.

    The target must be much more aggressive. I would suggest that a 2020 deadline for all governments in the West to erase their generational accounting gaps would be a reasonable goal. Some may not make it, but anything less is underaiming. This would require some immediate a intermediate term cuts, but primarily will be achieved by long term reductions in social programs, which is exactly what everyone claims to want. Now they just need to do it.

  31. [...] 2011 In Review: Four Hard Truths Posted on December 21, 2011 by iMFdirect [...]

  32. [...] The IMF’s Chief Economist Olivier Blanchard wrote a blog post yesterday that I can’t recommend highly enough. [...]

  33. [...] sugiere que los duros programas de austeridad pueden ser literalmente contraproducentes, dañando la [...]

  34. [...] Chief Economist at the IMF and is one of the world’s most accomplished economists. His perspective on 2011 makes interesting reading.  He draws four lessons from the past year and the third is particularly [...]

  35. [...] et risque de les empêcher de pouvoir rembourser leurs dettes. C’est ce que vient d’expliquer l’économiste en chef du FMI, Olivier Blanchard : “Some preliminary estimates that the IMF is working on suggest that it does not take large [...]

  36. Things have changed drastically in last few months. Unexpectedly, the U.S. economy is showing signs of recovery that is encouraging, but the conditions in the EU are the biggest cause of worries as of now, and at the same time emerging economies like India are losing their shine because of mismanagement of the economy and domestic petty politics between the ruling coalition and opposition.

    Apart from this, the current move of the U.S. of limiting BPO activities will not bring that much benefit, but it is likely to harm the world economy. It is a time where the U.S. must not be selfish. The United States must always bear in mind that it hugely depends on exports of goods and services and to sustain that it needs growing economies in third world and Europe. Europe seems to be losing steam but the third world can help the U.S. and world economy come out of this recession sooner than expected.

  37. [...] Reflecting on 2011, at the [...]

  38. [...] 2011 In Review: Four Hard Truths: What a difference a year makes… [...]

  39. I couldn’t have said it better.

    There never was an economic recovery in 2009, 2010, or even 2011. What is happening is the systematic concealment of debt defaults (by massive debt expansion) … first by the consumer … then the banks … and finally the govt’s controlled by the banks.

    When the thief finally takes off the mask … what will be discovered is an economy has been created entirely dependent upon cheap oil … that is no longer cheap because it’s been used up. The hydrocarbon economy will cease to exist … I just hope the rest of society doesn’t go down the drain with it.

    What’s really pathetic about all this is … electric batteries, natural gas, hydrogen … many other ways to get around town … but as long as XOM, COP and the like have a death grip on power ( and control ) … things just aren’t going to change.

  40. [...] an IMF blog, Blanchard wrote that the global economy in 2011 started in recovery mode with hope. However, it is [...]

  41. At the post linked above, Krugman wrote, “… If I have this right, Olivier is suggesting that harsh austerity programs may be literally self-defeating, hurting the economy so much that they worsen fiscal prospects…”

    Of course, I agree, but did you mean that?

  42. This is so true…once Italy was perceived as at risk, this perception did not go away. And perceptions matter: once the “real money’’ investors have left a market, they do not come back overnight.

    I agree that the global economy has gotten worse this whole year rather than improving. Wonder what we will get to hear in 2012.

  43. Dear sir, I think this post is worth reading and I noticed there have not been a Chinese version yet, so I translated it here imf首席经济学家布兰查德:2011年学到的4个经验教训. I hope this will bring some convenience to Chinese readers.

  44. [...] all this is the total uncertainty of the global financial system.   A well respected economist, Olivier Blanchard, had this to say today, “Yet, as the year draws to a close, the recovery in many advanced [...]

  45. Thank you, Professor Blanchard,

    I know you can’t name the ECB, but let me talk about that.

    Why did the ECB not choose a stick and carrot approach to help Greece back in 2009? We buy your short term debt if you enact structural reforms. I mean structural reforms, not austerity measures, there is a big difference.

    The ECB would have been much more credible than any other central bank in the world. Usually when central banks finance their own government debt, they loose credibility. They cannot withdraw if the goevrnment fails to respect the agreement –becoming the central bank of another country :-)- and, at the end, independence from policy makers cannot be absolute.

    The ECB was unique in this sense.

    But it turned a unique, but positive, quality into its worst enemy: not being a central bank at all.

    In twenty years, economic historians will probably agree with me.

    • Better yet, why didn’t the “Troika”, have a management debt team onsite to:

      1) Seize the Greek Ministry of Finance, and clean it up?

      2) have the EBA, under their European Supervisory Authority, take over Greek banks, freezing assets, pending audit results.

      3) have the EC suspend the Greek National Supervisory Authority, and replace it with a European Supervisory Authority, and enact an emergency plan under macro-prudential policy rules carried out by the European Systemic Risk Board.

      ANY amateur knows you do not send funding of that magnitude without a management team to track it.

      A government’s debt is not secured by the assets of the government, but by its ability to levy taxes. If Greeks refuse to pay tax, (which was, and still is the case) that’s an emergency.

  46. [...] December 21st, 2011 admin Leave a comment Go to comments From:Lessons from 2011 [Mankiw] As seen by Olivier Blanchard. Categories: News Tags: olivier, olivier-blanchard Comments (0) Trackbacks (0) Leave a [...]

  47. [...] blog post on what went wrong in 2011 is, in fact, totally sensible and on [...]

  48. [...] year, Blanchard, IMF´s Chief-Economist, was strongly proposing higher inflation targets. Almost a couple of years later he completely eschews monetary policy, only obliquely mentioning the need for “liquidity [...]

  49. yes, yes, but you have not addressed the big #1: poor monetary policy. inflation expectations are running sub-par in the U.S. and the Euro area (even in Germany) due to weak monetary policy and a peevish obsession with inflation. The big hyperinflation from half-hearted quantitative easing turned out to be hyperbole, and now the ECB and the Fed are waaaaaay behind the curve. I hear a lot of people saying monetary policy is not effective at the zero lower bound…. to which I say it has not been fully tried!

  50. [...] has been on the front lines of the crisis in Europe during a particularly tumultuous year. In a post on the IMF’s blog, he points to four main lessons from 2011 that he says explain why the year is ending much worse [...]

  51. You forgot the two other even harder truths “why the year ends much worse than it started.”

    First: Bank regulators insist on the banks making up for the capital they should have had, in case the ex-ante perceptions of risk had turned out wrong ex-post, had not the regulators allowed them otherwise. Remember when we used to worry about our bankers “lending the umbrella while the sun shines and taking it away when it rains”? Well the bank regulators made it much worse since they are also taking away the umbrella they so willingly lend when they thought and think the infallible exists… and forget that perceived risk have already been priced in interest rates, amounts borrowed and other terms.

    Second: The stacking of equity return on banks in favor of what is ex-ante perceived as not-risky is still well and alive, going strong in Basel III, as the regulators have yet to understand that all they achieved with their loony capital requirements for banks was to make the dangerous overcrowding of safe-havens the more possible, and to make the explorations of those risky but needed bays like the small businesses and entrepreneurs, the much more difficult and expensive.

    “Putting the recovery back on track”, requires understanding and acknowledging the mistakes.

    Occupy Basel! PS. http://bit.ly/dFRiMs

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