Amid the heaviest snowfall in Davos for decades, IMF chief Christine Lagarde has been making her case for urgent action to resolve the eurozone crisis, which is at the center of current global economic concerns. The Fund recently sharply revised downward its forecast for global economic growth and in a speech in Berlin Lagarde mapped a way forward.

Policy priorities

Lagarde has taken her messages to the Alpine resort in Switzerland, where global leaders are gathered for the 42^nd Annual Meeting of the World Economic Forum. At the top of the agenda is the need to find and implement the policy solutions to avoid a downward economic spiral—or what Lagarde as has called a “1930s moment.” She set out some of the policy priorities in a video interview and stressed the need for policy action to be “coordinated, cooperative and comprehensive”. The main goal is to get growth going again “because that’s most needed. There is too much unemployment around the world,” Lagarde said.

Worldwide repercussions 

While Europe may be at the epicenter of the crisis, today’s economic difficulties are being felt in all quarters of the globe, so policymakers and leaders everywhere are responsibility not only “for making sure that their jurisdictions, their countries, their regions, but also the global community does better and actually can manage through the crisis.” For the IMF to play its part, the institution has called for a big increase in its lending resources. The “IMF is a guardian of stability and a builder of confidence. And there is a lot to be done at the moment, and we probably will need more funding to be able to respond to a time of crisis … because it is our membership at large that we care for,” Lagarde explained. She also spoke on Facebook.

Watch the video here:

By José Viñals

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Since September of last year, risks to global financial stability have deepened, notably in the euro area.

However, over the past few weeks, markets have been encouraged by measures to provide liquidity to banks and sovereigns in the euro area. This recent improvement should not be taken for granted, as some sovereign debt markets remain under stress, and as bank funding markets are on life support from the European Central Bank (ECB).

Main sources of risk

Many of the root causes of the euro area crisis still need to be addressed before the system is stabilized and returns to health. Until this is done, global financial stability is likely to remain well within the “danger zone,” where a misstep or failure to address underlying tensions could precipitate a global crisis with grave economic and financial consequences.

Despite the recent improvements, sovereign financing stress has increased for many countries—with almost two-thirds of outstanding euro area bonds at spreads in excess of 150 basis points—and financing prospects are challenging. Markets remain very volatile and long-term foreign investors have sharply reduced their exposure to a number of euro area debt markets, including some in the core. Keeping these investors involved is essential to stabilizing markets.

Moreover, deleveraging by European banks may ignite an adverse feedback loop to euro area economies and beyond, even if acute pressures have been mitigated by recent extraordinary ECB measures. Like cholesterol, deleveraging can be good and bad. European banks have had excessive levels of leverage and had expanded into a number of non-core areas. So, increasing bank capital levels, shedding bad loans, and withdrawing from non-core businesses should be encouraged. But there is also the danger that deleveraging could be too fast, overly concentrated in some areas, and could cut off credit at the expense of the economy.

 All these risks could spill over well beyond the euro area. Emerging European economies would be most affected, reflecting the substantial presence of euro area banks in these countries. Nor is the United States immune to spillover risks, given the close trans-Atlantic financial and trade connections. A large shock from the euro area could be magnified by existing weaknesses, notably in the still-fragile U.S. housing sector.

Policy Priorities

Policymakers need to press ahead and bolster plans to restore financial stability in the euro area and beyond. Urgent policy action is needed:

 First, in the euro area, the “firewall” needs to be sufficiently large and convincingly built to avoid abnormally high funding costs for sovereigns and banks. To do this, it will be important to strengthen, and advance work on, the European Stability Mechanism (ESM) as soon as possible. Action by the ECB to provide the necessary liquidity support to stabilize bank funding and sovereign debt markets will also be essential. At the international level, the IMF aims to raise up to $500 billion in additional lending resources to create a global firewall. This would further help not only restore confidence in the euro area, but also address potential spillovers.

Second, a macroprudential gatekeeper is needed to assure bank deleveraging plans are consistent with sustaining the flow of credit to support economic activity and to avoid a downward spiral in asset prices. The potentially harmful effects of deleveraging should be addressed at both the national and international levels. Within the European Union, such a role should be coordinated among European banking authorities.

Third, a credible increase in bank capital buffers remains necessary to restore market confidence. Banks should increase their capital levels, not just capital ratios, in line with the recent European Banking Authority (EBA) recommendations. For those solvent and otherwise viable banks that cannot raise sufficient private capital, public funds should be made available, based on strict conditionality. To complement this support and limit the additional burden on some sovereigns, a pan-euro-area facility should have the capacity to take direct stakes in banks.

 Fourth, adjustment remains essential, but the short-term impact on growth should be taken into account. The solvency of sovereigns must be assured. Governments have to implement credible medium-term fiscal consolidation strategies within a solid euro area framework. Over the longer term, initiatives to strengthen fiscal and financial union will be crucial to restoring market confidence. Elsewhere, the United States and Japan need to address their fiscal challenges, and the United States must solve the problems of the housing market and mortgage debt overhang.

 Fifth, policymakers in emerging markets should stand ready to counter funding and credit strains, and to deploy countercyclical policies where headroom is available. Emerging markets in many cases have built ample cushions of reserves that could be used to counter external liquidity shocks

The global financial system remains fragile. It is urgent to restore confidence in the euro area and beyond. Otherwise we run the risk of a deepening of the crisis, with far-reaching global economic and social consequences.

Fortunately, it is not too late to put in place the right policies that take us out of the danger zone. But for this, we need good politics and the collective determination to reach now a cooperative solution both within Europe and at the global level.

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After the speech by the IMF’s Managing Director in Berlin yesterday, my main messages on the global outlook will not surprise you.

Starting with the bad news–the world recovery, which was weak in the first place, is in danger of stalling. The epicenter of the danger is Europe, but the rest of the world is increasingly affected.

There is an even greater danger, namely that the European crisis intensifies. In this case, the world could be plunged into another recession.

Turning to the good news–with the right set of measures, the worst can definitely be avoided, and the recovery can be put back on track. These measures can be taken, need to be taken, and need to be taken urgently.

And now the numbers, starting at the epicenter:

The IMF’s forecast for growth in Euro Area for 2012 is ‑0.5 percent—this marks a decrease of 1.6 percentage points relative to our September 2011 projection. In particular, we predict negative growth in Italy (‑2.2 percent) and Spain (‑1.7 percent).

We have also revised downwards our forecasts for other advanced countries, although by less. Only for the United States, is our forecast unchanged at 1.8 percent.

The growth outlook in emerging and developing countries is also down, at 5.4 percent, a decrease of 0.7 percent relative to our September forecast. The revision is particularly sharp in Central and Eastern Europe, reflecting their links to the Euro area. But it is also substantial in China and India, where internal factors explain most of the decrease.

What are the forces behind these numbers?

Most advanced economies are operating with two major brakes on.

• The first is fiscal consolidation. Consolidation is necessary—debt levels are very high—but, in the short run, it is clearly a drag on demand, it is a drag on growth.
• The second is tight credit. In many countries, particularly in Europe, banks are still weak. They are deleveraging. And, in many cases, deleveraging means tighter credit to households or firms, another drag on growth.

With those brakes on, the recovery cannot be very strong, and indeed this is something you see in past financial crises.

What is happening in Europe, however, is making things worse.

Doubts about fiscal sustainability are leading to high yields on sovereign bonds and, in turn, doubts about bank solvency. To reassure markets, governments have felt they had to consolidate further. To reassure investors, banks have deleveraged and tightened credit. Both actions have further decreased growth, leading to a dangerous downward spiral.

This explains our forecasts of negative growth for some of the Euro periphery countries, and low growth in the rest of the Euro area. Looking beyond Europe, spillovers through trade are already visible among Euro trade partners. And bouts of risk aversion and uncertainty are leading to high volatility of capital flows to emerging markets.

If not contained, this downward spiral can lead to even worse outcomes, be it disorderly default or Euro exit, with major spillovers, first to the rest of the Euro area, and then to the rest of the world.

In this context, the required policies are clear.

These are largely a repeat of the main messages from the Managing Director Christine Lagarde’s speech yesterday.

• First, fiscal consolidation must proceed, but at an appropriate pace. Decreasing debt is a marathon, not a sprint. Going too fast will kill growth, and further derail the recovery. It took more than two decades to successfully decrease debt from its World War II heights. We should expect that it may take as long or longer this time.

Of the essence here is a credible medium term plan, something still missing in the United States and Japan. Once such a plan is in place, in most countries, automatic stabilizers should be left to play. In some countries, slower consolidation may even be appropriate.

• Second, a credit crunch must be avoided. Where banks need to increase their capital ratios, they should do it through an increase in capital, rather than a decrease in credit. Recapitalization through public funds will help credit, sustain activity, and may actually improve the fiscal outlook.
• Third, and to the extent that they are taking the tough measures they need to take, Euro periphery countries—such as Italy or Spain—must be able to borrow at low interest rates. As many investors have left the market and are unlikely to return soon, public liquidity provision may be needed. It can be provided in various ways, by the European Central Bank, by the European Union, and by the IMF. Whichever combination is used, the available funds must be large enough to maintain low interest rates and fiscal sustainability.

Our forecasts are based on the assumption that these measures will be adopted, and the Euro crisis will slowly decrease in intensity. If they are not, one can fear the worst. If they are adopted decisively, the world economy may perform better than our forecast.

One should be under no illusion however. Even then, the brakes will still be on, and unemployment will decrease only slowly. We have a long way to go before the world economy has fully recovered.

(Version in عربي)

The issue of how to create more jobs is high on the minds of policymakers everywhere. The economies of the six Gulf Cooperation Council (GCC) countries—Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates—are no exception.

By many measures, these economies are doing very well. Abundant oil and gas reserves are producing large budget and external surpluses, growth is up, and considerable strides have been made on social indicators.

Yet, economic activity is dominated by the oil/gas sector and—given that many GCC countries have proven reserves of at least another 50–100 years at current rates of production—will remain so. However, that sector creates relatively few jobs directly—it employs less than 3 percent of the region’s labor force.

Diversification strategies are in place, and the non-oil sector has grown fairly rapidly over the past decade. But can it deliver enough jobs for GCC nationals? While unemployment rates differ across countries, even those with very low levels of unemployment—such as Kuwait, Qatar, and United Arab Emirates—are focusing on how to create more opportunities for nationals in the private sector.

We examined the issue of GCC unemployment in our study Gulf Cooperation Council Countries: Enhancing Economic Outcomes in an Uncertain Global Economy. In this post, I wanted to share with you a few of our findings.

Job creation is not the problem

Over the past 10 years, the GCC created about 7 million new jobs—a significant achievement for a region with a total population of about 40 million. But, fewer than 2 million—less than one-third—went to nationals. The sharp rise in expatriate employment took place mostly in the private sector, but also in the public sector in Kuwait and Qatar. Many of the positions filled by expatriates were low-skill and low-paying construction jobs, but a significant part also went to highly educated professionals for jobs where there was a shortage of nationals with the requisite skills.

As a result, even the creation of millions of new jobs has not been enough to reduce unemployment for GCC nationals. In Saudi Arabia, for example, unemployment among nationals has remained above 10 percent for the past several years, with joblessness concentrated among new entrants to the labor market—that is, young people and, increasingly, university graduates.

Overall job creation is set to remain high—at an estimated 6 million over the next five years. However, past labor market trends suggest that less than one-third of these jobs will go to GCC nationals. The workforce is also growing rapidly, with more than 4½ million nationals potentially entering the labor market during this period (compared to approximately 5 million employed nationals in 2010). Barring a change in labor market patterns, an additional 2 to 3 million GCC nationals could thus find themselves without employment.

Continued strong—or even accelerating—economic growth is unlikely, by itself, to be the solution. If labor market dynamics remain as they are, the amount of additional growth necessary to meet employment objectives could be quite substantial.

Increasing opportunities for nationals

The challenge is to promote the employment of nationals without imposing undue costs of doing business that would erode competitiveness and potentially reduce growth. Saudi Arabia, for example, is already implementing new initiatives to provide added impetus to private-sector activity and job creation: partial guarantees to ease access to credit for small and medium-sized enterprises; and new programs to match job seekers with employers, including through the scaling-up of placement programs and training and education schemes. Similar initiatives are under way in other countries too.

To enhance the appeal of working in the private sector, governments could make public-sector employment less attractive—perhaps by scaling back the high wages that come with it or by cutting some of the supporting benefits that have made it the dominant employer of nationals in most GCC countries. Another challenge is to help nationals become more productive and thereby more attractive to employers. Some options include:

• better aligning education and equipping prospective job-seekers with the skills demanded by the marketplace—including extending the training and placement services and other initiatives already in place in several countries;

• providing incentives for nationals to acquire the skills needed for private-sector employment;

• evaluating the possibility of a tax on foreign workers (for example, as an extension of plans to increase fees for work permits, as some countries are considering) in a way that minimizes distortions in the local labor market while redressing the effect of the high wage demands of nationals;

• considering the time frame and scope for offering the private sector financial and other incentives to employ nationals, and

• supplementing the income of nationals through a salary top-up scheme for nationals moving to the private sector, thereby facilitating initial recruitment by employers and reducing the bias on the part of workers toward seeking public-sector jobs.

(Originally published on the IMF’s blog, مواجهة تحدي العمالة في منطقة الخليج.)

Christine Lagarde, Managing Director of the IMF,  made the following statement.

The Wall Street Journal says the former Chicago University professor did not shy away from controversy. The Washington Post said he helped shape the IMF’s responses to financial crises in the 1990s. Later, as a senior fellow at the Peterson Institute, Mussa was well known for his semiannual forecasts of global economic growth, conveyed with tough assessments, clarity of expression, and biting wit. Paul Krugman said his most influential work was on currency regimes.

The IMF’s Research Department organized a conference in his honor called “MussaFest” to mark his 60th birthday in 2004.

Mussa contributed widely and influentially to economic theory and empirics, and served as the Fund’s Economic Counsellor and Director of the Research Department from 1991 to 2001. He also was a Member of the President’s Council of Economic Advisers from 1986 to 1988. He was a professor at University of Chicago, University of Rochester, the City University of New York, the London School of Economics, and the Graduate Institute of International Studies in Geneva, Switzerland.

During his career, Mussa studied extensively the macroeconomic problems inherent to open economies. Furthermore, he applied his knowledge to the design of economic policy and prevention of crises for developing and developed countries. His contributions inspired many economists in the academic world and at the IMF. Read his interesting address on global integration at Jackson Hole in 2000, and his analysis of the Fund’s approach to macroeconomics here.

Watch a video of his assessment of recent economic conditions from last September.

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As we slide into another year of tough economic times, it’s easy to understand why policymakers are preoccupied with the next few weeks. But they also need to be thinking about the longer term issue of leaving the planet in reasonable shape for future generations.

Without serious efforts to reduce greenhouse gases, scientists predict that by the end of this century global temperatures could be 2.5 to 6.0^OC higher than a couple of hundred years ago. That could mean more heatwaves, more droughts, higher sea levels, more violent storms—and so on. When you start to think about the potential impact of, say, droughts on the livelihood of farmers, especially in poorer countries… well, you get the point.

While some progress was made in the latest round of United Nations’ climate change negotiations in Durban, South Africa, we saw two major omissions. There was little progress on either carbon pricing or, related, financing for action against climate change. And there was not enough recognition of what economics has to offer to help tackle the problems.

Pricing that carbon: Playing the long game

At the IMF, we’ve been working on the fiscal, financial, and economic challenges of climate change. Two years ago Carlo Cottarelli wrote about the importance of carbon pricing as the sina que non (forgive the Latin) of a coherent mitigation policy.

Carbon pricing policies are easily the most effective instruments for reducing CO₂ emissions—the pre-dominant greenhouse gas—and providing incentives for the clean technology investments that are ultimately needed to stabilize the global climate system. Yet over 90 percent of global CO₂ emissions are still not covered by pricing schemes.

Carbon pricing would also provide a substantial new revenue source for cash-strapped governments. Pricing US CO₂ emissions (currently about 5.5 billion metric tons) at $25 per ton—a level suggested as reasonable in a recent report—could raise in just one decade about the same revenue as the entire aspirational target of the recent United States congressional deficit reduction ‘super committee.’

Of course, carbon pricing is challenging to implement, not least because consumers get hit with higher energy prices and energy intensive firms, such as steel and aluminum producers, become less competitive. And, measures to compensate those affected, especially the most vulnerable, will likely be a factor in effective implementation.

One possibility is to scale back pre-existing energy taxes that become redundant with carbon pricing. In many advanced countries, most, if not all, of the burden of carbon pricing on electricity prices and motorists could be offset by reducing pre-existing excise taxes on electricity consumption and vehicle purchases. Yet this tax change would be far more effective at reducing emissions as, for example, higher fossil fuel prices penalize firms using carbon-intensive fuels and driving.

Another possibility is to adjust the broader fiscal system. In Australia, revenues from planned carbon pricing will be used to substantially increase personal income tax thresholds—in effect, people can earn more before jumping up to the first tax bracket. A further option to deal with lost competitiveness is for carbon-taxing countries to levy fees on imports from non-carbon-taxing countries: so-called border tax adjustments. These adjustments penalize countries that do not price emissions, though they need to be carefully designed, especially to be consistent with international trade obligations.

Climate change finance: Show me the money!

Advanced country governments have also committed to raising $100 billion a year for climate adaptation and mitigation projects in developing countries, but it is far from clear where this money might come from. Earlier this year, the Group of Twenty advanced and emerging economies asked the IMF, along with others, to evaluate the options.

Many domestic revenue sources are up for debate (like taxes on electricity, fuels, income, capital, and even financial transactions). But carbon pricing seems the best bet—it raises this revenue and tackles the climate problem directly. Realistically though, it is difficult to imagine, in the current fiscal environment, governments parting with much revenue from any of these domestic sources.

Carbon charging for international aviation and maritime fuels might be more promising, given that national governments don’t yet have a clear claim on this tax base. (There are all sorts of legal issues with international aviation—but I’m no lawyer, so let me focus on the economics.)

There are clear environmental grounds for such fuel charges: about 3 percent of global CO₂ emissions result from flying or shipping, and currently there are no excise taxes analogous to those for motor fuels. There are also broader fiscal grounds for the charges. For example, international passenger tickets are generally not subject to value added taxes.

Charges should be coordinated internationally, and developing countries may need compensation to entice their participation in these charging regimes. Here, there are some promising options: they could keep the revenues they collect from aviation fuel charges or receive rebates for maritime charges in proportion to trade shares.

Insuring against catastrophe

Not to get too gloomy on you, but maybe we also need to start thinking about developing ‘last resort’ technologies like filters for sucking CO₂ out of the atmosphere, techniques for deflecting incoming sunlight, and the like. This could come in very handy in the very unlikely event that future warming imperils the planet as we know it. These possible technologies raise all sorts of tough issues.

But the longer policy omissions delay real progress on emissions pricing, the very small possibility of such a catastrophe creeps up just that little bit more.

The global crisis has pushed trade reforms off—or at least to the edge of—the political radar screen. But shying away from improving the trade system in these tough economic times seems a little like cutting off your nose to spite your face.

The IMF’s First Deputy Managing Director David Lipton summed the issue up in a recent speech: “trade wars can put millions of jobs in jeopardy, while trade integration can be an engine of growth.”

Rising pressures

As the crisis has become protracted and unemployment remains stubbornly high in many economies, there are worrying signs that protectionist pressures may be on the rise. There are plenty of examples: recent actions by Brazil at the World Trade Organization (WTO) aim to use trade remedies to offset currency misalignments, China imposed duties on cars made in the United States, and legislation is pending in the United States to use trade measures to defend against “undervalued” currencies such as the renminbi.

But now is certainly not the moment we should be putting jobs and growth to the test.

Fortunately fears of a widespread resurgence of 1930’s-style trade protectionism after the 2008 financial crisis proved unfounded. This was thanks, in large part, to a shared responsibility by countries and institutions for the multilateral trading system.

Yet, our analysis reveals that advanced economies experiencing the largest increases in unemployment were also those most inclined to impose trade restrictions—as suggested by the number of cases of anti-dumping and countervailing duties initiated against China. In fact, we saw a big uptick in these measures in recent years (see chart).

Macroeconomic barometer

The Fund may not be the main player on the trade ‘block’, but we certainly take an interest given its macroeconomic importance.

In fact, prospects for the global recovery and impending risks to the multilateral trading system were foremost in our minds when, together with the World Bank and WTO, we held a trade conference—the first such event—in December 2011.

Fund staff presented two papers at the conference.

Changing Patterns of Global Trade examined the growing role of vertical integration through global supply chains. It highlights the importance of value-added analysis (as opposed to gross exports) in examining trade inter-linkages and implications for the response of trade flows to exchange rate changes.

Protectionist Responses to the Crisis: Damage Observed in Product-Level Trade found evidence that, while there was no widespread protectionist action and only a limited generalized impact on trade, protectionist measures did have a strong impact on trade in the particular products to which they were applied.

This brings me back to David Lipton’s point—now is the time to resist protectionist pressures and re-energize the process of trade integration. Trade should be able to contribute to, and not detract from, a global recovery.

Which way the wind blows

On this score, reaching agreement on the Doha Development Agenda—the broad deal launched in November 2001 to facilitate development through trade—remains important, and we need to explore fresh approaches to conclude it.

But the multilateral trade agenda needs to go beyond Doha and focus on new emerging issues, such as open regionalism and food and energy security. Without multilateral attention, these issues risk giving rise to unilateral “trade remedies” and deals among smaller groups.

Encouragingly, trade integration is regaining strength through bilateral and regional initiatives.

• In October 2011, the United States ratified three bilateral free trade agreements with Columbia, Panama, and South Korea.

• In November, nine Asia-Pacific countries embraced a groundbreaking regional trade liberalization deal known as the Trans-Pacific Partnership (TPP). Japan’s commitment to join the TPP talks is particularly important, marking a potentially historic milestone in opening up sensitive sectors. And, with the world’s third largest economy, the TPP would be the largest free trade zone, representing close to 40 percent of the world economy.

What’s in the wind?

And, in the spirit of moving forward the discussion, and indeed the policies in support of, trade integration, the IMF has three main lines of work in the pipeline.

• In light of recent deleveraging by European banks, we launched in December an ad-hoc trade finance survey, in collaboration with the International Chamber of Commerce. The results will help us monitor risks to global trade credit and provide timely input into ongoing discussions by the Group of Twenty advanced and emerging market economies.

• Global supply chains will be an ongoing area of work, looking more in depth at value-added trade flows and the implications for trade interconnectedness and exchange rate assessments.

• Last, but not least, we are also developing a new index of protectionist pressure. The goal will be to summarize the key macroeconomic variables—such as growth rates, unemployment, imports, and exchange rate regimes—that help foreshadow protectionism. The index would be amenable to regular updates in line with revisions to the IMF’s global projections, and could thus serve as the Fund’s own gauge on trade winds. 

(Version in Español, Português)

A few days after the first sunrise of 2012 kissed the shores of Latin America, it is natural to ask: What does the New Year hold for the region’s economies, especially with Europe still under stress?

For sure, a dimmer economic environment, here and abroad. Growth has softened in the larger countries of the region. Looking North, the United States is growing a bit more, but elsewhere activity is softening, including in China—an increasingly important customer for the region’s commodities.

Perhaps more importantly, global financial markets are still strained, because many questions about advanced economies remain unanswered:   

• The future course of the European crisis remains the biggest risk. Progress so far toward a comprehensive solution has not yet calmed financial markets.

• The United States has yet to strike the right fiscal policy balance, with both near-term support for growth and long-term sustainability.

Reasons for caution

How do we at the IMF add this up to arrive at a new outlook for the Americas in 2012? While our official forecasts won’t be public for a few weeks, we can say that the outlook for the year ahead will not be better than what we thought in October, when our last forecasts were published (we publish new ones on January 24, in the World Economic Outlook Update; look for our blog update around then).

To be sure, we don’t see a recession coming in Latin America if the European crisis remains contained, but weaker growth is clearly in the cards, not least because confidence and commodity prices have been falling.

Financial risks continue to dominate the outlook. These days, all eyes are on Europe. While deteriorating conditions there have not yet spilled over to Latin America, we will not be immune if the risks move to the foreground. Euro zone banks account for one quarter of banking assets in the larger Latin American countries, on average, and many of those banks are not lending or rolling over existing lines in an effort to shore up their balance sheets.

But if the simmering crisis in Europe comes to a boil, that process could speed up, especially if euro zone banks are starved for short-term dollar funds (though these banks have prudently funded their Latin American activities largely through local-currency deposits, reducing their vulnerability to a dollar funding squeeze).

Fewer external credit lines available to banks could trigger a credit crunch in Latin America, coming on top of a decline in confidence and slower investment and, if the malaise spreads to Asia, falling commodity prices: a toxic mix for growth and stability.

Maintaining stability

What should countries do in the face of this risky outlook? A lot depends on their current macroeconomic situation.

On the monetary policy front, some countries are already taking preemptive steps, moving to neutral or easing, because they have inflation under control and activity is ebbing. (Easing may not be an option in countries with higher inflation or heavy dollarization.)

On the fiscal front, the major lesson from Europe today—and from Latin America’s past—is that sound public finances are crucial. In countries where fiscal room permits, there may be come a time to spend public money to fight a downturn as was done in 2009. But that time is later, if the risks appear; not now. The European crisis shows how countries with wide fiscal deficits can suffer a sudden loss of credibility that triggers capital flight, even when public debt is at manageable levels.

Meanwhile, financial systems should be under extra scrutiny for signs of stress, with a particularly watchful eye for liquidity strains.

The good news is that many countries in the region are entering 2012 from a position of strength. These countries have managed their economies and markets skillfully since the 2008 crisis. In particular, the 2008 crisis taught Latin America the importance of maintaining healthy liquidity conditions to avoid a credit crunch, which is very difficult to combat with macroeconomic policies.

Moreover, for the most part, banks are sound, monetary policy frameworks are increasingly credible, international reserve coverage is adequate, and public finances are strong. The key will be to hold that position.

Overall, as 2012 kicks off, our advice is to hope for good news, but prepare for the bad.

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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.

Christine Lagarde

Africa is on the move. While several other regions of the world have to address slowdown and uncertainty, many countries in Africa have been facing a contrasting challenge: to respond to the growing demand for their bountiful resources and manage rising investment in much-needed infrastructure. But at the same time, growing economic uncertainty in the world is raising concerns across the continent where vulnerability to global shocks remains high.

Christine Lagarde is visiting Africa for the first time as Managing Director of the International Monetary Fund this week and she says that she hopes to deepen the Fund’s partnership with Africa.

Listen and appreciate

 “I’m really going there to listen and to appreciate what is expected of us by the African countries, by the African governments, by the African people as well, because it’s a region of the world which is facing both huge challenges and huge opportunities,” says Lagarde, who will visit Nigeria and Niger.

Lagarde with Nigeria's President Goodluck Jonathan

“ And if we can help in any shape or form by providing technical assistance, by offering policy advice, using our best brains, and by making available the resources that we have, and to give credibility to the reform programs that some governments have announced and are implementing, then the better,” she said in a pre-trip video.

Here’s a collection of material related to the visit:

• Spotlight on Jobs and Investment in Africa (IMF Survey magazine)
• Managing Director’s speech in Nigeria
• Press release announcing the visit to Nigeria and Niger
• IMF Survey magazine on Africa’s newfound optimism
• F&D magazine on rise of a consumer class in Africa
• F&D profile of Nigeria’s economic czar Ngozi Okonjo-Iweala
• Podcast interview with Christine Lagarde  (Version in Français)
• F&D on Facebook – join the conversation
• IMF policy on low-income countries
• Africa’s new trade posture — facing in two directions
• Niger’s brighter prospects (Version in Français)