1. INTRODUCTION
It is my great honor to address such a distinguished audience and to share some thoughts on the situation and perspectives of the global economy. The specific topic of our exchange today, “Post-Crisis International Financial Architecture”, could not be timelier: the world economy has narrowly escaped a disaster of major proportions, which will be studied by researchers around the world for generations to come. Another Great Depression has been avoided, thanks to decisive actions by governments around the world: central bank balance sheets in 6 industrialized countries, together with that of the European Central Bank, increased by an average of more than 8 percentage points of GDP between June 2007 and June 2009. At the same time, government balance sheets of 16 advanced countries increased on average by about 5.5 percentage points of GDP. By any standards, these were public interventions of historic proportions.
The long-run consequences of the crisis may be severe, possibly turning a short-run macroeconomic adjustment into a long-term development problem. Researchers at the World Bank estimate that about 64 million more people will be living in extreme poverty (on less than $1.25 a day) by the end of 2010 than would have been the case had the crisis not occurred. When poor households pull their children out of school, there is a significant risk that they will not return once the crisis is over, or that they will not be able to recover the learning gaps resulting from lack of attendance. And the decline in nutritional and health status among children who suffer from reduced (or lower-quality) food consumption can be irreversible.
Thanks to a bold and rapid policy response, delivered by policymakers around the world with unprecedented cooperation, it appears that the storm has passed and the worst has been averted. Global economic activity is rising again. While the latest data available suggest that economic recovery is underway, albeit at a moderate pace, many challenges remain. Economists and policymakers are being confronted with some immediate challenges: (i) assessing the extent of the damage caused by the crisis and the effectiveness of the policy response; (ii) designing the appropriate exit strategies, that is, balancing the withdrawal of fiscal and monetary policies adopted to weather the crisis without jeopardizing the recovery; (iii) pursuing policies that create conditions for sustained growth and job creation; and (iv) reexamining some of the policy options and intellectual frameworks that may have led to complacency and mistakes prior to the crisis.
The tasks are clearly daunting and may require fresh, bold and pragmatic thinking, beyond all ideological fads. In fact, despite the return to positive growth, it will take several years before economies recoup the losses they have endured during the recession. It would be unrealistic to expect an overnight recovery from this deep and painful crisis: it will take several years for economies regain some of the pre-crisis momentum and to create enough jobs to compensate for the loss—and the toll on the poor will be very real.
In my remarks today, I wish to make two main points: first, sustaining the global recovery remains a challenge—the world economy is not out of the woods yet. Second, the recession provides a great opportunity for fresh thinking, and for a new partnership for international cooperation. If we can do that, we may turn the crisis into an opportunity for achieving a more sustainable and inclusive growth for the world. I will elaborate on these, and conclude with a few thoughts on Korea’s leadership role in the new global environment.
2. SUSTAINING THE GLOBAL RECOVERY REMAINS A CHALLENGE
A global economic recovery is currently underway, thanks to strong and coordinated global action, and to the good fundamentals exhibited by many developing countries prior to the recession. Global GDP, which declined by 2.2 percent in 2009, is expected to grow 2.7 percent this year and 3.2 percent in 2011. Developing countries are projected to grow 5.2 percent this year and 5.8 percent in 2011 -- up from 1.2 percent in 2009. GDP in industrialized countries, which declined by 3.3 percent in 2009, is expected to increase by 1.8 and 2.3 percent in 2010 and 2011. World trade volumes, which fell by 14.4 percent in 2009, are projected to expand by 4.3 and 6.2 percent this year and in 20111.
Policymakers around the world have responded swiftly and creatively to the crisis, using various instruments, including large-scale fiscal stimulus packages, very accommodative monetary policy, and decisive and often innovative support for the financial sector (liquidity provision, recapitalization, asset purchases and guarantees on various types of assets and liabilities). The objectives were to cushion the direct effects of the credit crunch and financial turbulence on the developed economies and to reduce the virulence of the so-called adverse feedback loop, in which economic weakness and financial stress become mutually reinforcing. In historical comparison, the cuts in interest rates by central banks around the world stand out as exceptionally rapid and proactive.
Fiscal policy has been particularly aggressive after the International Monetary Fund recommended that all countries with low debt and disciplined policies in the past that in turn left them with sufficient policy space be encouraged to undertake a fiscal boost equivalent to about 2 percent of GDP2. Indeed, the fiscal stimulus packages announced by G-20 countries amounted to 2.7 percent of total GDP, of which tax cuts and infrastructure each represented 0.8 percent, and other expenditure 1.2 percent3.
While the short-term effects of the policy response have helped the world economy avoid a depression, they have not addressed the underlying issues of heightened systemic risks, falling asset values, and tightening credit, which have taken a heavy toll on business and consumer confidence and aggravated a sharp slowing in global economic activity. The large provision of liquidity to banks and primary dealers by central banks has so far been mostly ineffective, because the current environment in developed countries is dominated by concerns about capital, asset quality, and credit risk as a result of the persistence of large excess capacity. These concerns continue to limit the willingness of many intermediaries to extend credit, even when liquidity is available.
Excess capacity could have persistent, negative effects on corporate profits, private sector investment and household consumption and may eventually render traditional monetary policies ineffective. To date, standard monetary policies have done little to address the underlying issues of heightened systemic risks, falling asset values, and tightening credit, which have taken a heavy toll on business and consumer confidence and aggravated a sharp slowing in global economic activity. Under excess capacity situations, low interest rates often do not stimulate private sector demand because often a lack of job security limits household consumption and investment opportunities.
Industrial production is on the rise but remains well below previous peaks. Global industrial production is growing at a 13 percent annualized clip. Nevertheless, industrial output in high-income countries is 14.5 percent below its January 2008 level. For developing countries, excluding China as well as Europe and Central Asia, the corresponding gap is markedly smaller at 2.2 percent. In contrast, output in China is now 20 percent above its level in January 2008. Reflecting these developments, capacity utilization rates across the world remain below pre-crisis peaks, although they have begun to inch-up in most countries. Exceptions include Bulgaria, Lithuania, and Romania, where utilization rates continue to decline4.
The outlook for the global job market also reflects the underutilization of capacity, which may well persist until 2014. Global unemployment has been on the rise since 2008, following four consecutive years of decreases. The International Labor Organization estimates the number of unemployed people worldwide in 2009 to be 212 million, up 34 million over two years. Wages in many industries are still flat or declining, further putting pressure on personal consumption. Deteriorating household balance sheets add to the uncertainty. The wait-and-see attitude of consumers and investors may sustain the downward spiral in output decline: the reduction in consumption due to the concerns about job security and low confidence about the future in turns causes even more excess capacity. Unfortunately, consumer confidence is not back to pre-crisis levels. Consumers' short-term outlook, while moderately more positive in recent months, does not suggest any significant pickup in activity in the future. Persistent high unemployment and shaky stock markets seem to be dampening optimism. Depending on consumer and business confidence in the next few quarters and the timing of fiscal and monetary stimulus withdrawal, global growth in 2011 could be as low as 2.5 percent and as high as 3.4 percent.
Moreover, financial markets remain troubled and private sector demand lags amid high unemployment. Excess capacity is also creating a vicious circle in financial markets: with still falling asset prices (real estate), private investment and household consumption are likely to remain sluggish, and excess capacity will persist. This dynamics in turn puts additional downward pressure to asset prices and corporate profits, and increases the volumes of nonperforming loans. The large provision of liquidity to banks and primary dealers by central banks has already been ineffective in many industries where concerns about capital, asset quality, and credit risk is limiting the willingness of many intermediaries to extend credit, even when liquidity is available.
Accommodative monetary policies that were necessary to stabilize financial systems when the crisis erupted should now be reassessed. There is wide consensus on the fact that keeping output close to potential and inflation low and stable should be the two main objectives of monetary policy. The key question is how to achieve these targets in the aftermath of the crisis6. Looking at the liquidity facilities and adding up the maximum levels reached by each, it is estimated that the US Federal Reserve (FED) alone loaned approximately $2 trillion to combat the crisis. Yet, in the face of excess capacity, “cheap money” has not been sufficient to stimulate private demand. Instead, access to cheap credit has fuelled the surge in some asset prices, most notably in emerging markets through trade and capital flows. Given low profitability levels in the real economies of many countries, such surges may not be sustainable. Central banks should therefore consider exiting from expansionary monetary policy.
While monetary policy should be reconsidered, there is a need for continued fiscal stimulus. In the short term, fiscal efforts to affect global output by spurring global demand should be sustained. But care needs to be exercised that “temporary” fiscal stimulus packages under way in many countries do not become a means of avoiding some of the difficult adjustments that will be needed eventually in most advanced economies (rethinking budget priorities and allocation, enforcing public expenditure controls, undertaking entitlement reform and implementing new strategies for revenue generation).
However, an immediate challenge accompanying the pursuit of active fiscal policy is the rising debt levels in many countries. Government deficits are already quite high in many industrialized countries and expected to be well above 9 percent of GDP in 2010 in the United States, the United Kingdom, and Japan (see Figure 2). Public debt in the advanced G-20 countries is projected to reach nearly 120 percent of GDP by 2014. Under such a scenario, it is estimated that returning to pre-crisis ratios would require rapid structural gains in budget balances of the magnitude of 8 percentage points of GDP. This would not be easy, given the scope of existing entitlement programs, defense budgets, and demographic trends. Even if fiscal stimulus packages are unwound relatively quickly, debt levels may still be too high.
As rich countries adjust their fiscal strategies to cope with high levels of indebtedness, developing economies face a different set of challenges: Many poor countries are not even in the position to implement counter-cyclical policies. They currently have both large current account and fiscal deficits (an estimated one-third of developing countries currently have large current account deficits of 10 percent of their GDP).
With the tightening of international financial conditions, firms in developing countries will face higher borrowing costs, lower levels of credit, and reduced international capital flows. Over the next 5 to 10 years, increased risk aversion, a more prudent regulatory stance, and the need to curb some of the riskier lending practices during the boom period that preceded the crisis can be expected to lead to scarcer, more expensive capital for developing countries.
Foreign direct investment (FDI) should be less constrained than debt flows. However, parent firms will face higher capital costs, reducing their ability to finance individual products. As a result, FDI inflows are projected to decline from recent peaks of 3.9 percent of developing country GDP in 2007 to around 2.8-3.0 percent over the medium term. The consequences of such a decline could be serious, as FDI represents as much as 20 percent of total investment in Sub-Saharan Africa, Europe and Central Asia and Latin America. As a result, the World Bank projects that over the next 5 to 7 years, trend growth rates in developing countries may be 0.2 to 0.7 percent lower than they would have been had finance remained as abundant and inexpensive as in the boom period. It is estimated that the poorest countries, those that rely on grants or subsidized lending, may require an additional $35-50 billion in funding just to sustain pre-crisis social programs.
For high-income countries, there is an urgent need to implement economic policies that prevent situations of the type that Japan suffered in the 1990s. During the “lost decade”, Japan's government was very aggressive in implementing a fiscal stimulus. In 1991, public debt represented 60 percent of the country’s GDP. By 2002, it had increased to about 140 percent—that 80 percent increase in government debt over a period of just 11 years implies a very large and very decisive stimulus of 7 percent of GDP per year. Yet, Japan did not emerge from the crisis. Rising debt levels, the ineffectiveness of monetary policy and the uncertainty surrounding fiscal policy pose serious risks of stagnation to in high -income countries.
Preventing a persistent global stagnation or slow growth should be a key priority for macroeconomic policy makers around the world. In recent decades, global growth has been mainly driven by high levels of consumption in the United States, often reflected in large imports from labor-abundant developing countries like China, where large quantities of goods could be produced and exported at very low cost. Much of that consumption was financed by easy credit made possible by lax monetary policy and insufficiently regulated financial markets. With the adoption of new restrictions on the size and scope of financial institutions to rein in excessive risk-taking and protect taxpayers (the so-called Volcker Rule8), the deleveraging, and the daunting challenge of excess capacity, access to credit is likely to be tighter in the most foreseeable future. Such problems would translate into sluggish growth in developing countries that rely mainly on international trade (the so-called “new normal” of lower growth). Thus, there is a need to reinvent the paradigm for generating growth in high- and low-income countries.
3. A NEW PARTNERSHIP FOR GLOBAL GROWTH
Continuing the implementation of fiscal stimulus packages is needed to sustain the global recovery but it can be constrained by low multipliers—the so-called Ricardian equivalence. As Barro has demonstrated, under certain assumptions, government deficits can be anticipated by private agents who react to tax cuts or public spending by increasing their savings because they realize that public borrowing has to be repaid later9. In such situations, it is conceivable that the multiplier could be less than 1, with the GDP seen as given so that an increase in government spending does not lead to an equal rise in other parts of GDP. This was clearly the case during Japan’s “lost decade”. A recent empirical study for the United States using data since 1914 estimates the multiplier for defense spending to be 0.6-0.7 at the median unemployment rate, with some evidence that it only rises with the extent of economic slack to reach 1 when the unemployment rate is around 12 percent10.
Another concern with the accumulation of public debt needed to support economic activity is the fact that it limits the fiscal space that countries may need if confronted with future crises. While Japan has been able to maintained interest rates near zero despite its debt ratio of over 200 percent, thanks to excess capacity and Ricardian equivalence constraints, the experience of several emerging market countries points to the existence of debt overhang effects. In economies where private agents have access to a limited pool of private savings, high debt levels can put upward pressure on real interest rates and crowd out financing for the private sector, which slows growth11. Therefore, it can be difficult to use expansionary fiscal policy in a recession when starting with a high level of debt.
The challenge for policymakers is to formulate strategies that stimulate global growth while ensuring long-term fiscal solvency. The relevant lesson from Japan is clear: Even if governments around the world agree to focus spending on public infrastructure, the issue remains of whether these fiscal programs will increase aggregate demand enough to offset the excess capacity accumulated during the 2002-2007 bubble. The Ricardian equivalence theorem assumes that fiscal policy is used for projects that yield the same productivity and growth rates as currently recorded by the economy. Yet, there are instances where fiscal stimulus packages are used to generate much higher productivity levels, which make them profitable investments for the government and allow the economy to grow and provide space for paying down the debt. If public spending is invested in projects and programs that release bottlenecks to growth and increase productivity, the investments will generate high enough future returns to pay for their costs, rational economic agents will not be taxed for repayment, the Ricardian equivalence effect will not exist, and the chance of a large multiplier effect and successful fiscal stimulus will be high.
“Green” investment and infrastructure are important avenues for enhancing productivity. “Green” investment aims at reconfiguring businesses and infrastructure to deliver better returns on natural, human and economic capital investments, while at the same time reducing greenhouse gas emissions, extracting and using less natural resources, creating less waste and reducing social disparities. Such investments are needed for national economies to transition from high- to low-carbon growth, which is required for coping with climate change and ensure environmental sustainability. In addition, “green” investments can boost short-term demand while preparing the ground for long-term growth. The challenge there is to finance and refocus policies, investments and spending towards a range of sectors, such as clean technologies, renewable energies, water services, green transportation, waste management, green buildings and sustainable agriculture and forests.
In designing strategies for achieving sustainable growth, especially in developing countries, it is important to keep in mind that infrastructure improvement is key to structural change and its corollary, industrial upgrading. An economy’s structure of factor endowments evolves from one stage of development to another. Therefore, the optimal industrial structure of a given economy will be different at different stages of development. Each industrial structure requires corresponding infrastructure (both “hard” such as power, transport or telecommunication systems and “soft” such as the financial system and regulation, education system, the legal framework, social networks, values and other intangible structures) to facilitate its operations and transactions. Economic development as a dynamic process requires industrial upgrading and corresponding improvements in infrastructure at each stage. When this is not the case, infrastructure becomes a major constraint on growth12.
As Korea’s example demonstrates, with strong leadership, it can be done. The country has always used major global crises as opportunities to transform its economic fundamentals and create new growth engines. According to the OECD, South Korea has enjoyed a boosted employment market with 200,000 new jobs since the outbreak of the global financial crisis, thanks to the government's economic stimulus packages. In the 2008-2010 period, its fiscal stimulus is forecast to account for about six percent of the gross domestic product, the largest among OECD members. The South Korean economy is also projected to grow 4.4 percent in 2010, performing better than most industrialized countries. The main reason for this is the allocation of 80 percent of its fiscal stimulus to public investments and subsidies to companies for the “green” transformation.
China’s economic stimulus of 1998-2002 is also an example of a successful fiscal policy strategy that enhances growth by targeting binding infrastructure constraints to growth. The Chinese economy entered a period of deflation at the end of 1997. In the midst of the Asian financial crisis, neighbors all depreciated their currencies with sharp economic slumps in Indonesia, Korea, Malaysia, Philippines, and Thailand. China chose to hold its exchange rate steady, and to launch a very large fiscal stimulus in 1998-2002. The government issued an estimated RMB 660 billion in bonds specifically to finance infrastructure, including highway, port facilities and electricity grids. As a result, the country’s infrastructure was improved substantially. For example, the total length of highway increased from 4,800 km in 1997 to 25,100 km in 2002. That strategy allowed China to effectively combat deflation, with uninterrupted growth at 8 percent on average during that period. Moreover, with the improvement in infrastructure the growth potential was enhanced. The average annual growth rate was increased from 9.6 percent in 1979-2002 to 10.8 percent in 2003-2008. With the increase in growth rate, the government’s fiscal revenue increased and the public debt as a percentage of GDP declined from about 30 percent in 1990s, down to 20 percent in 2008.
Unfortunately, the scope for investments in bottleneck-releasing type of infrastructures is limited in high income countries. Recent stimulus packages in developed countries such as the United States, the United Kingdom and Germany, have allocated a significant proportion of funds to tax cuts. This choice reflects not only political dynamics or the lack of so-called “shovel-ready” projects for quick injection of demand, but also the fact that in matured high-income countries, much of the critical infrastructure already exists. It is therefore hard to find “bottlenecks” – a reality that clearly impedes developed country growth. Indeed, many new public projects might not increase the growth potential for these countries. Moreover, “green” investment by itself may not be enough to stimulate economies that are trapped with excess capacity—especially in the capital goods sector.
The main policy objective in rich countries should be to create the conditions for sustained global demand. In today’s increasingly globalized economy, external demand and domestic demand can have the same effect on overcoming the crisis. Developing countries exhibit quite a lot of opportunities for projects that would remove bottlenecks to growth due to their poor infrastructure. Studies suggest for example that raising infrastructure services of all Sub-Saharan countries to the level prevailing in Korea could add 2.6 percentage points to per capita growth (World Bank, GMR 2009). Well-targeted investment in infrastructure in developing countries would boost their productive potential and also helps in the fight against poverty, by improving access to basic services such as public transportation, electricity or clean water. Therefore, channeling investment to where it can be most effectively utilized and investing in the developing world would be a profitable venture for industrialized countries.
An important lesson of the global recession is that close multilateral cooperation is a key condition for achieving and maintaining strong and balanced growth. It has become clear to all that creating the conditions for a more stable world requires committed and mutually consistent policy efforts that benefit both rich and poor countries. To overcome a global recession characterized by excess capacity, economic policies must aim at increasing global demand and productivity. Finding a mechanism to channel funds from rich countries to invest in high-return/high-growth potential projects in the developing world can help absorb existing excess capacity, create immediate effective demand for exports from the developed world, and also help strengthen the long-term fiscal position of the developed world. Struggling Asian, African, and Latin American countries should be part of the solution to the global crisis—not only on moral grounds, but also on the basis of economic logic.
A capital increase for the World Bank Group and other multilateral development banks would strengthen their capacity to finance investments that remove binding constraints on growth in developing countries and help solve the current global crisis. Besides the political economy issues involved (i.e., the difficulty to garner public support in the context of high fiscal deficits and high unemployment), no single individual industrialized country government may have enough incentives to support such cross-border investments because of the high cost and the “free-rider” problem involved. Therefore, support by all the high-income countries and reserve-rich countries should be required to increase the lending capacity of multilateral institutions. Such infrastructure investments would provide a profitable vent for the surplus capacity of firms in higher-income countries, and it could release the bottlenecks to growth that are hampering production, trade, and private-sector investment in developing countries. They would generate win-win opportunities for developed and developing countries to achieve a sustainable recovery, and overcome the slow global growth syndrome of the “new normal”.
Sovereign wealth funds could also finance such infrastructure investment in developing countries. For high-income countries, it would be an effective way of sustaining their recovery—just like the Marshall Plan, the additional funding would provide business opportunities for firms in industrialized economies and stimulate both their domestic demand and exports. For rich countries with large foreign exchange reserves, it would be a mechanism to restore stability in global trade and the management of their surpluses. For poor countries, financing from sovereign wealth funds would provide the much needed resources for domestic or regional projects that meet the market test—i.e. those projects with good returns.
4. CONCLUSION: KOREA’S LEADERSHIP ROLE
One of the lessons from the crisis is the recognition of the extent to which world economies are interconnected, and the acceptance that there is an opportunity to achieve substantial, perhaps historic, progress in strengthening international cooperation, and improve the global financial architecture. At their meeting in St Andrews in November 2009, Finance Ministers of the G-20 agreed on a process for mutual assessment of the consistency of their policies with their shared objectives of “strong, sustainable, and balanced growth and of raising living standards in the emerging markets and developing countries.”
The World Bank has important responsibilities to fulfill in this evolving process, and we are acting with vigor in anticipating and adapting to the needs of our members. Our institution has been asked by the G-20 countries to assess the implications of their national policy frameworks for development and poverty reduction. The inclusion of development and poverty reduction explicitly in the G20 growth framework and related mutual assessment process is particularly welcome, as it provides an opportunity for incorporating development issues more fully and systematically into G-20 policy discussions―which had focused predominantly on issues of macroeconomic policy and stability.
Because they now represent the epicenter of the world economy, Asian countries should strive to cooperate with other industrialized countries to sustain the recovery and combat world poverty, which is the source of instability and insecurity. Over recent years, Korea has become an even bigger player on the economic world stage. Thanks to strong fundamentals and quick and forceful policy responses to the crisis, it has performed considerably better than others—and has thus played an important role in supporting the global recovery. The Korean authorities have taken decisive and proactive fiscal measures to mitigate the effects of crisis, with the cumulative size of the 2009-2010 fiscal stimulus amounting to 4.8 percent of GDP, well-above the average response of other G-20 economies14.
As the host of the November 2010 G-20 summit, Korea has the opportunity to set the agenda and shape discussions for a new economic development and risk management model at the global level. It can also lead the effort to create a new, innovative mechanism for coordinating finance investment, irrespective of national borders, and channel it where its marginal impact is the greatest.
