As Prepared for Delivery
Speech at the Stanford Institute for Economic Policy Research (SIEPR)
Watch the full recording of the speech.
It is a pleasure to be here at Stanford. Thank you to the Stanford Institute for Economic Policy Research (SIEPR) and the King Center on Global Development for the invitation.
As we gather in this prestigious institution, a tough reality confronts the global economy – and especially the developing world. A series of harsh events and unprecedented macroeconomic policies are combining to throw development into crisis. This has consequences for all of us due to the interlinked nature of the global economy and civilizations around the world.
The World Bank Group’s mission is to alleviate poverty and boost shared prosperity. We leverage shareholder equity and annual contributions to provide grants and make loans to developing countries to help identify and respond to development challenges. Our financing to developing countries has expanded dramatically in recent years, especially for climate-related finance, which reached $31.7 billion in fiscal year 2022.
Of concern to our mission, our upcoming Poverty and Shared Prosperity report suggests that the deterioration in development progress began well ahead of the COVID-19 pandemic. The report shows that poverty had been steadily declining through the 1990s and 2000s, progress had slowed by 2015, and extreme poverty rose by roughly 70 million when the pandemic hit. The report also shows a 4% decline in global median income, the first decline since our measurements of median income began in 1990.
Human Consequence of Overlapping Crises
The developing world is facing an extremely challenging near-term outlook shaped by sharply higher food, fertilizer, and energy prices, rising interest rates and credit spreads, currency depreciation, and capital outflows. Under current policies, global energy production may take years to diversify away from Russia, prolonging the stagflation risk discussed in the World Bank’s Global Economic Prospects report from June 2022.
These shockwaves have hit development at a time when many developing countries are also struggling in other areas: governance and rule of law; debt sustainability; climate adaptation and mitigation; and limited fiscal budgets to counteract the severe reversals in development from the COVID-19 pandemic, including in health and education.
The human consequence of these overlapping crises is catastrophic. The COVID-19 pandemic – which alone led to over six million deaths – geopolitical conflicts, and extreme weather events have hurt countries and people worldwide, with the poor bearing the brunt, especially women and girls.
Evidence by the World Bank shows that 70% of children in low- and middle-income countries are in learning poverty – which is the share of children who are unable to read or understand a basic text by age 10. COVID-19 worsened the global learning crisis and resulted in the worst shock to education and learning in recorded history. Moreover, new challenges already loom in the form of demographic pressures: by 2030, according to UN population projections, more than 1 in 4 primary-school-age children will live in Sub-Saharan Africa, the region with the highest learning poverty. This indicates that education systems are now further away from reaching quality education for all.
The recent floods in Pakistan have left over 1,500 people dead. Droughts are taking a toll in the Horn of Africa and in South America, affecting food production and hydropower generation and throwing nine million more people into severe food insecurity across Ethiopia, Kenya, and Somalia alone. Developing countries are being hit by more frequent and more severe climate-related disasters. Man-made greenhouse gas emissions are causing climate change, which in turn is having tragic impacts on development in multiple ways. Both adaptation by countries and people harmed by climate change and mitigation of greenhouse gas emissions are urgently needed. This set of challenges receives the largest share of World Bank Group resources and focus. The World Bank Group has not financed new coal projects since 2010 and has been working actively with developing countries and partners in the global community to reverse the trend toward increased use of high-carbon emission fuels. Yet due to Russia’s invasion of Ukraine, and limited and high-priced natural gas supplies, coal-fired power plants are seeing their closures postponed across the world, and coal mining has accelerated.
Facing these overlapping crises, a pressing danger for the developing world is that the sharp slowdown in global growth deepens into a global recession, as the World Bank discussed in a September report. Global GDP per capita in 2021 barely exceeded its pre-pandemic level, but many developing countries have not reached their pre-pandemic per capita income levels. The U.S. has experienced contractions in GDP in the first two quarters of 2022. The sharp decline in asset prices worldwide has consequences for weakened corporate and pension balance sheets and could dampen new investment. China’s economy has slowed sharply due to COVID-19-related lockdowns, pushing the World Bank’s 2022 forecast for China down to 2.8% from 5% in April. Europe is confronting the sudden spike in energy prices caused by Russia’s invasion of Ukraine and market rigidities. The weakness of the euro and high inflation increase the likelihood of a European recession and further constrain the eurozone’s longer-term growth outlook.
Looking beyond this sharp cyclical downturn, developing countries face the risk that these trends in advanced economies –inflation, slow growth, lower productivity, the drain on global energy supplies, and higher interest rates – persist beyond 2023. If current fiscal and monetary policies become the new “normal,” it implies heavy absorption of global capital by advanced governments, prolonging the under-investment in developing countries and hampering future growth. This was the subject of my Churchill Symposium remarks at Zurich University in May, which focused on stagflation, capital misallocation, and the cost of Europe’s energy realignment.
The macroeconomic challenges facing development are consequential and are probably worsening. I’ll return to that in a moment, but I want to take note that there are many other aspects of the development crisis that also require global efforts. These include the devastating flow of arms into Africa, the consequent political fragility, adapting to climate change, mitigating greenhouse gas emissions, the violence and deprivation facing women and girls, and the severe reversals in education, health, and debt sustainability that I mentioned earlier. The World Bank Group works extensively in each of these areas, and I’d like to take a moment to highlight this work and thank our staff.
To combat the crises, the World Bank Group responded with unprecedented urgency, scale, and impact, deploying a record $115 billion in financing in FY22. We have committed consecutive surges of financing, analytical support, and policy advice, first in response to COVID-19, and now to address the food and energy crisis, the war in Ukraine, and its spillover effects. The war inflicted by Russia has brought loss of lives and destruction. The World Bank has mobilized $13 billion in emergency financing from bilateral and development partners, with about $11 billion already disbursed through our projects and trust funds.
To combat climate change, the World Bank Group is by far the largest single funder of climate-related finance in the developing world and a leader on climate diagnostics, methane emission reduction, and innovative climate financing. We are also the largest external funder of education in developing countries, much of it through the grants and highly concessional loans offered by IDA, the World Bank’s fund for the poorest 75 countries, and related trust funds. The health challenge is similarly immense, including the need for a wide range of life-saving vaccinations and preparedness for future health crises. With strong U.S. support and leadership, we have just launched a new trust fund for Pandemic Prevention, Preparedness, and Response (PPR) that will assess and strengthen health preparedness throughout the developing world. Each of these challenges and crises require urgent global attention and resources.
Confronting Unprecedented Fiscal and Monetary Policies
The remainder of my remarks today are focused on the macroeconomic challenge – the trade-off between the fiscal and monetary policies in advanced economies and the challenge this poses for stability and investment in developing countries. SIEPR is an important audience for this discussion, and I appreciate your interest.
At the core of the macroeconomic crisis facing development is the sea-change in fiscal, monetary, and financial regulatory policies of advanced economies since the 2008 financial crisis. Monetary policies over the last decade have been guiding capital to well-capitalized segments of the global economy – to governments, bond-issuing corporations, and wealthy individuals – at the expense of broad-based growth and development. Gross fixed capital formation in developing countries has been stagnant even as asset prices surged in advanced economies. The prospect of a continuation of these policies creates the risk of decades of under-investment in development. Four points stand out: first, the extent of the change in macroeconomic policy; second, the large size of the policies; third, the impact on the global allocation of capital; and fourth, the risk that these policies become permanent, impeding development.
Starting in 2008, advanced economies adopted wholly new monetary policies to combat the global financial crisis. Central banks set interest rates to zero or below and bought bonds financed by their own accumulation of excess bank reserves. These crisis-focused activities helped contain the impact of the financial melt-down. But as Larry Summers said in 2021 “…the beginning of wisdom is seeing that the quantitative easing prescription makes little sense today”.
Years of extremely low interest rates and the massive expansion of the monetary base controlled by pervasive regulation of credit amounted to a radically new monetary regime. In effect, monetarism gave way to post-monetarism in which the specifics of credit regulation and the central banks’ choice of bond holdings became more important than the money supply. The monetary base expanded manyfold during the first decade of this new policy without inflationary consequence because regulatory policy limited the money multiplication that would have occurred under the old system of reserve requirements. This left currencies relatively stable, but inflation vulnerable to supply chains and fiscal policy excess.
I’ll mention three side-effects of these new policies. First, with yields falling under the pressure of central bank bond buying (or, in the case of Japan, yields capped at a very low level) there is a search for yield that supports high prices on certain asset markets, such as real estate and bonds. Keeping these monetary policies for long periods allows asset prices to diverge from their fundamental values. In developing countries, this resulted in low government bond yields and borrowing costs, drawing capital into unproductive activities. Yet a shortage of working capital for trade finance and short-term financing as an increasing portion of the international banks’ short-term assets became interest-bearing loans to central banks.
Second, “low for long” reduced the incentives of business to clean up their balance sheets and of governments to push for structural reforms. Evidence shows that large-scale purchase programs have promoted the presence of zombie banks and businesses, which means that creative destruction is not occurring, damaging the economy’s growth potential. Research by the Bank for International Settlements (BIS) shows that the share of zombie firms – those with the ratio of the market value of their assets to their replacement cost (Tobin’s q) that is below the median within their sector – in advanced economies increased from 5 percent in 2000 to more than 12 percent in 2018, a misallocation of capital that is restraining productivity growth and raising the cost of capital needed for sound development.
A third example of increased capital misallocation can be seen in the U.S. investment-grade corporate bond market. Between 2008 and 2020, the amounts outstanding of BBB-rated bonds more than tripled to $3.5 trillion, representing 55% of all investment-grade debt in 2020, up from 33% in 2008. A growing concentration of issuance in the riskiest investment-grade bonds increased the vulnerabilities in the corporate sector. These materialized at the onset of the COVID-19 pandemic when the number of downgrades from BBB was two times larger than during the entire 2008 financial crisis. This vulnerability is one of the reasons the U.S. Federal Reserve (“the Fed”) had to step in to stabilize the U.S. corporate bond market in the wake of the COVID-19 shock.
During the COVID-19 pandemic, the major central banks moved fully into post-monetarism through their large purchases of long-maturity bonds. The balance sheet of the Fed ballooned from $4.2 trillion in March 2020 to almost $9 trillion two years later. The eurozone central banks expanded the balance sheet from 4.7 trillion euros to 8.7 trillion, propelled by the purchase of bonds of eurozone governments. The Bank of Japan’s bond ownership is increasing weekly as it maintains the 0.25% ten-year yield peg during yen weakness and rising global inflation. As a result, the monetary authorities of advanced economies have built their portfolios to over $20 trillion in government bonds, supporting those markets over others.
For now, by not renewing bonds that reach maturity, the Fed is reducing its balance sheet month by month. This has raised concerns about liquidity in the U.S. bond market, but even at the current pace, it would take more than four years for the central bank balance sheet to return even to its pre-COVID-19 level.
Importantly, a new concept of normalization has emerged in which the Fed will seek to maintain bank reserves as a percentage of GDP. Earlier concepts of monetary policy normalization had assumed a run-off of the Fed’s bond holdings and a related shrinkage of bank reserves. Today’s normalization policy and the projections in the Fed’s Open Market Operations report from May suggest large future net and gross purchases of government bonds by the Fed later this decade, making their choice of bonds and of the interest rate on the reserves used to hold them two critical issues for development and the flow of global capital.
Of course, fiscal policy has been changing dramatically toward larger national debts in the advanced economies. This has major impacts on capital markets worldwide as available savings flows into government securities. During the pandemic, governments borrowed heavily from savers around the world, almost always to support consumption more than production. Most of this spending or reduced taxation supported advanced economies, often consumption by people with incomes well above the median. Demand grew faster than supply, an imbalance that became more apparent when supply chains began to diversify from China and when the post-COVID-19 recovery and restocking got underway.
Relevant to development, the combination of large government spending, government debt issuance, and central bank bond buying had the effect of allocating increasing amounts of global capital to a narrow group. The purchase and ownership of bonds by central banks allocates capital from small savers to over-capitalized sectors of advanced economies. The regulation of banks has the explicit bias that debt of advanced country governments is considered zero risk while other debt, especially that of small countries, developing countries or new entrants, is treated as risky and requires bank equity capitalization.
The challenge for development is whether global capital will be enough to fund the capital needs of the advanced country governments and have enough left over for the investment needs of developing countries.
In 1990, Bob Lucas presented a puzzle (later known as the “Lucas Paradox”) by showing that even though poor countries have lower levels of capital per worker than rich countries – and therefore higher potential returns to added capital – capital does not flow well from rich to poor countries. Quite the contrary: capital generally flows from poor to rich countries. The literature has offered several explanations for this puzzle, ranging from capital market imperfection to institutions, political risk or human capital externalities.
Quantitative easing (QE) seemed to have modified this paradox – at least superficially. QE helped to ease risk aversion globally and lowered borrowing costs for emerging markets. Large capital flows from advanced economies flooded developing countries. The problem is that these capital inflows largely went to governments, not capital formation or foreign direct investment. Total public and private debt in developing countries increased by 60 percentage points of GDP since 2010, but in most of them, investment as a percentage of GDP declined. This combination is one of the most concerning trends for development prospects. High debt levels make developing countries vulnerable to external shocks and, in particular, to monetary policy normalization in advanced economies.
For advanced economies, a key challenge is that fiscal and monetary policy have increasing overlap, raising serious concerns for the independence of monetary policy. The starting point is the setting of interest rates with national debts very large relative to GDP. Second, the rising interest paid by central banks to commercial banks based on a rate set by the central bank is an explicit overlap between fiscal, regulatory, and monetary policy. Third, the liability management of the central banks, discussed earlier, has grown astronomically, creating challenges that are fiscal in nature. As fiscal and monetary authorities adjust to each other’s maturity decisions of central banks, the policy overlap is large and growing. And fourth, perhaps the largest overlap is due to the unprecedented size of the maturity mismatch of the central banks as they fund long-maturity asset portfolios with overnight bank reserves and reverse repurchase agreements. The maturity mismatch affects not only the flow of global capital and financial regulatory policy – it has institutional impacts as well. As the book value of central banks declines, and likely goes negative with the sharp ongoing decline in global government bond prices outside Japan, the central banks’ need for absolute political support increases. These concerns can be addressed, but the worry is that they are significant enough to prolong the shortage of investment capital for development. With few effective statutory or constitutional limits on debt in most advanced economies, this tension can be expected to continue, especially during downturns.
Over the years of post-monetarism, the increase in fiscal and monetary policy accommodation has fed primarily into asset prices in advanced economies. This supports the wealthy who hold these assets, rather than the bulk of the population, at a moment of nearly unprecedented inequality. Growth in median income has lagged with only a few exceptions; for developing countries, capital inflows mostly supported government spending and asset portfolios, with little showing up in foreign direct investment or gross fixed capital formation.
To unwind this imbalance would require clear communication that increased production is a policy goal as is a market-oriented flow of capital to development. With inflation high, several tools are available beyond interest rate hikes: first, create the conditions for supply to increase in response to price increases; markets are forward looking, so even the announcement of future supply by private investors and governments would help; second, in the advanced economies, reduce the size of government current spending and improve efficiency by targeting it more on the poor and vulnerable; this would reduce non-productive demand and leave more space for global capital markets to fund investment, taking pressure off inflation; and third, reduce the maturity of the central banks’ current and future bond holdings; this would send a signal to markets that capital can flow to other assets such as the short-term floating rate capital needed by smaller businesses to increase global output.
These adjustments of macroeconomic policies would improve the allocation of global capital, providing a path to reduce inflation, increase the value of a broader set of assets, and restart the growth in median income that is key to shared prosperity. The alternative is the status quo – slowing global growth, higher interest rates, greater risk aversion, fragility in many developing countries.
The crisis facing development is intensifying. Developing countries are in the middle of one of the most internationally synchronous episodes of monetary and fiscal policy tightening of the past five decades. Central banks in developing countries are already facing critical macroeconomic dilemmas. To curb the damaging inflation stemming from food, energy, and other imported and domestic goods and services, central banks in developing countries are having to raise interest rates and their private sectors will be facing much higher borrowing costs. This effect is being amplified as the search for yield becomes a search for safety, accelerating capital outflows and a depreciation of domestic currencies. Moreover, the aversion to long term investment risk is growing. The negative impact on growth is already palpable. At the same time, this new crisis that follows COVID-19 finds developing countries with eroded fiscal positions, including high debt and depressed budget revenues. Countries do not have enough fiscal buffers to provide support to key pro-growth and development spending.
More spending on education and health preparedness are urgently needed. Developing country governments will need to spend their limited budget in these sectors more efficiently. Infrastructure investment is key to enable jobs in the short term and growth over the medium-term. In times of crisis, these critical investments often lose out. We need to push against that historical trend through expanded private sector participation and optimization of the often-large balance sheets of SOEs.
The fiscal needs can also be helped with decisive action to broaden the tax bases and improve collection efficiency. Debt relief from bilateral and commercial creditors will also play a key role in the most indebted countries. Indeed, the potential magnitude of the debt crisis ahead raises the stakes and may galvanize the interest by all parties in finding a workable solution.
At the same time, the climate crisis caused by greenhouse gas emissions continues to be relentless. Climate-related natural disasters are impacting agriculture production, livelihoods of people across sectors of the economy, and migration. To support climate action, many developing countries need massive investments, concessional finance, and grants to enable their energy, transport, and agriculture transitions. Large sources of funding are also needed to support adaption and resilience in most developing countries. A principal thrust of our Climate Change Action Plan is to identify concrete impactful projects and policies in these areas and build the financing mechanisms and facilities to help the global community support global public goods in developing countries. We’re working with public and private partners, shareholders, and stakeholders on these challenges in the recognition that much more needs to be done in these areas.
Weathering this perfect storm and undoing the recent reversals in development require new macro- and micro-economic pathways in both advanced and developing countries. The urgency is clear in daily news reports of inflation, climate change, famine, civil protests, and violence. The World Bank Group is fully engaged in these challenges, realistic in our assessments, and eager to work on solutions, including with all of you participating today.