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Crisis Update

The Day After Tomorrow: Fiscal Quality

Submitted by Otaviano Canuto, co-authors: Marcelo Giugale on Thu, 10/14/2010 - 12:41

This is the second in a series of blogs where we take a look at the issues and the countries that will be at the forefront of the development agenda, not now, not next year, but over the next 2 to 5 years—as we discuss it in more detail in the recently released book The Day After Tomorrow: A Handbook on the Future of Economic Policy in the Developing World.

Most advanced countries face a post-crisis period in which fiscal adjustment will be the norm. They need more revenues and less expenditure. Their priority is quantity. In contrast, developing countries came in and out of the crisis with relatively strong fiscal positions, and see a horizon of solvency, especially those that export commodities. This gives them an opportunity to improve the functioning of fiscal policy—their priority is quality. There are several reasons to believe that many of them will seize the opportunity.

First, fiscal policy may start leaning more “against the wind,” that is, may become more countercyclical. This is not just because of the proliferation of “medium-term budget frameworks,” “fiscal rules,” and “fiscal responsibility laws,” many of which were in place before the crisis. There are also the political rewards that accrued to leaders that had previously accumulated funds and could spend them at the outset of the global recession. Think Chile’s former President Bachelet. Imitation is likely.

Re-thinking Trade Models - Why did Trade Collapse During this Crisis?

Submitted by Raj Nallari on Sun, 07/04/2010 - 14:00

Seventy percent of all trade is trade in goods. World trade volume declined by over 20% from peak levels trough April 2008 to January 2009, and this decline was observed across the board – advanced economies recorded a decline of over 23%, Asia about 25%, and so on. Several explanations were provided. One was that countries were raising tariffs and nontariff measures to protect domestic industries during the global downturn. Now, there is evidence that despite some ‘buy American’ and ‘buy British’ type of fiscal stimulus packages, and notwithstanding the rhetoric of governments, protectionism was muted and almost all countries held up their side of the WTO agreements. Others stressed that decline in economic activity was the primary cause of sharp decline in trade. But as pointed out by Chinn (2009) and others, the decline in US imports was much larger than that warranted by the decline in US GDP. The value of the dollar, as it gained strength during a period of international uncertainty, and the change in relative prices were other plausible explanations, but these too do not fully explain the decline in trade volume across all parts of the world.

The Next Wave of This Crisis

Submitted by Raj Nallari on Wed, 06/30/2010 - 16:52

After all is said and done, this crisis had its genesis in US and European countries living beyond their means. This was reflected in large current account deficit which was financed by emerging economies of China, Russia, Brazil, Korea and others. This was in contrast to economic theory which tells us that advanced economies are supposed to generate savings and hence have current account surpluses while developing countries should be borrowing to finance their deficits (as they need foreign capital to finance their infrastructure and other needs).

The world is in the midst of extreme political risk – defined as not only wars and coups but governments rushing in with quantitative easing, banking bailouts, and large fiscal stimulus packages, embarking on industrial policies, and trying to re-regulate without fully understanding the unintended consequences of their actions. These expansive domestic policies have increased sovereign debt risk and raised stock prices in a large number of countries. Governments are trying to find domestic solutions to global problems of market volatility – volatility as reflected in descent of euro vis-à-vis the dollar, large movements in stock market indices, and swings in commodity prices. Markets in turn are looking at how governments are coping with big problems, such as the sovereign debt problems in Greece, Spain and other European countries. California could default on its debt obligations – what then for the global economy?

Reflections on Development Economics After the Crisis

Submitted by Jean-Christophe Maur, co-authors: Raj Nallari on Tue, 06/15/2010 - 10:15

We took advantage of the recent ABCDE conference in Stockholm during May 31-June 2, 2010 to hold side discussions with 15 high-profile academics and researchers. We were expecting that they would tell us that economic development thinking should be revisited in the light of the crisis, but surprisingly, the responses were that likely no. Views fell in two broad camps – first, that it is too early to say because the evidence has not yet been fully studied; and second, as far as the poor are concerned, the crisis is a ‘tempest in a tea-cup’ as the bottom 20% of the population living close to the poverty line of $1.25 per day are in ‘perennial’ crisis, are always at risk and vulnerable.

The finer grain of the researchers’ reflections highlighted six main aspects:

(1) Those focusing on extreme poverty alleviation underscored that even before the crisis markets were not working for the poor. The crisis unfortunately furthers highlights this and will probably impede further efforts to fight against poverty. Financial markets were singled out as particularly deficient. It was observed that globalization has widened the income inequality with haves at one end and poverty traps at the other end. Some of our interlocutors went further to say that the bottom 20 percent do not have physical capital/assets to use as a stepping stone, and a solid enough human capital base, and therefore end up being forced to eke out a living relying on natural capital (environmental assets) and social capital precluding any possible accumulation.

Recoupling or Switchover

Submitted by Otaviano Canuto on Tue, 06/01/2010 - 17:30

The current recovery in advanced economies is now exhibiting several signs of fragility. Their medium term growth prospects also look difficult. In this environment two questions arise: Will developing economies experience a renewed downward “recoupling” as a result of a low-growth scenario in advanced economies? Or, on the contrary, could developing countries “switchover” to become locomotives in the global economy, providing a countervailing force against an otherwise slowing-down train? As discussed in my new paper, here are some of the factors pushing in these two opposite directions.

Several factors point to a medium-term reduction of both actual and potential growth in most advanced economies. First, sooner or later fiscal consolidation will become a major issue among advanced economies once—or even before—recovery is fully established. Future fiscal contraction negatively affecting the private sector will be the price paid for the role of fiscal stimulus in helping rescue advanced economies from the brink of the abyss during the crisis.

Secondly, the process of US households’ balance-sheet deleveraging and adjustment is far from complete. Consumption spending growth is likely to remain weak and/or wobbly in the absence of large renewed hikes in asset prices.

A third aspect to weigh against a return to a high-growth path is the likely jobless nature of the current recovery in many high-income countries. Slow-to-reverse shocks—a financial crisis combined with a house price bust, cross-sector differentiated job creation/destruction—have been in play and continued macroeconomic uncertainty is also countering employment growth.

Conditional Individual Bailouts - a Potential Anti-crisis Instrument

Submitted by Ihssane Loudiyi on Mon, 04/12/2010 - 12:48

by Rebekka E. Grun

Why save the banks, and not their clients?

The current financial crisis is not the first for economists or central bankers. What was relatively new though is that many proven tools do not seem to work. Monetary impulses, liquidity – for a long time the market did not seem to take notice. Fiscal impulse, stimulus packages and bank bailouts – little success in most places. Increasing the dose – ditto. Maybe it is time to step back and acknowledge this crisis as different, to examine it for specific causes and tailor a new tool.

The root cause of the crisis is known; financially semi-literate clients were talked into mortgages they did not understand and resulted a bigger bite than they could chew. This happened to an extent that generated a crash wave big enough to shake more than one national banking sector.

Why now does the discussion on remedies not focus on this cause? Why not save the individuals that went bust rather than their banks? Unconditional bailouts, of course, would generate the wrong incentives (for the banks as well, by the way). It is therefore important to attach smart conditions to discourage free riding. For example a course in financial literacy and commitment to a program of (maybe painful) debt restructuring, and possibly further measures to improve the education or health of the affected individual or family.

Greece's $6.5 billion Crisis Plan

Submitted by Ihssane Loudiyi on Wed, 03/03/2010 - 18:31

In order to fight the financial crisis, Greece will take new austerity measures ranging from cutting civil salaries to increasing consumer taxes. A summary of some of these key fiscal measures can be found here.

According to the Associated Press article, Prime Minister George Papandreou explained that the country must get back on its own feet with the help of the market and the EU: "Now, it is the time of Europe."

Greece will however turn to the International Monetary Fund (IMF) as a last resort if the cost of borrowing for the country is not brought down with the collaboration of European counterparts such as France and Germany.

Already high unemployment rates in Greece might further be affected by these measures that are also likely to cut back on consumer spending.

The Greatest Financial Crisis Globally Ever?

Submitted by Ihssane Loudiyi on Thu, 02/25/2010 - 17:55

Yes, according to Former Federal Reserve Chairman Alan Greenspan in his speech to Washington on Tuesday. He added in the Bloomberg News article that the global recovery from the recent crisis will be "extremely unbalanced".

The World Bank also estimates that 64 million more people globally may be living in extreme poverty by the end of 2010 as an aftermath of the crisis. Although GDP growth is improving globally, it will be a long road to full recovery as developing countries need to anticipate scarcer and more expensive capital.

The World Bank feature story on Crisis, Finance and Growth on the new 2010 edition of Global Economic Prospects (GEP 2010 - released January 21) provides more insight and shows that, while the worst is over, the global economy may indeed be fragile for years to come.

Changing Development Paradigms

Submitted by Raj Nallari on Wed, 01/06/2010 - 13:20

This global crisis in not only about financial market failures but also government failures in several countries as reflected in failure to contain the housing bubbles and credit booms, bad regulations, and lack of supervision and enforcement). Both in advanced and developing countries, there are second thoughts on open markets, private ownership of nationally ‘strategic’ industries (autos, banks), and movement of transnational financial and industrial firms, and migrant labor. Trade and financial protection is on the increase as countries that have been less reliant on exports and foreign capital are weathering the storm better. In this semi-open global environment, would export-led growth strategy be combined with industrial policies to protect domestic industries, and/or emphasize resource-dependent growth, where possible?

Before we respond to these questions, it will be useful to focus on what went wrong in economics in 2007-08. Some economists are re-inventing economics to respond to such a query.

The 'Perfect Storm'

Submitted by Raj Nallari on Wed, 12/23/2009 - 11:12

The collapse of the dot.com bubble in early-2001 and the 9/11 attacks was followed by an easing of monetary policy in the US and Euro Area as a response to avert an economic slow-down. Around the same time, coming out of the Asian crisis, emerging BRICs and Gulf countries started building up huge foreign exchange reserves, primarily denominated in US dollars and safest financial securities, such as US Treasury bills. The ex-ante global saving glut that resulted from the emergence of the BRICs and the redistribution of global wealth and income towards the Gulf states caused by the rise in oil and gas prices. This depressed long-term global real interest rates to unprecedentedly low levels (see Bernanke (2005). The supply of safe financial assets did not meet the demand. Western banks and investors began to scout around for alternative, higher-yielding financial investment opportunities. China, India, Brazil, Vietnam and other labor-rich but capital-scarce countries raised the return to physical capital formation everywhere. The unsustainable current account deficit of the US was made to appear sustainable through the willingness of China and many other emerging markets to accumulate large stocks of US dollars, both as official foreign exchange reserves and for portfolio investment purposes.

The excess liquidity in the world went primarily into credit growth and resulted in speculative bubbles in housing, stocks, and commodities (and not into consumer price inflation). The exact time when the home mortgage problems surfaced can now be pin-pointed as mid-2006 even though the housing problem was not fully acknowledged by the government and market players until almost summer of 2007. By mid-2006, there was now enough evidence that housing prices began to decrease significantly and default rates increased in some states such as California, Arizona etc.