1 TRADE AND DEVELOPMENT REPORT 2011: Post-Crisis Policy Challenges in the World Economy Vaibhav Gupta MIB, DoC, DSE, DU

2 Main messages  Economic recovery is losing steam, particularly in advanced economies  A shift from fiscal stimulus towards fiscal tightening at this time is self-defeating – fiscal space is a largely endogenous variable  Comprehensive financial reform is needed more than ever – unambitious efforts initiated after the crisis have failed

3 Global economic recovery is slowing down, with strong downside risks

4 “T wo-speed” recovery pattern continues Note: Linear trends correspond to 2002–2007. Real GDP at market prices, 2002–2011 (Index numbers, 2002 = 100)

Fiscal Aspects of the Financial Crisis  Governments’ Fiscal Policy more viewed as a problem than solution  Policy driven fiscal stimulus packages and affect on fiscal balances and public debt through several channels: Reduced tax Revenues Increasing Social Expenditure(Developed Economies) Abrupt fall in commodity prices(Exports Economies) Currency depreciation and high interest rates spreads Government bailing out ailing institutions(Developed) which converted former private debt to public debt.

 So, the CRISIS clearly was not the outcome of excessive public expenditure on public sector deficits; rather it was the cause of fiscal deficits and / or high public-debt-to-GDP ratios.

Fiscal Tightening from Fiscal Stimulus  Some economies have already started this, some are planning, to gain confidence of financial markets.  Although it is clear that crisis was the result of financial market failure, little has been learned about placing too much confidence in the judgment of financial actors including “rating agencies”.  Worst seems to be over– but policymakers and large body of public opinion are again putting trust in the same agencies

Fiscal Tightening from Fiscal Stimulus  Fiscal tightening appears to be premature in any case in many countries, where private demand has not yet recovered on a self sustaining basis.  Could be self –defeating Weakens the recovery Hampers improvement in public revenues Increases fiscal costs related to recession and bailouts. Hence, by hindering growth, such a policy would fail to achieve fiscal consolidation.

Lawson Doctrine Contradiction  Primary deficits caused by discretionary fiscal policies were a much smaller contribution to higher debt ratios than the slower (or negative ) GDP growth and banking crisis.  Therefore any policy that seeks to reduce public debt should avoid curbing GDP growth; without growth, any fiscal consolidation is highly unlikely to succeed.  These findings challenge the influential “Lawson Doctrine”, that financial crises are caused by excessive public sector borrowing, and that private sector debt never poses a problem because it is the outcome of optimal saving and investment decisions

Talking of US  US need to invest: Investment should come in Job Skills and Infrastructure. Makes the scene more competitive.  Declining Social Mobility, lacking in public finance in preschool and teachers’ union.  They have been long demonizing governments. Need to stop.  Reagen himself once said, “ Government does not create problem, Government is the problem”.  Most dynamic economies of the world are promoting market reforms India, China, Brazil, why not US.

and the world  Age of global dissatisfaction  Partying hard is fun, but it is often followed by even harder hangover.  Special case : Argentina(2001 crisis: $100B default) : 5 presidents in 2 weeks Incumbent Cristina re-elected. Huge subsidiaries Doctored numbers of Inflation Devalued currency  Greece can soon follow in Argentina’s footsteps

12 Developing countries cannot lead the global recovery  They have insufficient weight, relatively low absorptive capacity and cannot issue international currencies  Most large emerging economies face demanding domestic adjustment needs which require significant domestic resources  They also face significant external risks because of continued economic weakness in developed economies and the lack of significant reforms in international financial markets – they are vulnerable to decline in trade volume and sharply fluctuating primary commodity prices

13 Global imbalances remain a risk to sustained economic recovery  Post-crisis unwinding has been short-lived  Country-specific evolution depends on whether domestic demand (BRIC) or net exports (Germany, Japan) drive recovery  Exchange-rate movements have sometimes enlarged imbalances

14 Premature fiscal tightening is counterproductive  The best strategy for reducing public debt ratios is to promote growth and maintain low interest rates  Fiscal space is a largely endogenous variable  Fiscal retrenchment is likely to be self defeating, as it affects GDP growth and reduces fiscal revenues  ‘Functional finance’: changing the composition of revenues and expenditure can further extent fiscal stimulus and maximize multiplier effects  Fiscal expansion tends to be most effective if higher spending takes precedence over tax cuts spending targets infrastructure and social transfers tax cuts target lower income groups

15 Developing countries’ post crisis increase in public debt was relatively small Ratio of public debt to GDP, selected income groups, 1970–2010 (Median, in per cent)

IMF-sponsored programmes systematically underestimate their negative impact on GDP growth and fiscal balances

17 Proactive incomes policy is a key element of growth-friendly macroeconomic policies  Wages should grow in line with productivity growth (plus an inflation target) to pave the way for a steady expansion of domestic demand as a basis for expanding investment while containing cost-push inflation risks  An individual country may strengthen its international competitiveness through wage compression – but a simultaneous pursuit of this strategy by many countries causes deflationary pressure

18 Financial deregulation was one of the main factors leading to the global crisis  Financial deregulation: Led to a large, opaque and undercapitalized “shadow banking system” Concentrated the traditional banking segment in a few “too big to fail” (and “too powerful to regulate”) institutions Reduced diversity of financial system and increased systemic risk  While government regulation has weakened, its lender-of- last-resort support to the financial system has increased, and even extends to the shadow banking system

19 Financial reform agenda remains uncompleted  Strong re-regulation is urgently needed. It must: Be tighter with the “too-big-to-fail” institutions Cover the “shadow banking” and avoid regulatory arbitrage Incorporate a macro-prudential dimension, with anti-cyclical capital requirements and capital controls  In addition, the financial system must be restructured Re-regulation alone will not orient credit to real investment or make it accessible to small and medium-sized firms Banking restructuring should aim at more diverse financial systems, with a bigger role for public and cooperative institutions Giant institutions must be sized down The activities of commercial and investment banking should be clearly separated, in order to reduce the risk of contagion

20 Commodity prices have recovered amidst high volatility Monthly evolution of selected commodity prices, January 2002–May 2011 (Price indices, 2000 = 100)

Many explanations are available for recent commodity price movements  C hanges in fundamentals Demand: rapid income growth in emerging economies (intensity of use; dietary habits); biofuels Supply: increased production cost; earlier low rates of investment  Increased participation of financial investors who treat commodities as an asset class Index investors (passive, long positions in range of commodities) Money managers (active, short and long positions in specific or range of commodities)

Financial investment continues to rise AUM/global GDP ratio doubled in 2005–07 and rose 4-fold in 2008–10 Commodity investment, assets under management, 2005–2011 ($bn)

Why does financialization matter?  Financialization risks impairing appropriate functioning of commodity exchanges  Uncertainty (price trends disconnected from fundamentals; high volatility) deters investment and supply growth  Financialized commodity markets may cause pre-mature macroeconomic tightening and declining demand

24 Policy recommendations to improve commodity market functioning  Increase transparency in physical and derivatives markets  Arrange for internationally coordinated tighter regulation of financial investors  Consider occasional direct intervention to avert price collapses and deflate price bubbles

25 Exchange rates have become disconnected from macroeconomic fundamentals Real effective exchange rate, selected countries, January 2000–May 2011 (Index numbers, 2005 = 100, CPI based)

26 Leaving currencies entirely to market forces entails considerable risks for both the global financial system and the multilateral trading system  Instead, a rules-based managed floating can deliver Sufficient stability of real exchange rate to enhance international trade and support fixed investment in the tradable sector Sufficient flexibility of exchange rate to accommodate differences in cross-country developments of unit labour costs or inflation  Such a system could be based in two approaches : Adjustment of nominal exchange rates to inflation differentials – emphasizes need to avoid trade imbalances Adjustment of nominal exchange rates to interest rate differentials – emphasizes limiting currency speculation  Rules-based managed floating may be practiced unilaterally, regionally or (preferably) multilaterally

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