The IMF has argued for some time that the very high public debt ratios in many advanced economies should be brought down to safer levels through a gradual and steady process. Doing either too little or too much both involve risks: not enough fiscal adjustment could lead to a loss of market confidence and a fiscal crisis, potentially killing growth; but too much adjustment will hurt growth directly. At times over the last couple of years we called on countries to step up the pace of adjustment when we thought they were moving too slowly. Instead, in the current environment, I worry that some might be going too fast.
Coming in to the 2011 Annual Meetings of the IMF and World Bank this past weekend, I had warned of the dangerous new phase for the global economy and had called for bold and collective action. Coming out of the Meetings, I feel strongly that the global community is beginning to respond. Why? Three reasons: a shared sense of urgency, a shared diagnosis of the problems, and a shared sense that the steps needed in the period ahead are now coming into focus. So, looking ahead, follow through—by all concerned—is now even more important. That means taking action not in the years ahead, but in the weeks ahead. And, in that, we are all in this together and we can only get out of it together.
In the midst of jittery financial markets, and global economic doom and gloom, it’s easy to become pessimistic. Public debt and fiscal deficits in many advanced economies remain very high. Nevertheless, important progress has been made in fiscal adjustment—the fiscal outlook in most countries is stronger than we expected two years ago. So to the pessimists I say, don’t lose sight of what’s been achieved. But, to the optimists (if there are any) I say, don’t underestimate what still needs to be done. The task that policymakers face is complicated. They need to ensure the public sector is not a source of instability by committing to a plan that will stabilize and then bring down public debt. At the same time, they need to make sure that fiscal tightening itself does not undermine the recovery.
The global economy has entered a dangerous new phase. The recovery has weakened considerably, and downside risks have increased sharply. Strong policies are urgently needed to improve the outlook and to reduce the risks. Growth, which had been strong in 2010, decreased in 2011. What was going on was the stalling of the two rebalancing acts—internal and external—which, as we have argued in many previous reports, are needed to deliver “strong, balanced, and sustainable growth.” This has been compounded by a sharp increase in financial volatility since the middle of the summer. These developments have, not surprisingly, led us to revise our forecasts down. In light of the low baseline and the high risks, strong policy action is of the essence. It has to rely on three main legs.
In various guises, the “Year of Living Dangerously” has been used to describe the global financial crisis, the policy response to the crisis, and its aftermath. But, we’ve slipped well beyond a year and the financial system is still flirting with danger. Financial stability risks may have eased, reflecting improvements in the economic outlook and continuing accommodative policies. But those supportive policies—while necessary to restart the economy—have also masked serious, underlying financial vulnerabilities that need to be addressed as quickly as possible. Many advanced economies are “living dangerously” because the legacy of high debt burdens is weighing on economic activity and balance sheets, keeping risks to financial stability elevated. At the same time, many emerging market countries risk overheating and the build-up of financial imbalances—in the context of rapid credit growth, increasing asset prices, and strong and volatile capital inflows. Here is our suggested roadmap for policymakers to address these vulnerabilities and risks, and achieve durable financial stability.
Undertaking a sizable fiscal adjustment is a lot like driving up a tall mountain: it’s hard work, it can take a long time, and you don’t want to run out of fuel partway up the incline. Countries are starting the climb, cutting back government deficits and debt levels, but according to our analysis often current plans aren’t enough to get countries where they need and want to go. The plans in place are large by historical standards, which brings with it difficult choices, and particular risks and uncertainties. Let me fill you in on what these are.
Fiscal policy this year in some leading advanced economies is shaping up to be quite different from what was expected just last November, according to the just-published Fiscal Monitor update. Some of this change is attributable to the somewhat better than projected fiscal results in 2010. Most of it, however, is due to additional stimulus measures introduced in recent months. Altogether, sovereign risks remain elevated and in some cases have increased since November 2010. No amount of deficit reduction this year, however, can be sufficient to restore countries’ fiscal accounts to robust good health. Putting the government accounts in order will require a multi-year effort. So, how are countries doing in setting out their longer-term plans? Here, we see somewhat of a mixed picture.