The global economy is on a knife-edge, teetering between a vicious and a virtuous cycle, warned Olivier Blanchard, Director of the Research Department at the International Monetary Fund (IMF) and the Institution’s top economist, at a discussion hosted by Carnegie.  Though a recovery is expected in early 2010, the strength of policy responses will determine whether the economy emerges in a high or low equilibrium. 

Marco Terrones, Deputy Division Chief in the Research Department of the IMF, outlined trends in recessions and recoveries in advanced economies.  Stephan Danninger, Senior Economist in the World Economic Studies Division of the Research Department of the IMF, described how financial stress is transmitted from advanced to emerging market economies.  Carnegie’s Uri Dadush moderated.

Two Cross-Currents
In its recently released World Economic Outlook, the IMF predicted that the global economy will experience its first recession since World War II, declining 1.3 percent in 2009.  Despite severe contractions in the real economy, stock markets across the globe have experienced a sustained rally since the start of March.  Blanchard explained these two seemingly contradictory trends by noting that the world economy is in the grips of two cross-currents:

  1. Declining demand leads to layoffs and unemployment, which reduces household income, which further depresses demand in a system of dynamic multipliers that pulls the global economy further downward.
  2. Monetary and fiscal policy responses, inventory correction, and natural stabilizers triggered by pent up demand for housing and automobiles work to pull up the global economy. The effect of natural stabilizers remains barely evident in the data at this point.   

A Recovery Nearing, but Only if Policies Remain Strong
On balance, Blanchard expressed some confidence that natural stabilizers and stimulus policies will start to overtake downward momentum by the end 2009 or beginning of 2010, when he predicts we will start seeing positive global economic growth.  However, he stressed that unemployment will continue to increase until growth returns to pre-crisis levels, which will likely not occur until the end of 2010.  He predicted that many countries will see unemployment rates in excess of 10 percent.

Blanchard further cautioned that predictions of recovery beginning in late-2009 were premised on assumptions that fiscal policies would remain strong and that financial systems would be able to at least slowly regain normal operations. 

From Recession to Recovery: How Soon and How Strong?
Recessions driven by financial crises tend to last two quarters longer than average recessions, explained Marco Terrones.  Add in a globally synchronized recession, and they last three quarter longer than average.  Recovery is also more sluggish during a financially-fueled recession, typically requiring an additional six quarters to return to pre-crisis growth rates compared to the average recession.  Globally synchronized, financially-driven recessions require an additional eight quarters.

The financial underpinnings of these recessions also deepen the severity of their impacts.  Asset bubbles often precede these crises, and falling values continue even once recovery begins in order to reach equilibrium.  In addition, the popping of credit bubbles that typically precede financial crises drives consumers to adjust their consumption patterns and save even more than they would during a typical recession.  When these crises occur concurrently around the globe, their dampening effect on exports, which typically play an important role in recovery, amplifies the damage.

Terrones highlighted that while a strong fiscal response cannot speed recovery to the pace experienced after an average recession, it can significantly shorten the length from that typically required after a financially-driven recession.  Terrones also noted that the impact of monetary policies -- which are often more effective than fiscal policies during an average recession -- are blunted by the presence of a financial crisis, as banks choose to save rather than transmit the stimulus to potential borrowers during uncertain financial times.  In contrast, fiscal policies are more effective during financially-drive recessions because they provide liquidity when most needed.

Transmission of Financial Stress from Advanced to Emerging Economies
Emerging market financial stress, as measured by exchange market pressure, sovereign spreads, banking sector performance, and stock market returns and volatility, tends to trend with financial stress in advanced economies, observed Stephan Danninger. The result is strong transmission of financial stress from advanced to emerging markets.  Countries experiencing the strongest transmission, such as those in Eastern Europe, often have banking sectors that borrowed heavily from advance economy banks.

However, Danninger cautioned countries not to adopt isolationist economic policies, explaining that they are ineffective.  He noted that even strong pre-crisis economic conditions, such as possession of large reserves or current account surpluses, provide only a weak buffer against the transmission of financial stress.

Danninger proposed that additional multilateral financial support to emerging market economies could mitigate the risks associated with financial integration.  However, he noted that, ultimately, emerging markets cannot surface from today’s crisis without a resumption of exports to, and capital from advanced economies.  Recovery in emerging markets, therefore, is best pursued by promoting recovery in advanced economies.

Question & Answer

In response to fears about deflation, Blanchard explained that deflation is not currently his top concern.  He noted that, empirically, the link between output gaps and deflation breaks down at low levels of inflation.

Blanchard reiterated that the IMF has not substantially altered its position on the benefits of openness and global economic integration.  He did, however, stress that today’s crisis highlights the risks of increase exposure to shocks associated with openness.  He suggested that the appropriate policy response is not protectionism, but the development of insurance schemes to mitigate the impact of downturns.

Dadush observed that the countries worst affected are running large current account deficits financed partly by short-term debt in foreign currency. These countries have repeated the errors that contributed to the Asian crisis of the late 1990s. This underscores the need not only to draw the policy lessons from the crisis, but also to better understand the political impediments to the adoption of correct policies.