January 17, 2019
By David Lipton
The global economy faces a number of complex challenges from technological change and globalization, and the lingering effects of the 2008-9 financial crisis. At the same time, we are witnessing lower levels of trust in the core institutions that have helped to deliver tremendous growth and prosperity over the past 40 years. These developments threaten to fragment the international order that has governed the global economy.
History suggests such a downturn is somewhere over the horizon.
The symptoms of this fragmentation include rising trade tensions, discord with and within some multilateral institutions, and a dilution of efforts to address the profound cross-border challenges of the 21st century, such as climate change, cyber-crime, and refugee flows. The question inevitably arises: if this is occurring at a time of solid global growth and relative financial stability, what might the next economic downturn produce?
History suggests such a downturn is somewhere over the horizon, and recent signs of slowing global growth should underline the imperative to prepare for unexpected developments.
The distrust of institutions is not confined to the multilateral realm. National governance has in many respects fallen into disrepute—witness the turmoil resulting from recent elections in many countries. If we are to forestall the next economic downturn—and mitigate the impact when it arrives—countries need to shore up their defenses now.
These defenses comprise financial firepower, policies to fight crises, and regulatory regimes, many put in place after the Global Financial Crisis. However, as matters stand now, there is no guarantee that they will be sufficient to keep a “garden variety” recession from becoming another full-blown systemic crisis.
On monetary policy, there is considerable discussion about how central banks can respond to a deep or prolonged downturn. For example, past U.S. recessions have been met with 500 basis points or more of Federal Reserve easing, and in the global financial crisis, central banks used their balance sheets extensively. However, with policy rates still so low in so many countries, and balance sheet normalization still underway, that same policy response may not be available.
Some suggest that unconventional monetary measures may provide the scope to respond to a crisis through negative rates, forward guidance pledges to hold rates at lower levels longer than justified by inflation targets or policy rules, or other innovations. But with the effectiveness of these ideas at best uncertain, there is reason for concern about the potency of monetary policy.
The next line of defense is fiscal policy, where many observers insist that the room for maneuver has been narrowing in the advanced economies. Public debt has risen—notably in the U.S. in the wake of tax cuts and spending increases. Indeed, in many countries deficits remain too high to stabilize or reduce debt. At the same time, if the next slowdown creates unemployment and economic slack, we should expect the multipliers to grow. That would restore some potency to fiscal policy, even at high debt levels. However, we should not expect governments to have the room in their budgets to respond as they did ten years ago. With high sovereign debt levels, fiscal stimulus may be a hard sell politically.
One lingering resentment growing out of the Global Financial Crisis was the perception that bankers were saved at the expense of the average worker. As a result, a future recession that endangers the finances of small businesses or homeowners would likely lead to calls to help relieve debt burdens. Supporting a larger share of the economy could further stress already stretched public finances, but failing to do so could deepen political divides.
If recession once again threatens the stability of banks, the recourse to bailouts is now limited in law, following financial regulatory reforms that call for bail-ins of owners and lenders. But those new systems remain underfunded and untested.
We should not lose sight of the fact that the impairment of key U.S. capital markets during the global financial crisis, which might have produced crippling spillovers across the globe, was robustly contained by unorthodox central bank actions supported by backstop funding from national treasuries. The capacity to do so again also is unlikely to be readily available.
The point is that national policy options and public financial resources may be much more constrained than in the past. The right lesson to take from that possibility is for each country to be much more careful to sustain growth, to limit vulnerabilities, and to prepare for whatever may come.
Another takeaway is the importance of multilateral preparedness and action. Institutions like the IMF have played a crucial role in responding to crises and keeping the global economy on track. The ability to respond effectively to these challenges has required a constant process of reform that needs to continue.
In the face of the discontent with multilateralism in some advanced economies, it is essential for the process of IMF evolution to continue—across the range of lending, analytical and research activities—so that we continue to meet our core mission of supporting global growth and financial stability. This will become all the more important if national policy tools prove insufficient to meet a crisis.
The IMF’s lending capacity was increased during the Global Financial Crisis to about one trillion dollars—a forceful response from our membership at a time of dire need. From that point of view, it was encouraging that the G20, at the November meeting in Buenos Aires, restated its commitment to support the global financial safety net, with a strong and adequately financed IMF at its center.
IMF Managing Director Christine Lagarde has called for a “new multilateralism,” one that is dedicated to improving the lives of all this world’s citizens and ensures that the economic benefits of globalization and technology are shared much more broadly. This is an essential goal, and one element is to ensure that we can prevent future crises—and respond effectively to the next recession. This is a practical and pragmatic way to overcome distrust in institutions and build a shared and prosperous future.