Responding to Crisis, Core and Periphery
From prosperity to crisis
In the new millennium the world economy, especially its emerging-market part, experienced an unprecedented period of prosperity, with most countries growing at high or very high rates regardless of the quality of their economic policies. This global boom could be partly attributed to policy reforms in a number of important countries and regions in the last two decades, and progress in global trade liberalization (the results of the Uruguay Round). However, it was also stimulated by highly accommodative monetary policies in the United States and elsewhere, which responded to fears of recession and deflation by drastically cutting interest rates in 2001-2002 and then keeping them at record-low levels for too long. Likewise, many emerging market economies pursued neo-mercantilist policies by keeping their currencies undervalued and building up large precautionary foreign exchange reserves, which they saw as the best insurance against a currency crisis (a view that was shared by the International Monetary Fund (IMF)).
These policies led to the accumulation of excessive liquidity in the world economy, which in turn caused global overheating and the growth of the housing bubble in the United States and several European countries, stock market bubbles, and commodity market bubbles. The bursting of these bubbles destabilized the financial sector in the United States and in other developed countries. As with the prosperity that preceded them, the financial crisis and recession have a truly global character. According to a recent IMF projection, the world gross product may contract in 2009 for the first time since the 1930s.
The crisis started in summer 2007 at the core of the world economy, in the US financial system. It then moved to Western Europe and Japan, finally hitting the periphery (i.e., developing and transition countries) at the end of 2008. The September 2008 bankruptcy of Lehman Brothers, one of the largest US investment banks, was a turning point, which deepened the crisis and accelerated its spread to parts of the world that had not yet been affected.
In addition to monetary policy miscalculations, institutional, regulatory, and microeconomic factors contributed to the eruption and depth of the crisis. The absence of international macroeconomic (monetary) policy coordination and the lack of supra-national financial supervision of the world’s highly integrated financial markets were perhaps some of the most serious systemic inconsistencies. Also, national financial supervision was often too lax and did not have sufficient tools to follow new financial products. Its traditional sectoral segmentation left financial supervision unable to keep pace with the rapid cross-sectoral integration of financial institutions, as was apparent in the construction of such large financial conglomerates as AIG. Pro-cyclical prudential regulations (Basel 2 has an even stronger pro-cyclical character than Basel 1), risk assessment methodologies that were unable to follow financial innovations, and wrong incentives schemes (e.g., remuneration of management based on short-term profit, fees for rating agencies paid by clients) also contributed to market distortions, and exacerbated both boom and bust phases of the business cycle.
How have emerging economies been hit by the crisis?
The direction of this crisis’s contagion (from ‘core’ to ‘periphery’) stands in contrast to the 1997-1998 emerging market crises, which started in Asia, then spread to Russia, the Commonwealth of Independent States (CIS), and Brazil and finally hit some US financial institutions. The present crisis is closer to that of the Great Depression of the 1930s or the US dollar crisis in the 1970s. Emerging economies were therefore relatively late victims. They continued to grow through most of 2008 thanks in part to high commodity prices, until their crash in late summer of 2008. Ultimately, they were hit by the contraction in global demand and falling commodity prices, the global liquidity squeeze and the resulting capital outflows and increasing risk aversion, sometimes by troubles in parent financial institutions in developed countries, increased exchange rate volatility (including competitive depreciation of major trade partners and competitors), and decreasing demand for migrant labour. The second-round effects may involve, among others, banking sector troubles resulting from clients’ insolvency caused by recession and depreciating exchange rates.
Policy responses: core and periphery
Concrete responses must reflect national economic circumstances and available resources. However, there are some general recommendations which all countries should try to follow. First, they should avoid protectionist measures and beggar-thy-neighbour policies, which could deepen the global recession (as occurred in the 1930s). Second, they should resist temptations to nationalize and permanently expand the public sector, which may lead to decreasing productivity, excessive fiscal burdens, the politicization of business activity, corruption, and rent-seeking. Nationalization should be seen only as a temporary solution, and only for banks and other financial institutions of systemic importance, and only when other options for rescue/recapitalization are unavailable. In each case a clear exit strategy should be foreseen from the very beginning.
Many countries must return to structural and institutional reforms that were forgotten during the time of prosperity, in order to soften the consequences of the crisis and increase growth potential after the crisis ends. Such packages of reforms must be tailor-made to address the specific conditions in each country, but they could involve a greater labour- and product-market flexibility, measures to improve business climates, fighting corruption, privatization of remaining state-owned enterprises, and rationalization of social policies. Financial supervision should be overhauled both on national and supra-national levels (both inside the EU and globally). The same can be said for the global and regional coordination of macroeconomic policies, and bringing the Doha trade liberalization round to a successful conclusion. The recent G-20 decisions to recapitalize the IMF and World Bank, broaden their mandates, and rebalance voting power in favour of developing countries are quite hopeful in this respect.
However, countries belonging to the ‘core’ of the world economy have different roles and resources in conducting anti-crisis policies than do countries at the ‘periphery’. These are most apparent in terms of currencies, only some of which (such as the US dollar, the Euro, and, to lesser extent, the Japanese yen, Swiss frank, and British pound) serve as a global means of exchange, unit of account, and store of value. After the collapse of financial intermediation (and associated reduction in the money multiplier) following the Lehman Brothers bankruptcy, economic agents increased their demand for base money issued by the largest central banks. Despite their previous policy excesses, these banks had to meet this demand–as is shown in Figure 1 below. The key questions are how far to go with this monetary expansion, how to withdraw the monetary stimulus when the risk of deflation gives way to the risk of inflation or stagflation, and what to do with bad assets accumulated by some central banks (like the US Federal Reserve) in the course of aggressive quantitative easing.
The economies of the ‘periphery’ face other challenges: declining demands for their currencies both reflect and lead to massive capital outflows and exchange rate depreciation, which could trigger bankruptcies of enterprises, consumers and banks that are indebted in foreign currency. Aggressive monetary easing to help the real sector can therefore accelerate the flight from the domestic currency and exacerbate the effects of the crisis.
Source: World Bank staff calculations, based on United Nations 2005.
Things are even more complicated in the case of fiscal policy. The global fiscal stimulus proposed by the IMF is unrealistic in light of countries differing borrowing constraints–especially in times of market distress. Excessive fiscal easing in economies of the ‘periphery’ with limited fiscal space can raise the spectre of default. But even those countries that are in a better starting position (with smaller public and foreign debts, or larger fiscal reserves, as is the case with oil producers) and better market reputation should think twice before choosing aggressive fiscal stimulation. First, many of these will face a huge fiscal challenge related to aging populations in the coming decades. Second, while initiating a fiscal stimulus is politically easy, stopping or withdrawing it is much more difficult. Third, fiscal stimulus packages often involve dangers of explicit or implicit trade protectionism. Finally, a large-scale fiscal stimulus could mean crowding out private sector activities or claims on resources that are badly needed by developing countries.
Despite these risks, ‘core’ economies have no alternative to taking fiscal responsibility for repairing the global financial system and helping ‘peripheral’ economies to resist downward pressures on their currencies. Without repair of the global financial system, the timely end of the recession is very unlikely.
Looking ahead: the world after crisis
The quality of crisis management will determine its length and severity, as well as post-crisis economic prospects. While no one can accurately predict the length, depth, and consequences of the crisis, the study of business cycles shows that it will end at some point and the economy will start growing. Let’s hope that major countries will avoid protectionist temptations and that global economic governance will be strengthened. If this optimistic scenario holds, the main achievements of globalization during the last three decades would remain intact. However, there is little chance that the world economy will grow at the pace experienced earlier in this decade. Macroeconomic policies in major economies will have to be less accommodative, and the financial sector less leveraged and more risk-averse. There are no new major sources of productivity gains apparent on the horizon. It is also clear that both ‘core’ and ‘periphery’ economies will face stronger fiscal constraints, which will require serious adjustments in public expenditure policy. A return to economic and institutional reforms, both nationally and internationally, may be the best chance to increase global growth potential.
“Responding to Crisis, Core and Periphery” by CASE President, Marek Dąbrowski, was originally published in the July 2009, Issue 13 of the LSE and UNDP, Development and Transition Newsletter titled, “The Regional Impact of the Global Economic Crisis”http://www.developmentandtransition.net/index.cfm?module=ActiveWeb&page=WebPage&DocumentID=722
