Navigating the Storm

By John Lipsky, first deputy managing director of International Monetary Fund (THE WASHINGTON POST, 10/10/08):

After several years of exceptional progress, the global economy is entering a major slowdown. The risks of a more worrisome outcome are palpable. The International Monetary Fund’s World Economic Outlook released this week notes that many advanced economies are close to or are moving into recession; growth in emerging economies also is weakening.

With the crisis spreading, it would be easy to give in to deep pessimism. Nonetheless, there are good reasons for hope that a protracted downturn can be avoided and that the IMF’s expectation that the global economy can begin a gradual recovery by the second half of next year is realistic.

The IMF has long experience in dealing with banking and financial system breakdowns in advanced and emerging economies. We have distilled practical lessons regarding how to halt systemic decay and lay the foundations for recovery. But past IMF experiences also suggest that even a successful path won’t be quick or easy. The tectonic plates of the global financial system are shifting. There is no reasonable prospect of restoring the current system, so it is imperative that innovative solutions be found.

Dramatic policy moves this week in the United States and in key European countries made clear that government officials and central bankers recognize the extreme danger signs in the financial markets and the unfolding economic data. Already, officials have come to understand that earlier piecemeal initiatives undermined confidence and that decisive action is necessary. Some initiatives that previously would have been rejected out of hand as too extreme, such as a coordinated round of interest rate cuts, have been implemented. Surely more will follow.

The first priority must be to halt and then reverse the current turmoil. To overcome this crisis — which is familiar in outline, if unprecedented in scale, scope and complexity — a set of decisive, coherent and consistent policy initiatives, implemented vigorously, will be required. This principle is classic. What is novel is that global and regional responses are necessary for success in the current circumstances, not just national responses — however bold.

At this decisive phase, policies must be aimed at addressing the key systemic problems — illiquid assets, capital shortages and the collapse of counter-party trust. The continued provision of massive liquidity is one necessary element of a solution. So is an internationally consistent approach to deposit insurance.

The possibility of extending at least temporary public guarantees to interbank or other loans has not yet been addressed clearly, though such moves have proved useful in several previous instances. Moreover, the effective implementation of plans for public-sector swaps for or outright purchase of troubled assets — such as in the Bank of England’s Special Liquidity Scheme or, prospectively, in the U.S. Troubled Asset Relief Program — could play an important role in restoring confidence in the financial markets.

It is critical for bank capital to be rebuilt quickly. In many past crises, a public provision of capital has been crucial in catalyzing private funds and in helping to restart credit creation. Of course, the use of public funds in this way requires adequate safeguards and a viable exit strategy. That this crisis has specific roots in the United States and other housing markets suggests that direct public support for this sector should be considered, an aspect of policy that will inevitably be decided by each country individually.

Looking beyond the immediate crisis, a new multilateral framework for macro-financial stability will be needed. It should cover regulatory frameworks as well as economic policies. A variety of efforts are well underway in this area. The priority now must be to break the negative feedback loop between dysfunctional financial markets and a weakening global economy. The IMF stands ready to play its unique role of policy adviser and source of crisis aid to its member countries, whether they are advanced, emerging or developing economies.

The annual meetings of the IMF and World Bank, beginning tomorrow, will bring together the world’s key economic and monetary officials. The schedule includes sustained opportunities to confront both immediate and structural policy challenges. It would be unrealistic to expect dramatic decisions to follow immediately. But the next few days will be critical in setting a multilateral path toward global success in resisting the downward spiral of financial strains and weakening growth. Over the coming weeks, a new coherence in global policy efforts should address the profound shifts occurring in financial markets.