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April 19, 2012, Thursday

Boosting economic growth and financial stability

As countries around the world try to boost economic growth and financial stability in the aftermath of the global crisis, the International Monetary Fund (IMF) offers them help through its high-powered if not always conclusive and widely applicable research.

In advance of this week's springtime IMF/World Bank meetings in Washington, the IMF released last week the analytical chapters of its two flagship biannual reports, “World Economic Outlook” (WEO) and “Global Financial Stability Report” (GFSR), which I will discuss here. The WEO, which analyzes and projects global economic developments, is titled “Growth Resuming, Dangers Remain.” The GFSR, which assesses developments in global financial markets, focusing on how the financial system functions and how to cope with the forces that can destabilize it, is titled “The Quest for Lasting Stability.” The latest edition of the IMF's third flagship publication, the “Fiscal Monitor,” titled “Balancing Fiscal Policy Risks,” as well as the conjunctural chapters of the WEO and the GFSR, containing the IMF's global and regional reviews and forecasts of economic and financial trends, were released this week.

The WEO's analytical chapters are three, “Dealing with Household Debt,” and four, “Commodity Price Swings and Commodity Exporters,” motivated, like the analytical GFSR chapters, by recent IMF research papers on these topics. Chapter three analyzes how household debt burdens, housing busts and recessions affect each other and how government policies can help households cope with high debt due primarily to unaffordable home mortgages that result in negative equity. Those mortgages became a crushing burden after the housing boom turned into bust, with home prices collapsing as the Great Recession led to massive unemployment. The US has been the epicenter of the housing mess, triggered by the subprime mortgage debacle, which ultimately led to the global financial crisis, but other advanced countries such as Spain and the UK have also been hit hard. This chapter highlights “bold” targeted household debt restructuring policies, argued to be effective in the past -- in easing repayment burdens, minimizing defaults, foreclosures and fire sales -- in order to remove housing bust as an obstacle to economic growth. But its claim that such redistributive policies, creating clear losers and winners, at relatively small fiscal cost, need not create serious moral hazard risks in the future is debatable.

Chapter four examines how commodity price swings affect procyclically the macroeconomic performance of commodity exporting countries, which have benefited from a sustained run-up mostly in energy and metals prices during the last decade, excepting the 2008-2009 global financial crisis. It advises governments of especially small, open commodity exporters to insure themselves against temporary price downswings, while prices are still high, through countercyclical fiscal buffers for smooth adjustment to boom-bust cycles. But that advice would apply to only a few countries with democratic governments free of widespread corruption. Norway, a major crude oil and natural gas exporter, with a sovereign wealth fund to husband its oil and gas export revenues, is the best example.

The GFSR's analytical chapters are three, “Safe Assets: Financial System Cornerstone?” and four, “The Financial Impact of Longevity Risk.” Chapter three highlights how the recent financial upheaval caused by the back-to-back global and eurozone crises, have forced, after widespread mispricing of risk, reconsideration of what safe asset are, as AAA-rated US mortgage-backed securities and presumably riskless sovereign bonds of Greece turned into junk. It lists “safe asset” criteria as: (1) low credit and market risks, (2) high market liquidity, (3) limited inflation risks, (4) low exchange rate risks and (5) limited idiosyncratic risks. From the demand side, it reviews the importance of safe assets in portfolio construction, in prudential regulations and foreign exchange reserves and in financial transactions as collateral and benchmark securities. From the supply side, it discusses the role of sovereign issuers, the private sector, central banks and emerging market economies (EMEs).Finally, it explores the potential destabilizing effects, and how they could be mitigated, of the higher price of safety arising from the imbalance between rising demand and falling supply of safe assets.

Chapter four argues that longevity, although individually and socially beneficial, is costly and stresses that average life expectancy has been consistently underestimated. It analyzes the financial and fiscal implications for private and public pensions, as well as the risks for individuals and their families, of unexpected longevity, as a slow-burning critical issue not only for advanced economies (AEs) with stagnant or falling populations but also for EMEs, such as Turkey, with rising populations. It estimates that if longevity were three years longer than expected and society were to budget for the extra costs in the next 40 years, the already huge costs of aging would rise by another 50 percent, amounting to 50 percent of 2010 gross domestic product (GDP) of AEs and 25 percent of 2010 GDP of EMEs, in tens of trillions of US dollars globally. The capital market-based transfer of longevity risk through over-the-counter bilateral contracts and longevity bonds is an elegant but not obvious solution. The obvious solution is to get people to work longer, linking retirement age to expected longevity, and have them save more, starting early, while they work. It is obvious but also hard to apply politically and psychologically even if we could predict longevity perfectly.

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