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DEVELOPMENT

Outreach
P U T T I N G K N O W L E D G E T O W O R K F O R D E V E L O P M E N T D E C E M B E R 2 0 0 9

WORLD BANK INSTITUTE


L E A R N I N G F O R D E V E L O P M E N T
MARY MCNEIL
ABOUT THIS ISSUE FOUNDING EDITOR

EDITORIAL BOARD
very crisis has its lessons. A global financial and SWAMINATHAN S. AIYAR

E economic convulsion of the magnitude we have


just experienced should offer more lessons than
most. That is why we have selected “Growing Out of
ECONOMIC TIMES OF INDIA, NEW DELHI, INDIA

MICHAEL COHEN
NEW SCHOOL UNIVERSITY, NEW YORK, USA

PAUL COLLIER
Crisis” as the theme for this issue of Development OXFORD UNIVERSITY, OXFORD, UK
Outreach. JOHN GAGE
As 2009 draws to a close, policymakers in all coun- SUN MICROSYSTEMS, PALO ALTO, CALIFORNIA, USA

tries are assessing the fault lines in their economic man- JOSEPH K. INGRAM
PERUGIA, ITALY
agement systems, and working together in international
KWAME KARIKARI
forums such as the G-20 and IMF/World Bank meetings, SCHOOL OF JOURNALISM AND COMMUNICATIONS,
THE UNIVERSITY OF GHANA, LEGON, GHANA
among others, to define an agenda for reform, and to
improve international coordination systems. VIRA NANIVSKA
NATIONAL ACADEMY OF PUBLIC ADMINISTRATION,
We asked some of the world’s leading economic KIEV, UKRAINE

thinkers, as well as regional experts and policymakers, PEPI PATRON


CATHOLIC UNIVERSITY, LIMA, PERU
to discuss the impact of the crisis from different per-
spectives and in different parts of the world, and to J. ROBERT S. PRICHARD
TORSTAR, TORONTO, CANADA
reflect on changes at national and international levels RAFAEL RANGEL SOSTMANN
that would better protect us from the next crisis. MONTERREY TECH UNIVERSITY SYSTEM, MONTERREY, MEXICO

World Bank President Robert Zoellick, in an address VIVIENNE WEE


CENTRE FOR ENVIRONMENT, GENDER AND DEVELOPMENT, SINGAPORE
at Johns Hopkins University in September, pointed to the
vital role of developing economies in leading the world Development OUTREACH is published three times a year by the World
Bank Institute and reflects issues arising from the World Bank’s many
out of this crisis. Indeed, this is perhaps the major water- learning programs. Articles are solicited that offer a range of
shed produced by the crisis. The emerging market coun- viewpoints from a variety of authors worldwide and do not represent
official positions of the World Bank or the views of its management.
tries have arrived, the G-20 has replaced the G-7, and
more hands are on the levers of global economy. CHRISTOPHER NEAL
EXECUTIVE EDITOR
Not least, this has had implications for international
ANNA LAWTON
financial institutions. The World Bank Group commit- MANAGING EDITOR
ted itself to lending $100 billion over three years to pro- MOIRA RATCHFORD
vide a counter-cyclical stimulus to the developing world. PUBLICATION DESIGN

The IMF has also tripled its lending to $750 billion. Both PHOTO CREDITS
institutions must seek additional support to cover these Unless otherwise noted, all images from Newscom.
Cover: Naylor Design, Inc., Washington, DC; Page 4: Richard B.
new demands, and both face pressure to reform their Levine/Newscom; Page 8: Newscom; Page 12: AFP Photo/Kirill
governance and representation to reflect shifting global Kudryavtsev; Page 13: John Dooley/Sipa Press; Page 16: AFP
Photo/Romeo Gacad; Page 18: AFP Photo/Mauricio Lima;
economic influences. Page 19: AFP Photo/Andrei Smirnov; Page 20: AFP Photo/ Attila
The World Bank Institute, whose mission includes Kisbenedek; Page 22: AFP Photo/Rajesh Jantilal; Page 25:
Benedicte Desrus / Sipa Press; Page 28: Benedicte Desrus / Sipa
capacity building for government officials and other Press; Page 29: Newscom; Page 32: AFP Photo/Joseph Agcaoili;
stakeholders, responded to the economic and financial Page 34: John Dooley/Sipa Press; Page 37: Topshots AFP Photo/Liu
crisis by hosting videoconference discussions among Jin; Page 38: AFP Photo/Roslan Rahman; Page 39: AFP
Photo/Mandel Ngan; Page 41: Newscom; Page 43: Sipa Press;
policymakers in developing countries’ finance, planning Page 45: AFP Photo / Bob Low; Page 47: Newscom; Page 50: Rod
and trade ministries, as well as central banks. Rolle/Sipa Press; Page 53: Richard B. Levine/Newscom.
A series of seminars, Pathways to Development, will fol-
low, aimed at drawing further lessons to help countries
grow out of crisis. This magazine is printed on recycled paper, with soy-based inks.

For his guest editing of this issue of Development ISSN 1020-797X © 2009 The World Bank Institute
Outreach, I would like to thank Raj Nallari, Lead WORLD BANK INSTITUTE
Economist with WBI’s Growth and Crisis Unit. L E A R N I N G F O R D E V E L O P M E N T

World Bank Institute www.worldbank.org/wbi


Sanjay Pradhan www.worldbank.org/devoutreach
Vice President devoutreach@worldbank.org
The World Bank
1818 H Street NW
Christopher Neal Washington, DC 20433, USA
EXECUTIVE EDITOR
DEVELOPMENT

Outreach
VOLUME ELEVEN, NUMBER THREE DECEMBER 2009

PAGE 16 PAGE 32 PAGE 39

SPECIAL REPORT 34 Coming Out of Recession: The role


GROWING OUT OF CRISIS of business in alleviating poverty
V. K A S T U R I R A N G A N A N D D J O R D J I J A P E T K O S K I

2 After the Crisis


ROBERT B. ZOELLICK RETHINKING POLICIES
6 Growing Out of Crisis
Guest Editorial 37 Trade Openness Is Now More Important
RAJ NALLARI
Than Ever
8 The Economic and Fiscal Consequences ANNE O. KRUEGER

of Financial Crises: North and South


CARMEN M. REINHART
39 The Imperative for Improved Global
Economic Coordination
JOSEPH E. STIGLITZ
CURRENT CRISIS:
IMPACT AND POLICY RESPONSES 43 Lender of Last Resort and Global
Liquidity: Rethinking the system
MAURICE OBSTFELD
13 Shock Producers and Shock Absorbers in
the Crisis 47 The Dollar Dilemma
HANS-WERNER SINN
BARRY EICHENGREEN

16 The Crisis and the World’s Poorest


M A R T I N R AVA L L I O N AU CONTRAIRE
19 Growth Is Disappearing and May Not
Recover in the Medium Run 50 Government Actions and Interventions:
VLADIMIR GLIGOROV More harm than good?
J O H N B . TAY L O R

22 South Africa’s Policy May Offset the


Financial Downturn 54 KNOWLEDGE RESOURCES
BRIAN KAHN
55 BOOKSHELF
25 Small States Face Big Challenges 56 CALENDAR OF EVENTS
DWIGHT VENNER

29 Policy Responses to the Global


Economic Crisis
JUSTIN YIFU LIN
AFTER THE CRISIS
BY ROBERT B. ZOELLICK Indeed, today, China acts as a stabilizing force in the
global economy. Together, China and India account for 8.5
Excerpted from a speech delivered at the Paul H. Nitze School of percent of world output. They and other developing coun-
Advanced International Studies of the Johns Hopkins tries are growing substantially more rapidly than devel-
University, September 28, 2009. oped countries.
And yet…China’s future is not yet determined. Its rapid
G R E AT U P H E AVA L S produce shock waves that widen recovery in 2009 was fueled by an expansion of credit of 26
cracks in political, economic, and security orders. percent of GDP in the first eight months of this year. This
Sometimes the old orders break. Yet it can be in the power flood is now easing, and authorities are likely to limit it fur-
of leaders and peoples to shape the directions of change. ther for fear of effects on asset prices, asset quality, and
eventually general inflation. China still faces big uncer-
Outcomes are not predetermined tainties in 2010.
The United States, in turn, has been hit hard by the cri-
I N 2009, we are living through an upheaval that is chang- sis. But America has a culture of resilience to set-backs,
ing our world. What will be its implications for the future? adapting to new circumstances and remaking itself. The
The last 20 years have witnessed a huge economic shift. future for the United States will depend on whether and
The breakdown of the planned economies in the Soviet how it will address large deficits, recover without inflation
Union and Central and Eastern Europe, the economic that could undermine its credit and currency, and over-
reforms in China and India, and the export-driven growth haul its financial system to preserve innovation while
strategies of East Asia all contributed to a world market adding to safety and soundness.Understanding shifting
economy that vaulted from about 1 billion to 4 or 5 billion power relations is fundamental for shaping the future—as
people. This shift offers enormous opportunities. But it the Bretton Woods delegates appreciated. The political
has also shaken an international economic system forged basis for that system was forged through a shared experi-
in the middle of the 20th century with patched-up changes ence in failed responsibility after World War I and a clear
in the decades since. assessment of power after World War II. Change those
Already, we can see potential shifts in power and insti- power relations—and the nature of the markets that con-
tutions and international cooperation. In part, the shifts nect them—and the system looks out of touch.
will depend upon how the parties adapt to new circum-
stances; in part, upon the rapidity of the recovery; in part, Will the U.S. dollar remain the
upon changes in who holds the world’s capital, technology, predominant reserve currency?
and human resources and what they do with them; in part,
upon how countries cooperate—or do not. gave way in
T H E B R E T TO N WO O D S C U R R E N C Y SYS T E M
1973 to floating rates, with the dollar as the world’s main
What are the perceptions and realities reserve currency. For all the questions about the dollar’s
of power after this crisis? reliability as a reserve currency, its value strengthened
during the crisis as it offered investors a safe haven. But
THE CURRENT ASSUMPTION is that the post-crisis politi- the United States would be mistaken to take for granted
cal economy will reflect the rising influence of China and the dollar’s place as the world’s predominant reserve cur-
India, and of other large emerging economies. Supposedly, rency. Looking forward, there will increasingly be other
the United States, the epicenter of the financial crisis, will options to the dollar.
see its economic power and influence diminish.

2 Development Outreach WORLD BANK INSTITUTE


The Bretton Woods system was forged by 44 countries Yet it won’t happen by itself
at a time when power was concentrated in a small number
of states. The great waves of decolonization were just stir- AT T H E G-20 S U M M I T I N L O N D O N I N A P R I L , leaders
ring; the few developing countries were seen as objects, stared into an economic abyss. The danger today is not
not subjects, of history. That world is long passed. The new freefall, but complacency. As the crisis wanes, it will be
realities of political economy demand a different system. harder to press countries to cooperate in “building back
better.” Peer review of a new Framework for Strong,
What will be the role of developing Sustainable and Balanced Growth agreed at the April G-20
countries after the crisis? Summit is a good start, but it will require a new level of
international cooperation and coordination, including a
THE CRISIS HAS UNDERSCORED the growing importance new willingness to take the findings of global monitoring
of the large emerging economies, especially China and seriously. Peer review will need to be peer pressure.
India, but others as well. In effect, the world economy is Global finance and currencies. The trading system.
being “rebalanced” toward the relative shares of some two Inclusive and sustainable development. Climate change.
hundred years ago, before the industrial revolution, plus a States struggling with fragility and conflicts. And a host of
new North America. other security issues. Each topic is important on its own.
The rising developing economies should play a key role But each interconnects with the others.
in the recovery. Most forecasters expect demand to be The countries of the world will never deal effectively
tepid, with a pullback by the U.S. consumer. Many devel- with this agenda unless they cooperate. The economic mul-
oping countries could expand demand if they can get tilateralism of another age does not reflect today’s realities.
access to financing. They have fiscal space to borrow, but We need to modernize multilateralism and markets.
cannot get the volumes they need at reasonable prices As agreed at the Pittsburgh Summit, the G-20 should
without crowding out their private sectors. Moreover, the become the premier forum for international economic
middle-income countries are home to 70 percent of the cooperation among the advanced industrialized countries
world’s extreme poor. The World Bank Group and the and rising powers. But it cannot be a stand-alone commit-
regional development banks can assist. tee. Nor can it ignore the voices of the over 160 countries
The World Bank Group can offer a counterweight to left outside.
financial and trade protectionism by supporting this devel- The G-20 should operate as a “Steering Group” across
opment globally. We have launched a new Asset a network of countries and international institutions. It
Management Corporation, through IFC, our private sector could recognize the interconnections among issues and
arm, to invest in banks, equity, infrastructure, and debt foster points of mutual interest.
restructuring. We have a parallel effort to support and invest The question is whether leaders can cooperate in steer-
in the development of local currency bond markets. ing the changes. They will be drawn to the interests of the
Longer-term investors—such as sovereign and pension national publics they represent, as they should. Yet they
funds—now recognize that developed markets pose risks, also will be challenged to recognize and build common
too, and developing markets can offer good growth interests, not only case-by-case, but through institutions
prospects. reflecting a “Responsible Globalization.”
Coming out of this crisis, we have an opportunity to Bretton Woods is being overhauled before our eyes.
reshape our policies, architecture, and institutions. We This time, it will take longer than three weeks in New
have an opportunity to craft a new global system for a 21st Hampshire. It will have more participants. But it is just as
century of “Responsible Globalization”—one that would necessary. The next upheaval, whatever it may be, is taking
encourage balanced global growth and financial stability, form now. Shape it or be shaped by it.
embrace global efforts to counter climate change, and
advance opportunity for the poorest. It means expanding Robert B. Zoellick is President of The World Bank Group.
the benefits of open markets and trade, investments,
competition, innovation, entrepreneurialism, growth,
information—and debates on ideas. It must be a globaliza-
tion that is both inclusive and sustainable—expanding
opportunity with care for the environment.

D E C E M B E R 2 0 0 9 3
008
5, 2
e r 1
te mb
Sep
SPECIAL REPORT

GROWING OUT OF CRISIS


Guest Editorial reduced harvest yields; rising biofuel production in advanced
economies jacked up corn prices as well as feedstock costs; the
BY RAJ NALLARI rise in oil and energy prices boosted production costs for food
commodities through higher prices for transportation fuels
on subprime housing loans in the
H OW C O U L D S M A L L L O S S E S and fertilizer; and the growing use of export restrictions by
United States, estimated at about $100 million in early 2007, food exporters as a way of raising domestic food supplies and
lead to a global financial and economic crisis? Worldwide stock lowering domestic prices has put pressure on world prices,
markets plunged and housing values declined sharply during contributing substantially to the run-up in rice prices in 2008.
2007-08; and the IMF has projected that output losses are like- Finally, the bursting of the housing bubbles in the U. S. and
ly to be about $4.7 trillion between 2008 and 2015. Most experts Europe in 2007 led to a surge in defaults and foreclosures,1 which
were blind-sided by the magnitude and speed with which this resulted in a plunge in the prices of mortgage-backed securities.
financial crisis, which originated in the U.S., spread to the rest These financial losses have left many financial institutions with
of the world. Large investment banks, big corporations, mil- too little capital relative to their debt. They have, therefore, been
lions of jobs, and about $1 trillion of private capital flows to unable to provide the credit required for economic growth.
developing countries evaporated within days of the collapse of Many other culprits have also been implicated and it is more
Lehman Brothers on September 12, 2008. Some argue that if than a government or regulatory failure. Markets also failed. A
Lehman had been bailed out, the U.S. financial system would long period of abundant liquidity, low interest rates, and a glob-
not have melted down and, consequently, a global recession al “search-for-yield” led to rising asset prices. In addition,
could have been avoided. Others, such as Kenneth Rogoff (The there was a steady build-up of macroeconomic imbalances as
Economist, 9/12/09), argue that even if Lehman had been saved Asian countries and oil-importers were pursuing policies of
it would still have had to be sacrificed later, along with other foreign exchange reserve accumulation. All this was taking place
investment banks, because the system had exceeded sustain- at a time when financial systems were going global and integrat-
able levels: trillions of dollars had been borrowed against an ing through new technologies. Complex, nontransparent finan-
asset bubble in stock and house prices. cial instruments were mispriced and levels of risk were misun-
In this issue of Development Outreach, we asked experts with derstood. Regulators in some cases failed to respond to, and in
diverse perspectives to address the key questions that concern other cases facilitated the build-up of imbalances. Service
the developing countries. These questions include: what were providers, including credit rating agencies, loan originators
the prevailing economic conditions when the crisis struck; and payment collectors were also involved.
what was the impact during the first year of the global crisis; When Lehman Brothers went belly-up, the global financial
what policies have the developing countries taken in system itself was on the verge of collapse. Globalization, defined
response; and what effects will those policies have on output, as the increasingly free flow of ideas, people, goods, services,
employment, poverty, and public finances. In this overview and capital that leads to the integration of economies and soci-
article, we provide our own thoughts on these questions. eties, has become a major force for global change. It has also
added to the number of channels through which shocks can be
What were the economic conditions transmitted across borders more quickly. As shocks have
before the crisis? become larger and more frequent, economies from North and
South have to move in lock-step. This co-dependence reduces
A “ P E R F E C T S TO R M ” WA S B R E W I N G as U.S. and European the ability of individual economies to manage their way out of a
housing defaults began piling up in late 2006, oil prices dou- crisis, especially when it is the largest economy that is transmit-
bled during late 2007 and early 2008, and rice, wheat, and ting the shock.
corn prices jumped by 40-50 percent during the same period.
Sustained global growth between 2000 and 2007, especial- What has been the immediate impact
ly in emerging and developing economies, had catalyzed of the crisis?
demand for many commodities, including oil, metals, and
food. At the same time, supply had been slow to catch up to this WO R L D O U T P U T D E C L I N E D by an unprecedented 2.25 per-
growing demand, causing prices to rise. Beginning in 2006, a cent (annualized) in the last quarter of 2008; and global trade
number of other factors also contributed to the rapid jump in and industrial activity have fallen substantially since
food prices. For example, unfavorable weather conditions November 2008. All the major industrial economies entered a

D E C E M B E R 2 0 0 9 5
period of deep recession, and several emerging markets were bled industries (for example, General Motors and Chrysler in
sputtering in late 2008. Growth in emerging and developing the U.S. and the French auto industry). Fifth, the govern-
economies has decelerated abruptly to 3.25 percent, mostly ments became “market makers.” However, despite this
because of external pressures—lower foreign demand, reversal expansionary fiscal policy, John Taylor’s article details why the
of capital inflows, and plunging commodity prices. Anemic U.S. and European governments’ fiscal (and monetary) poli-
global growth has reversed the commodity price boom and cies may not work and could actually exacerbate the problem,
lowered inflation. These price declines (except for gold) have including prolonging the recession.
dampened growth prospects for a number of commodity- As a result, public finances have deteriorated in a number of
exporting economies. advanced and developing countries, and this has increased fis-
In the first few months of the global crisis, there were mas- cal risks and raised premiums for government-issued bonds.
sive lay-offs of workers in China’s garment, toy and electronics Early IMF estimates for advanced economies are that fiscal
manufacturing sectors, in Bangladesh’s jute mills, in balances could decline by about 8 percent of GDP between the
Cambodia’s garments industry, and in India’s diamond pol- end of 2007 and the end of 2009, and by 5 percent of GDP in
ishing, textile and garment firms. Martin Ravallion’s article in the case of emerging economies. There is likely to be a dramat-
this issue describes how more than 50 million people may have ic increase in public debt levels in both advanced and develop-
been pushed below the poverty line during the first few months ing economies. Carmen Reinhart’s paper, in this issue, is
of the crisis. If the Asian crisis is any indication, poverty levels based on an historical analysis which concludes that this crisis
are likely to be much higher in several of the affected countries is essentially no different from past crises and that they always
and to remain so, long after the global economy recovers. end with deficit, debt, and default. But small open economies
Professor Sinn’s essay makes an interesting point: that the such as the Caribbean and Pacific Islands are highly dependent
U.S. was the main shock producer because it reduced its imports on external economic conditions and on imports. As Dwight
more than its exports during late 2008 and early 2009. To a Venner’s piece argues, these countries cannot use fiscal stimu-
lesser extent, China, Brazil, the United Kingdom, and South lus packages to respond to an external shock since their
Korea followed a similar practice. In contrast, Germany, Japan increased spending will fully leak out through higher imports.
and Russia were the main shock absorbers as their imports To date, few countries have taken major steps toward trade
exceeded exports during the same period. protectionism, despite the fact that exports fell by as much as 23
percent in China and other emerging markets. However, some
How did policy makers react to the have targeted export firms for subsidies and included protec-
tionist measures in their fiscal stimulus packages. Anne
global economic crisis? Krueger’s essay makes a strong case for open trade policies,
since resumption of global trade is imperative for economic
early on that the current
P O L I C Y M A K E R S U N D E R S TO O D recovery. She argues that with the liquidity crunch, internation-
global downturn was far from your normal garden-variety al traders needed more secured means of payment and there is
recession. The central banks were the first to react, while a demand for newer trade-finance instruments than the tradi-
commercial banks were sharply curtailing credit in the face of tional letters of credit. Moreover, countries have refrained from
global deleveraging—there was monetary easing as interest “beggar-thy-neighbor” competitive exchange rate devaluations
rates were cut dramatically, liquidity provision was stepped to ensure their own exports. Brian Kahn’s essay details the pol-
up, limits to deposit insurance were expanded, and special icy mix that was used to stabilize the South African economy.
credit lines were set up for use by troubled banks. Joseph Stiglitz’s essay focuses on international coordina-
The size of governments expanded overnight. First, sever- tion issues. This is a global crisis and therefore there is a need
al crisis-affected and crisis-prone countries directly support- for collective action, such as the attempts made by the G-20
ed their financial sectors by injecting funds to recapitalize since November 2008. Fiscal stimulus in the U.S. will not be
banks, insurance companies and investment banks, especial- very effective if the Euro zone countries do not stimulate their
ly those deemed “too big to fail.” For example, the economies. When all countries act in concert, the amount of
International Monetary Fund (IMF) estimates that advanced global fiscal stimulus needed is much less, and the world
G-20 economies spent about 3.5 percent of their GDP on such economy will recover much sooner.
financial support. Hungary, Poland, and Ukraine took similar
steps in providing direct support to the financial sector. What is the outlook for the world
Second, as growth slowed in almost all countries, declines in economy after one year of meltdown?
the price of equities, properties, and commodities led to
reductions in government revenues and private and public T H E R E W E R E S O M E S I G N S O F R E C OV E RY or “green shoots”
spending. Aggregate demand had to be shored up by fiscal in the U.S. and a few other advanced economies between July and
stimulus packages. Third, the losses on funded pension September 2009, but unemployment is still rising in the
schemes increased governments’ fiscal liabilities. For exam- Western world. After increasing between 2000 and 2007, world
ple, countries in the Eastern and Central Asian region have output growth slowed down to about 3 percent in 2008 and is
automatic stabilizers such as unemployment benefits. Fourth, projected to decline by 1 percent in 2009. Underlying these
several countries used public resources to bail out their trou- averages is the fact that advanced economies, which grew at

6 Development Outreach WORLD BANK INSTITUTE


about 0.6 percent in 2008, are projected to decline by 3.4 per- This crisis can prompt a structural transformation that
cent in 2009, and begin to show some recovery in the year 2010. could change the economic history of the world. The develop-
The reason for this low performance is that the financial system ing economies, which together account for about 50 percent of
in the U.S. and Europe has been damaged and the fiscal burden world output, are on the rise and playing a major role in the
of the economic and financial crisis is quickly mounting. On the world recovery. Some of them have the fiscal space to borrow,
other hand, emerging and developing economies are expected to but the volume of financing they need at fair prices, without
grow at about 6 percent on average in 2009, with China, India, crowding out the private sector, may not be available. To
and other Asian countries pulling the world wagon. Conversely, address such impediments, the World Bank has set up a new
there have been steep declines in output in Central and Eastern Asset Management Corporation through its private sector
Europe, Russia, Mexico, and a few other countries. Vladimir wing (the International Finance Corporation) to invest in
Gligorov’s essay on Southeastern European countries points out banks, equity, infrastructure, and development of local cur-
that output declines in crisis-affected Eastern European coun- rency bond markets, and to facilitate debt restructuring.
tries may never come back to the trend growth rate.
How can countries sustain their economic recovery? There Conclusion
is a need to recover the funds released as bail-outs and to ensure
liquidity. Central Banks need to be aware that their balance and could it happen again?
I S T H E F I N A N C I A L C R I S I S OV E R
sheets have expanded because of measures they took to achieve National supervision and regulatory systems were inadequate
monetary easing, and their debt levels have risen. There is an to manage transnational institutions, such as Lehman
increased likelihood of a sudden jump in inflation. But policy Brothers, Citibank, AIG, Dexia Bank and others.
makers should not be tied too strongly to inflation-targeting Consequently, national authorities will have to pay closer
and they must learn to better manage asset bubbles. Interest attention to risk-taking behaviors, to limit leveraging, tighten
rates have to be increased gradually as the economy gains capital regulation, attend to liquidity supervision as well as
strength. Asian central banks have to be more prudent in for- supervision of complex cross-border financial institutions,
eign exchange reserve accumulation and move away from cur- and to improve transparency of transactions.
rency manipulation. More and more countries are moving to The crisis has also revealed deficiencies in international
intermediate exchange rate regimes such as managed float, tar- coordination such as the IMF’s weak surveillance of advanced
get bands, and basket pegs. On the fiscal side, highest priority economies and its lack of enforcement authority. National and
should be assigned to bringing down deficits and debt levels global solutions are needed to regulate capital flows and pre-
that were incurred in fighting the recent recession. Subsidies to vent systemic and global risks by reining in financial firms
large auto industries and financial firms put similar entities in and conglomerates; to ensure higher international standards
developing countries at a disadvantage. for credit rating agencies; and to eliminate inconsistencies in
Fiscal discipline has to be reinstated and governments will national legal frameworks. There is even talk of creating “a
have to reform health and pension systems. Financial regula- global college of supervisors.”
tions are urgently needed to deal with institutions such as How can we deter another crisis? One way is for central
banks, investment banks, insurance, housing-finance enti- banks not only to keep inflation low but also to manage asset
ties and so called too-big-to-fail firms. Further, prudential bubbles early on. Rapid growth in credit should be tracked and
regulations need to be counter-cyclical if they are to be suc- carefully analyzed to ensure that it is in line with financial
cessful in managing credit growth and asset bubbles. In devel- development and not fueling asset price increases. Some
oping countries, a lack of financial intermediation is an would prefer that the early warning systems of macro- and
underlying cause of global macroeconomic imbalances. micro-prudential indicators be further developed. However,
For almost a decade, international economic observers have each financial crisis is different and such indicators may not be
advised that the world economy needs a major adjustment. very useful in predicting a banking or financial crisis because
Sustained global growth requires that the U.S. cut back on its they do not take into account the inter-linkages between
domestic demand and let the dollar depreciate to increase net credit flows to various sectors and issues of “too-big-to-fail”
exports, which will enable the U.S. to improve its current account conglomerates and cross-border financial flows.
balances. Conversely, China and other Asian countries should
stimulate domestic demand and let their exchange rates appreci- Raj Nallari is Lead Economist with the World Bank Institute,
ate. Such a rebalancing of aggregate demand, away from the U.S. Growth and Crisis Unit.
and toward China, would help sustain a global recovery. If this
rebalancing does not happen quickly, global growth may be flat. Endnote
With the U.S. at the epicenter of the financial crisis, coun- 1 It is estimated that in the United States there were almost 7 million hous-
tries such as the BRICS (Brazil, Russia, India, China, South ing loans “under water” and close to default, each loan averaging about
$300,000; this totals to $2.1 trillion. In addition, potential defaults on credit
Africa) and oil producers holding large foreign exchange
card payments, student and car loan payments are estimated to be in the
reserves primarily in U.S. dollars began to worry about the range of about $10-12 trillion. The government could have directly taken over
efficacy of the dollar as the main reserve currency. Barry these bad housing loans and loans held potential defaulters but moral hazard
Eichengreen’s essay discusses why the euro and the yen may (rewarding bad behavior will incentivize even non-defaulters to default on loan
find it hard to dislodge the dollar as the reserve currency. payments) can exacerbate the problem.

D E C E M B E R 2 0 0 9 7
SPECIAL REPORT

The Economic and Fiscal


Consequences of Financial Crises
North and South
BY CARMEN M. REINHART conclusion that the world economy is moving through
uncharted waters. There is little need to convince anyone that
The Ds: Sharp economic downturns follow banking crises; financial crises are associated with economic downturns and
with government revenues falling, fiscal deficits worsen; deficits severe dislocations in financial markets.
lead to debt; as debts pile up rating downgrades follow. For the In a recent paper with Kenneth S. Rogoff we examined the
most fortunate countries it does not end in default. international experience with episodes of severe banking
crises to identify empirical similarities as regards the depth,
S I N C E T H E S U B P R I M E C R I S I S B E G A N to unfold in the sum- duration, and characteristics of the economic slump following
mer of 2007 and escalated in the early fall of 2008, a cursory the crises.1 Our findings in that paper can be summarized as
reading of the global financial press would lead to the logical follows:

8 Development Outreach WORLD BANK INSTITUTE


■ Financial crises are protracted affairs. systemic financial crises: the “big five” advanced economy
■ Asset market collapses are deep and prolonged. crises (Spain 1977, Norway 1987, Finland 1991, Sweden 1991,
■ Real housing price declines average 35 percent stretched and Japan 1992) plus a number of famous emerging market
out over six years. episodes: the 1997–1998 Asian crisis (Hong Kong, Indonesia,
■ Equity price collapses average 55 percent over a downturn Korea, Malaysia, the Philippines, and Thailand); Colombia,
of about three and a half years. 1998; and Argentina 2001. Central to the analysis are histori-
■ There are profound declines in output and employment. cal housing price data, which can be difficult to obtain and are
■ The unemployment rate rises an average of 7 percentage critical for assessing the crisis episode. We also include two
points over the down phase of the cycle, which lasts four earlier historical cases for which we have housing prices,
years on average. Norway in 1899 and the United States in 1929.
■ Real GDP per capita falls (from peak to trough) an average Figure 1 looks at the bust phase in housing price cycles sur-
of more than 9 percent, and the duration of the downturn rounding banking crises, including the current episode in the
averages roughly two years. United States and a number of other countries now experienc-
■ The financial crisis has significant adverse consequences ing banking crises: Austria, Hungary, Iceland, Ireland, Spain,
for government finances. and the United Kingdom. Ongoing crises are in dark shading,
■ Tax revenues shrink as the economic conditions deterio- past crises are in light shading. The cumulative decline in real
rate, the fiscal deficit worsens markedly, and the real value housing prices from peak to trough averages 35.5 percent.2
of government debt explodes, rising an average of 86 per- The most severe real housing price declines were experienced
cent in the major post–World War II episodes. by Finland, the Philippines, Colombia and Hong Kong. Their
In this article I elaborate on these points and follow up with a crashes were 50 to 60 percent, measured from peak to trough.
sketch of how the crises and their ramifications affected The housing price decline experienced by the United States to
sovereign risk in the aftermath of the crisis episodes. date during the current episode is already more than twice
that registered in the U.S. during the Great Depression. The
The downturn duration of housing price declines is quite long, averaging
roughly six years.
IT IS NOW BEYOND CONTENTION that the present U.S. As illustrated in Reinhart and Rogoff (2009a), the equity
financial crisis is severe by any metric. As a result, we focus on price declines that accompany banking crises are steeper than

FIGURE 1: PAST AND ONGOING REAL HOUSE PRICE CYCLES AND BANKING CRISES: PEAK-TO-TROUGH PRICE DECLINES (LEFT PANEL) AND YEARS
DURATION OF DOWNTURN (RIGHT PANEL)

Austria, 2008
Hungary, 2008
US, 1929
UK, 2007
ONGOING Iceland, 2007
Malaysia, 1997
Thailand, 1997
Korea, 1997
Ireland, 2007
Norway, 1899
Argentina, 2001
US, 2007
Sweden, 1991
Spain, 1977
-35.5 percent Historical Average 6 years
Japan, 1992
Norway, 1987
Indonesia, 1997
Finland, 1991
Colombia, 1998
Philippines, 1997
Hong Kong, 1997

PERCENT DECLINE DURATION IN YEARS

Sources: Reinhart and Rogoff (2009a).

D E C E M B E R 2 0 0 9 9
FIGURE 2: PAST UNEMPLOYMENT CYCLES AND BANKING CRISES: TROUGH-TO-PEAK PERCENT INCREASE IN THE UNEMPLOYMENT RATE
(LEFT PANEL) AND YEARS DURATION OF DOWNTURN (RIGHT PANEL)

Malaysia, 1997
Indonesia, 1997
Japan, 1992
Thailand, 1997
Philippines, 1997
US, 2007
Hong Kong, 1997
Norway, 1987
Korea, 1997
Argentina, 2001
7 percent Historical Average 4.8 years
Sweden, 1991
Spain, 1977
Colombia, 1998
Finland, 1991
US, 1929

0 5 10 15 20 25 0 2 4 6 8 10 12

PERCENT INCREASE DURATION IN YEARS

Sources: Reinhart and Rogoff (2009a).

housing price declines, if somewhat


TABLE 1: FISCAL DEFICITS shorter lived. The average historical
decline in equity prices is 55.9 per-
COUNTRY Years before the crisis Peak deficit (year) Increase (-decrease) cent, with the downturn phase of the
in the fiscal deficit
cycle lasting 3.4 years. Notably, dur-
CENTRAL GOVERNMENT BALANCE/GDP
ing the current cycle, Iceland and
Argentina, 2001 -2.4 -11.9 (2002) 9.5 Austria have already experienced
Chile, 1980 4.8 -3.2 (1985) 8.0 peak-to-trough equity price declines
Colombia, 1998 -3.6 -7.4 (1999) 3.8 far exceeding the average of the his-
torical comparison group.
Finland, 1991 1.0 -10.8 (1994) 11.8
Figure 2 shows increases in unem-
Indonesia ,1997 2.1 -3.7 (2001) 5.8 ployment rates across the historical
Japan, 1992 -0.7 -8.7 (1999) 9.4 episodes. On average, unemployment
rises for almost five years, with an
Korea, 19972003
Source: WHO 0.0 -4.8 (1998) 4.8
increase in the unemployment rate of
Malaysia, 1997 0.7 -5.8 (2000) 6.5 about 7 percentage points. None of
Mexico, 1994 0.3 -2.3 (1998) 2.6 the postwar episodes rivals the rise in
Norway, 1987 5.7 -2.5 (1992) 7.9 unemployment of over 20 percentage
points experienced by the United
Spain, 1977 -3.9 -3.1 (1977) -0.8
States during the Great Depression.
Sweden, 1991 3.8 -11.6 (1993) 15.4 Although Figure 2 indicates that
Thailand, 1997 2.3 -3.5 (1999) 5.8 the emerging markets, particularly
those in Asia, have done better in
Source: Reinhart and Rogoff (2009b).
*Spain was the only country in our sample to show an increase (modest) in per capita GDP terms of unemployment than the
growth during the post-crisis period. advanced economies (Figure 2), there
are well-known data issues in com-

10 Development Outreach WORLD BANK INSTITUTE


market economies is that they are
FIGURE 3: CUMULATIVE INCREASE IN REAL PUBLIC DEBT IN THE THREE YEARS FOLLOWING more affected by abrupt reversals in
THE BANKING CRISIS
the availability of foreign credit. When
foreign capital comes to a “sudden
stop,” to use the phrase coined by
Malaysia, 1997
Mexico, 1994 Guillermo Calvo, economic activity
Index=100 in year of crisis
Japan, 1992 heads into a tailspin.3 The cycle from
Japan, 1992 peak to trough in GDP is much shorter,
Philippines, 1997 two years.
Korea, 1997
Sweden, 1991
Thailand, 1997
Deficits
Historical Average 186.3 (an 86 percent increase)
DECLINING REVENUES AND HIGHER
Spain, 1977
E X P E N D I T U R E S owing to a combina-
Indonesia, 1997
Chile, 1980 tion of bailout costs and higher trans-
Finland, 1991 fer payments and debt servicing costs
Colombia, 1998 have led to a rapid and marked wors-
ening in the fiscal balance. The
100 150 200 250 300
episodes of Finland and Sweden stand
PERCENT INCREASE
out in this regard, as the latter went
from a pre-crisis surplus of nearly 4
Sources: Reinhart and Rogoff (2008b) and sources cited therein.
percent of GDP to a whopping 15 per-
cent deficit-to-GDP ratio.

paring unemployment rates across countries. Widespread Debt


“underemployment” in many emerging markets and the vast
informal sector are not captured in the official unemployment F I G U R E 3 S H OWS T H E R I S E in real government debt in the
statistics. three years following a banking crisis. The deterioration in
As to real per capita GDP, the average magnitude of the government finances is striking, with an average debt rise of
decline is 9.3 percent. The declines in real GDP are smaller over 86 percent. We use the percentage increase in debt,
for advanced economies than for emerging markets. A proba- rather than debt-to-GDP, because steep output drops some-
ble explanation for the more severe contractions in emerging times complicate interpretation of debt–GDP ratios. As

FIGURE 4: INSTITUTIONAL INVESTOR (II) SOVEREIGN RATINGS CYCLES AND BANKING CRISES: PEAK-TO-TROUGH INDEX DECLINES (LEFT PANEL)
AND YEARS DURATION OF DOWNTURN (RIGHT PANEL)

Chile, 1980
Argentina, 2001
Indonesia, 1997
Malaysia, 1997
Korea, 1997
Thailand, 1997
-15.1 Average 5.1 years
Colombia, 1998
Finland, 1991
Japan, 1992
Norway, 1987
Default/restructuring Sweden, 1991
Near-default/bailout
Hong Kong, 1997
Mexico
-35 -30 -25 -20 -15 -10 -5 0 0 5 10 15

PERCENT DECLINE DURATION IN YEARS

Notes: II ratings range from 0 to a 100, rising with increased creditworthiness.

D E C E M B E R 2 0 0 9 11
Reinhart and Rogoff (2009b) note, the huge buildups in gov- emerging market sovereign defaults since World War II took
ernment debt are driven mainly by sharp falloffs in tax rev- place at levels of debt below 60 percent and would have satis-
enue. The much publicized bank bailout costs are typically fied the Maastricht criteria.6 Debt intolerance applies to both
second order. Fiscal stimulus also adds to the deficits in external and domestic debt.
advanced and emerging market economies.4
Carmen M. Reinhart is Professor of Economics at the University of
Maryland.
Downgrades
(sometimes default) References

Ilzetzki, Ethan, Enrique Mendoza and Carlos Vegh, “How big (small) are
A S S H OW N I N F I G U R E 4
(on the previous page), sovereign fiscal multipliers?” Mimeograph, University of Maryland. College Park, June
default, debt restructuring, or near defaults (prevented by 2009.

international bailout packages) have been a part of the finan- Reinhart, Carmen M. and Kenneth S. Rogoff , “The Aftermath of Financial
cial crisis experience in many emerging markets, therefore a Crises,” American Economic Review, Vol. 99 No. 2, May 2009a, 466-472.

decline in the country rating hardly comes as a surprise. Reinhart, Carmen M. and Kenneth S. Rogoff , “Banking Crises: An Equal
Advanced economies, however, do not go unscathed Finland’s Opportunity Menace,” NBER Working Paper 14587, December 2008. CEPR
Working Paper 7131, January 2009b.
score went from 79 to 69 in the space of three years, placing it
close to the scores for some of the emerging markets! Reinhart, Carmen M., Kenneth S. Rogoff and Miguel A. Savastano, “Debt
Intolerance,” Brookings Papers on Economic Activity, Vol.1 Spring 2003,
1-74
Conclusions and implications for Endnotes
emerging economies 1 “The Aftermath of Financial Crises,” (with Kenneth S. Rogoff), American

A N E XA M I N AT I O N of the aftermath of severe financial crises Economic Review, forthcoming, May 2009.
http://terpconnect.umd.edu/~creinhar/Papers.html
shows deep and lasting effects on asset prices, output, and
2 The historical average, which is shaded in black in the diagram, does not
employment. Unemployment rises and housing price declines
include the ongoing crises.
extend out for five and six years, respectively. The recessions
3 See Calvo, Izquierdo and Loo-Kung (2006).
are almost invariably accompanied by massive increases in
government debt. The crises adversely impact sovereign cred- 4 While, historically, stimulus packages have not been as large in emerging
itworthiness, as reflected in higher risk premia. market economies as in advanced economies, fiscal multipliers also appear
The global nature of the present crisis will make it far more to be smaller for the former. Ilzetzki, Mendoza and Vegh (2009) show that
while fiscal multipliers are roughly of the same order of magnitude in
difficult for many countries to grow their way out through
advanced and developing economies on impact, they erode much more
increased exports. The growth slowdown is amplified in world quickly in emerging markets.
commodity markets, as many emerging markets face steep 5 Reinhart and Rogoff (2009b).
declines in their terms of trade.
6 See Reinhart, Rogoff and Savastano (2003).
If historical patterns hold, showing a
link between banking and debt crises
the current lull in sovereign defaults or
restructurings in emerging markets will
likely come to an end, particularly if the
recovery process in the world’s largest
economies is delayed.5
With the advanced economies’ run-
ning large government deficits that are
accompanied by a rapid rise in govern-
ment debt, emerging markets will find
external private financing less avail-
able—this is the global dimension of
crowding out. Emerging markets will
therefore rely more on the multilateral
institutions for external funds and on
domestic debt. It is important for poli-
cymakers in these countries to remem-
ber that “fiscal space” is limited, that
their scope for sustained stimulus
packages financed by debt is capped by
their low thresholds for debt (at least An apartment for sale in St. Petersburg, Russia.
historically). More than one half of

12 Development Outreach WORLD BANK INSTITUTE


SPECIAL REPORT

Shock Producers and


Shock Absorbers in the Crisis
BY HANS-WERNER SINN
After the bubble burst
in the United States (U.S.). Since
T H E C R I S I S O R I G I N AT E D
about 1980 the savings rate of U.S. households had fallen from house values declined by a third
A FT E R T H E B U B B L E B U R S T,
about 10 percent to nearly zero and, because households did by April 2009, which was a decline in wealth in the order of 6
not save, the U.S. had to import gigantic amounts of capital trillion dollars. The decline in home values was followed by a
from the rest of the world to finance its investments and gov- worldwide decline in other asset values of about 50 trillion
ernment budget deficit. Capital imports amounted to 790 bil- dollars because of secondary effects. This has sent shock
lion dollars in 2008. One of the reasons for the decline in sav- waves through the U.S. and the rest of the world via three main
ings rates was that the U.S. financial system generously pro- channels. The first and most important channel was the
vided mortgages to homeowners, which often was tantamount decline in construction in the U.S., following the decline in
to hidden consumer credit. The excess of new mortgages over the sale of new homes: 75 percent by April 2009. The second
housing investment approached 60 percent in the years was a decline in worldwide consumption because of the wealth
before the crisis. Homeowners and banks had jointly specu- effect and the increase in unemployment. The third was a
lated on increasing house prices. On top of that, the govern- credit crunch resulting from the fact that huge equity losses
ment with its Community Reinvestment Act had forced banks had forced banks to scale down their lending and investment
to lend even to the poorer segments of the population. operations so as to avoid violating the supervisory minimum

Would jumbo loans replace the economic void left by the collapse of the subprime mortgage market?

D E C E M B E R 2 0 0 9 13
debt-equity ratios. The U.S. banking system alone had lost 53 points, the U.S. comes close to the OECD average, and at 3.6
percent of its equity stock by February 2009. points Germany comes close to the Euroland average. Among
The shock waves of the bursting bubble were then mitigated the big European countries, France and Italy lag a bit behind
through extensive bank rescue packages in the order of 4.1 tril- with 3.3 and 2.6 points respectively.
lion euros and Keynesian counter-cyclical budgetary effects in In the winter months some international irritation was
the order of 1.1 trillion euros. The budgetary effects came caused by U.S. officials and scholars accusing Germany of not
through discretionary measures as well as through the built-in providing sufficient Keynesian stimuli against the crisis. The
flexibility of the national tax-expenditure systems. Figure 1 data show that there may have been some foundation for this
shows the changes in the deficit/GDP ratios from 2008 to 2009 allegation. However, the differences are not particularly large.
for the OECD countries and thus measures the respective While it is true, for example, that the U.S. has taken more sub-
countries’ Keynesian stimuli to counteract the world recession. stantial discretionary measures than Germany, the built-in
flexibility of one of the world’s largest welfare states has pro-
Fiscal stimuli vided an automatic stabilization effect that must also be taken
into account. Still, as is shown in Figure 1, the overall U.S. fis-
W H I L E S M A L L E R C O U N T R I E S like Norway, Australia, cal stimulus was somewhat bigger.
Sweden, or Denmark are among the countries that have exert-
ed the proportionally largest fiscal stimuli, the U.K. is the out- Trade balances
performer among the big countries with a 7.3 percentage point
increase in the deficit share in GDP. On average, the OECD H OW E V E R , T H I S I S N AT U R A L since the crisis originated in
countries have increased their deficit share by 4.5 points, and the U.S. and not in Europe. A more important question for an
the euro area has increased its own by 3.7 points. At 4.3 overall assessment of the situation is, therefore, how large the

FIGURE 1: CHANGES IN GOVERNMENT DEFICIT/GDP SHARES 2008-2009, OECD COUNTRIES, PERCENTAGE POINTS

Source: OECD Economic Outlook 85 database; calculations by the Ifo Institute.

14 Development Outreach WORLD BANK INSTITUTE


net demand shocks exerted by various countries really were respectively. This exonerates Germany from the accusations
for the rest of the world . This is answered in Figure 2 for a of free riding in the current crisis. Germany is currently the
number of countries for which data could be found, including world’s biggest shock absorber.
the BRIC countries (Brazil, Russia, India, and China). The The reason for this result is that the German economy is
graph shows the changes in the respective trade balances from still surprisingly stable internally. The welfare state has many
the first quarter 2008 to the first quarter 2009 and hence the allocative disadvantages in the long run, but in a crisis it has a
net reductions in aggregate demand that were exerted from cushioning effect: 42 percent of adult Germans live on gov-
the respective country to the rest of the world. ernment transfers including state pensions, and the govern-
It is not surprising that the U.S. has been by far the world’s ment pays short-term work insurance for up to 24 months to
largest shock producer in this crisis. While both its exports and employers who keep their employees working at reduced
imports fell, its annualized imports shrank by 361 billion dol- hours during the crisis. Moreover, Germany has had no hous-
lars more than its exports. More surprising is that China did ing bubble, and its mortgage system is particularly safe and
not reduce its huge trade surplus but increased it even further. stable. Germany has long-term fixed interest loans, extreme-
Its imports declined by 71 billion dollars more than its exports. ly tight credit constraints for home owners (loans rarely
China amplified the shockwave coming from the U.S., and so exceed 60 percent of a home’s value), and double-secured,
did Brazil, Spain, the U.K., and South Korea, among others. mortgage-backed securities (Pfandbriefe) that give buyers
direct claims against the banks rather than only against the
Shock absorbers homeowners. The world has benefitted from this stability.

THE BIG SHOCK ABSORBERS on the other hand were Japan, Hans-Werner Sinn holds the Economics and Public Finance Chair at
Russia, and Germany, whose exports all shrank more than the University of Munich and is President of the Ifo Institute for
their imports: by 110 billion, 124 billon and 168 billion dollars Economic Research.

FIGURE 2: CHANGE IN ANNUALIZED TRADE BALANCES1), FROM Q1 2008 TO Q1 2009, IN BILLION US DOLLARS2)

1) Trade in goods, seasonally adjusted and annualized figures. 2) January and February 2009 against January and February 2008.
Source: OECD; calculations by the Ifo Institute.

D E C E M B E R 2 0 0 9 15
SPECIAL REPORT

The Crisis and the World’s Poorest


BY MARTIN RAVALLION nerable even to seemingly small income shocks. For example,
productive activity is simply not feasible at low levels of nutri-
has spilled over
T H E C R I S I S I N T H E D E V E L O P E D WO R L D tion; this “threshold effect” means that a negative shock of
into the lives of the world’s poorest. Because of the crisis, sufficient size can push a poor household past its tipping point
poverty is higher in most developing countries, although the and put it on a path to destitution.
impact is greater in some countries than in others, due to dif- Research has shown that past crises have left lasting
ferences in their dependence on foreign trade, investment effects. A study of the longer-term impacts of the East Asia
and remittances. Differences in pre-crisis savings rates and crisis found that about half of Indonesia’s poverty count in
in the accumulation of foreign reserves also mean that some 2002 was attributable to the 1998 crisis even though macro-
countries are facing more severe fiscal adjustment problems economic recovery had been achieved well before 2002.1
than others. While some countries have had scope for a fiscal Many of the actions poor families have to take to help protect
stimulus, others have not. their current living conditions have lasting consequences.
The effects are certainly not confined to the poorest, and Debts rise; key productive assets (such as livestock or land)
not all of the poor will be affected. Indeed, some are being are sold. And kids are taken out of school to save money and
protected by the same factors that have kept them poor—geo- add to the family’s current earnings.
graphic isolation and poor connectivity with national and When poor families are compelled to cut short their chil-
global markets. However, the poorest can be particularly vul- dren’s schooling in response to a shock, this creates a lasting

A family living under a bridge in Jakarta, Indonesia.

16 Development Outreach WORLD BANK INSTITUTE


impact on poverty since school drop-outs tend to earn less as be in South Asia; 10 million will be added to the poverty count
adults. This impact will vary, depending on the extent of the in East Asia and 7 million in Sub-Saharan Africa. Another 64
shock and initial conditions. Declining wages make child million will be added to the number of people living under $2
labor relatively less attractive, and schooling more so; but, at a day. Given the current growth projections for 2010, there
the same time, lower parental incomes increase the value of will be a further increase in poverty in that year, with a cumu-
the extra money that children can bring to the family budget if lative increase of 89 million people living under $1.25 a day
they work. The balance of these forces varies from place to and 120 million more under $2 a day by 2010.
place. There is evidence that in low income countries school- Of course, aggregate poverty measures cannot tell the
ing tends to decline in a macroeconomic or agro-climatic cri- whole story. There will also be impacts on non-income
sis while in middle- and higher-income countries school dimensions of welfare. Colleagues in the Bank’s research
attendance increases.2 Impacts on the nutritional status of department estimate that the crisis will lead to 30-50,000
young children in poor families are also of special concern, excess deaths amongst infants in Sub-Saharan Africa this
since poor nutrition in the early years of life retards child year; these will be disproportionately girls.5
growth, cognitive and learning ability, schooling attainments
and, in all likelihood, earnings in adulthood. Social policy responses6
Expected impacts on aggregate poverty CRISIS RESPONSES NEED TO BALANCE short-term relief
against the need for rapid recovery. Restoring economic growth
P OV E RT Y C O U N T S R E Q U I R E H O U S E H O L D S U RV E YS , which will be crucial to recovery for the world’s poorest. Protecting the
will not be available for some time. Given these lags, we must poorest through social assistance need not entail a trade off
rely for now on projections. Before the crisis, the incidence of against growth. Indeed, it can be argued that to help restore
poverty in the developing was on a trend decline. The propor- growth, domestic stimulus efforts and external assistance
tion of the developing world’s population living under $1.25 a should favor poor people; and any required fiscal adjustments
day in 2005 prices fell from 52 percent in 1981 to 25 percent in should minimize negative impacts on the poor. A pro-poor
2005; that implies 500 million fewer poor by this standard stimulus is likely to be more effective because poor people tend
(from 1.9 billion in 1981 to 1.4 billion in 2005).3 to be more financially constrained—notably due to credit mar-
This trend would have almost certainly continued in the ket failures—and so are most likely to engage in rapid consump-
absence of the crisis. To assess the impact of the crisis we need tion or investment when extra cash becomes available.
to estimate the difference between the expected level of However, experience has been mixed. Crises have given
poverty, given the crisis, and what we would have expected birth to some of the worst “social protection” policies, as well
based on the pre-crisis trajectories. as some of the best. Governments have sometimes been drawn
The poverty impact of the crisis in a given country will into introducing generalized food and fuel subsidies that have
depend on how it affects both average consumption and the come at a huge fiscal and economic cost, are not easily
distribution of consumption relative to the mean. The World reversed, and have had at best modest impact on poverty. Yet
Bank’s Development Prospects Group has made projections some developing countries have been able to turn a crisis into
for average consumption at the country level after the crisis. an opportunity for dismantling inefficient subsidies in favor
These can be compared to the Bank’s pre-crisis projections to of more effective safety-net programs.
assess the expected impact of the crisis. At the time of writing Relief work (“workfare”) is likely to be an important ele-
(mid-June 2009), we expect the crisis to knock almost 5 per- ment of an effective social policy response. But design is cru-
centage points off the consumption growth rate for 2009, cial: a well-designed workfare scheme has built-in features
bringing it down to zero. The effects on growth impacts will that encourage only those in need of help to seek out the pro-
tend to be greater in less poor countries. (Eastern Europe and gram and encourage them to drop out of it when help is no
Central Asia figure prominently in this group). This pattern longer needed given better options in the rest of the economy.
will help dampen the overall impact of the crisis on poverty. A famous example is the Employment Guarantee Scheme (EGS)
What about the distributional effects within countries? in Maharashtra, India, which started in the early 1970s in
Experience suggests that relative inequality falls about as response to the threat of famine. The EGS aims to assure
often as it rises during aggregate economic contractions, with income support in rural areas by providing unskilled manual
zero change on average. So the most defensible assumption labor at low wages to anyone who wants it. The employment
for estimating the effect on aggregate poverty is that the bur- guarantee is a novel feature of the EGS, which helps support
den of the crisis will be more-or-less proportional to initial the social insurance function, and also helps empower poor
income. However, while this is plausible in the aggregate, dis- people. In 2004, India introduced an ambitious national ver-
tributional impacts can be expected in individual countries, sion of this scheme under the National Rural Employment
with inequality rising in some and falling in others. Guarantee Act. This promises to provide up to 100 days of
Applying country-specific growth projections to survey- unskilled manual labor per family per year, at the statutory
based data and aggregating them, we estimate that the crisis minimum wage rate for agricultural labor, to anyone who
will increase the 2009 count of people living below $1.25 a day wants it in rural India. The scheme was rolled out in phases
by 50 million.4 More than half of this increase is expected to and gained national coverage—just in time to help cushion the

D E C E M B E R 2 0 0 9 17
impact of both the crisis and the drought that hit many areas These are the views of the author and need not reflect those of the
of the country this year. Bank, affiliated organizations or member countries.
An ideal workfare scheme will guarantee low wage work on
community-initiated projects. The low wage rate ensures that
the scheme is self-targeted in that the non-poor will rarely Endnotes
want to participate, and those needing relief during the crisis 1 See Martin Ravallion and Michael Lokshin, “Lasting Impacts of Indonesia’s
will voluntarily leave once recovery is underway. The federal Financial Crisis,” Economic Development and Cultural Change 56(1), 2007,
or state government announces that it is willing to finance up pp. 27-56.

to, say, 15 days of work a month on worthwhile community 2 See Francisco Ferreira and Norbert Schady, “Aggregate Economic Shocks,
projects for any adult at a wage rate no higher than the market Child Schooling and Child Health.” Policy Research Working Paper 4701,
World Bank, Washington DC., 2008.
rate for unskilled manual labor in a normal year. The work is
available to any adult at any time, crisis or not. As long as the 3 The average poverty line for the world’s poorest countries is $1.25 a day in
2005 prices at purchasing power parity, while the average line for all devel-
guarantee is credible it will also help reduce the longer-term
oping countries is $2.00 a day; see Martin Ravallion, Shaohua Chen and
costs of risk facing the poor. Thus a well designed and imple- Prem Sangraula, “Dollar a Day Revisited,” World Bank Economic Review.
mented scheme of this sort it can help in fighting chronic 23(2), 2009, pp. 163-184.
poverty as well as transient poverty in a crisis. 4 Shaohua Chen and I have used the latest growth projections for 2009 and
Relief work will need to be supplemented by transfers, in 2010 (as of mid-June 2009) as the “post-crisis” growth rates while the
cash or food, targeted to specific groups of people who either counterfactual (pre-crisis) projections for those done by the Bank in
cannot work due to physical incapacity, including poor nutri- December 2007 for 2009 and 2010. We have used the growth projections
tional status, or should not be taken out of other activities, for private consumption per capita. (Consumption is more appropriate than
GDP for predicting the short-term impacts on poverty, since the shock to
notably school. A recently popular class of transfer programs
GDP is unlikely to be passed on fully to consumption in the short term.)
requires the children of the recipient family to demonstrate See Shaohua Chen and Martin Ravallion, “The Impact of the Global
adequate school attendance, and health care in some ver- Financial Crisis on the World’s Poorest,” for further detail on the assump-
sions. Early influential examples were Bangladesh’s Food-for- tions and methods.
Education Program, Mexico’s PROGRESA program (now called 5 See Jed Friedman and Norbert Shady, “How Many More Infants are Likely
Oportunidades) and Bolsa Escola in Brazil. Such programs aim to Die in Africa as a Result of the Global Financial Crisis?” Policy Research
to strike a balance between reducing current poverty (through Working Paper, World Bank.
the transfers) and reducing future poverty (through the 6 For a fuller discussion of the issues raised in this section see Martin
behavioral responses). In a crisis, the largest benefits from Ravallion, “Bailing out the World’s Poorest,” Challenge 52( 2), 2009,
such programs may well be found in the poorest countries, pp. 55-80.

where the income effect on


schooling will probably domi-
nate. Targeting the transfers
made as part of a fiscal stimu-
lus to women in poor families
can also improve the terms of
the trade-off between current
and future poverty reduction,
notably by assuring that chil-
dren benefit more.
Experience with such pro-
grams suggests that it should
be possible to protect a sig-
nificant share of the world’s
poorest in a crisis. And with
careful policy design, this can
be done without damaging the
longer-term prospects of
escaping poverty, and even
enhancing them.

Martin Ravallion is Director of the


World Bank’s Research
Department, the Development
Research Group.
People look for job opportunities in downtown Sao Paolo, Brazil.

18 Development Outreach WORLD BANK INSTITUTE


SPECIAL REPORT

Growth is Disappearing and May Not


Recover in the Medium Run
BY VLADIMIR GLIGOROV the status quo ante does not seem realistic, at least not in the
medium term.
C O U N T R I E S I N T R A N S I T I O N in Central, Eastern, and South
Eastern Europe (CESE) have been hit hard by the global crisis. Integration and contagion
Though there was some stabilization at the turn of the first to
second quarter of this year (2009), the risks of further deteri- M O S T O F T H E C E S E E C O N O M I E S are small, open, and quite
oration in some of the countries are still quite high (Gligorov, integrated with the European Union (EU). These include the so
Poeschl, and Richter 2009). These risks are mainly connected called New Member States (NMS) that joined the EU in 2004
with the stability of the financial sector, with falling public and 2007, two of which have recently entered the euro area
revenues, and with slow revival of demand in the European (Slovenia and Slovakia), as well as the countries in Southeast
Union which is the principal market for CESE exports. There Europe that have yet to join the EU (so called Future Member
is also a need to rethink the growth model because a return to States, FMS, or candidate and potential candidate countries,

People attend a job vacancy fair in Moscow. The slogan on the wall reads: "Need work? Come on in, we'll help!"

D E C E M B E R 2 0 0 9 19
which include Turkey). Countries farther to the east, for exam- (though not the income account), while countries to the
ple, Ukraine, Belarus, and in particular Russia are either larg- southeast (FMS) have more pronounced, or very pronounced,
er countries or less integrated with the EU or both. trade deficits. Countries farther to the east are less integrated
Integration has been a mechanism of both propagation and and also depend more on export specialization—they export
mitigation of crisis. Because of the high level of trade integra- mainly oil, gas, metals, and raw materials—and thus have dif-
tion, the crisis has led to a sharp decline in both exports and ferent balance of payments structures reflecting a somewhat
imports. In addition, financial integration is a source of insta- different model of growth and development.
bility, even though their domestic financial sectors may be In the group of countries with current account deficits, the
sound. Thus, countries that are more integrated with the EU lack of demand for their exports and the declining availability
have suffered more from the crisis. On the other hand, these of foreign financing work together to produce sharp and in
countries are also better positioned to profit from the various some cases disastrous recessions. Negative growth rates vary
measures introduced in the EU to support stability and spur between minus almost 20 percent in some of the Baltic coun-
recovery. As long as these measures stimulate trade and stabi- tries to minus 1 percent in some Balkan countries (Poland
lize the financial system that has positive consequences for being an exception with close to 1 percent growth so far this
the more integrated CESE countries because it supports their year). Overall, more open countries (in terms of the exports to
exports to the EU markets. GDP ratio) with trade and income account deficits, such as the
A more fundamental problem of deep integration is that it Baltic countries, are doing worse, while more closed
leads to a strategy of growth that implies high and persistent economies such as Poland, with less of a deficit in their
external imbalances: the main indicator being the current income accounts (for example, the FMS), are experiencing
account deficit. This could be called a neoclassical growth milder recessions. On the other hand, economies that are
model. In the initial phases, foreign investments rush in to more open are better placed to benefit from fiscal and other
profit from high productivity growth in capital scarce measures that are supportive of trade and may also have more
economies and, later on, exports increase sufficiently to cover stable, though not risk-free, financial systems.
the trade deficits: in the process, there is convergence growth,
that is, when growth in less developed countries is faster than Risks and sustainability
in the more developed ones. The real and nominal exchange
rates adjust, basically appreciate, in order to support that E XC H A N G E R AT E R E G I M E S and fiscal policies account for
process. In the end, the remaining current account deficit much of the change in risks and in the assessment of sustain-
reflects the income balance, where the profits and dividends ability of macroeconomic balances. Given that the main vul-
of the foreign investors are recorded. nerability is the external imbalance, the adjustments of the
Countries in transition can be classified by the stage in exchange rates have to be expected, as are the limitations on
which they find themselves in this process. Roughly, EU the activism of fiscal policy, because widening fiscal deficits
member states (NMS) have mostly balanced trade by now can spill over into higher imports.
The risks to the stability of
exchange rates are significant,
though the general direction for
countries with current account
deficits is one of exchange rate
depreciation. However, the distri-
bution of risks depends to a large
extent on the exchange rate regime:
countries using the euro, those with
fixed exchange rates and those with
flexible rates have different finan-
cial and real consequences.
In general, countries with flexi-
ble exchange rates have seen sharp
nominal devaluations, which have
also led to weaker but still signifi-
cant real exchange rate devaluations
(for example, Poland, the Czech
Republic, Hungary, Romania,
Serbia, and Turkey). This has had
some cushioning effect for the trad-
able and the real sectors generally,
In Budapest, Hungary, construction work has slowed down as a consequence of the financial crisis. but in certain cases has increased
financial risks (for example,

20 Development Outreach WORLD BANK INSTITUTE


Hungary, Romania, and Serbia). Countries with fixed Republic and Montenegro, Russia, and some other oil-
exchange rates, on the other hand, have struggled to stabilize exporting countries. But overall, fiscal expansion is not an
their financial sector, with increasing risks in the real sector option because of growing risks to exchange rates, nominal or
in some cases (for example, Baltic countries and Croatia). In real, and unsustainable fiscal balances.
these cases, real exchange rate adjustment has to come about
through deflation which introduces huge risks in the real Savings and exports
economy. Finally, economies that are inside the euro area
(Slovakia and Slovenia) or that use the euro (for example, I F T H E P R O C E S S O F D E L E V E R AG I N G C O N T I N U E S for some
Montenegro and Kosovo) have additional difficulties to engi- time, the possibility of going back to the neoclassical model of
neer real exchange rate adjustments because they tend to growth may be called into question. If foreign financing
resort to fiscal stimuli which, although they work against the remains unavailable or expensive, what is the alternative
deflationary tendencies, put their tradable sectors at risk. model of growth? Clearly, domestic savings will have to
Thus, to the extent that the financial sector has been stabi- increase. At the moment, trade deficits are shrinking fast as
lized for the moment, the remaining risk has to do with the are current account deficits. Although this is mostly the con-
adjustment of the real economy, which may prove to be rather sequence of the decline in consumption, it is not altogether
more difficult in those countries with fixed exchange rates (or clear that savings are increasing, which would have to happen
hard pegs, for example, currency boards) in the short run, due for investments to increase as well. Finally, growth will have to
to the problems that deflation brings, and rather more diffi- be supported by exports and by the expansion of the tradable
cult for countries using the euro in the medium run, due to sector in general. The latter depends on the recovery of
loss of competiveness. Countries with flexible exchange rates, demand in the EU, which will take some time. Growth based
however, may run into liquidity problems in the short run, on domestic demand is possible in larger countries like
because of worsening balance sheets in the financial, house- Russia, Ukraine or Poland, but smaller economies cannot
hold and the corporate sectors, but should be in a better posi- normally rely on domestic markets. In that context, adjust-
tion to take advantage of the increase in external demand in ment of the real exchange rate is crucial, as mentioned earlier
the medium run. in this article.
In some countries, monetary policy is not completely There are, however, some limitations on the growth of sav-
impotent, though only Russia has enough room to manoeuvre. ings. Most countries in transition are demographically quite
When it comes to fiscal policy, however, some countries are in old and employment rates are relatively low (European
a better position than others. In general, transition Commission 2009). In addition, public sector and social
economies have had relatively lax fiscal constraints in the last security reforms have not led to significant increases in sav-
decade or so because of their high growth rates. So, even with ings rates. An increase in public savings does not seem realis-
persistent fiscal deficits, debt to GDP ratios tended to decline. tic, while private savings increases are limited. Finally, prof-
This was also supported by declining interest rates. Thus, itability has declined and it may take some time before it
irrespective of fiscal deficits, sustainability of fiscal balances improves; thus incentives to invest will be weak. As a conse-
was not an issue: the real limitation on fiscal expansion was quence, there are significant risks that the recovery will take
the sustainability of the current account because of the steady some time and growth will be weak in the medium run: in
accumulation of foreign debt, mostly by the private sector. some cases, prolonged stagnation is a distinct possibility.
Because credit was readily available at affordable prices, many
countries ran pro-cyclical fiscal policies even in the face of Social and political risks
rising current account deficits and surging private debt. As a
consequence, fiscal policies in the crisis have also had to be MOST OF THE COUNTRIES IN TRANSITION are democracies,
pro-cyclical and fiscal positions in many cases now seem so risks to political stability are relatively low; and EU mem-
unsustainable: with rising interest rates, rising fiscal deficits, bership as well as the EU accession process also have a stabi-
and worsening growth prospects, public debt to GDP ratios lizing effect. Countries that are less integrated and less
tend to increase without limit. democratized may experience more political instability.
Sustainability of fiscal balances does not look much better Social unrest has been rather rare in the last twenty years or
even in countries with quite low levels of public debt, for so, in part because labor unions tend to be weak. Currently,
example, the Baltic countries. This is because credit has dried however, populism is on the rise, and may change the political
up, depression has set in, and fiscal risks have increased very landscape in the medium run. There are two risks to overall
rapidly. These countries are trying to cut public expenditures stability (more in Gligorov et al. 2009).
dramatically, but if that leads to mass bankruptcies in the The first is that financial systems may yet collapse, which
household and the corporate sectors, public obligations will would have significant social and political consequences. The
shoot up immediately and fiscal balances will be unsustain-
able. This is what is meant by fiscal risks. A minority of coun-
tries have stuck to countercyclical policies and so can resort to
G r ow t h i s D i s a p p e a r i n g
fiscal stimuli in times of crisis. These include, for example, continued on page 24
the countries in the euro area, as well as Bulgaria, the Czech

D E C E M B E R 2 0 0 9 21
SPECIAL REPORT

South Africa’s Policy May Offset


the Financial Downturn
BY BRIAN KAHN equities market between November 2007 and July 2008. The
decoupling hypothesis—that emerging markets in general
AS THE GLOBAL CRISIS UNFOLDED during 2008, it initially were no longer intricately tied to the fortunes of the advanced
appeared as if South Africa, along with other emerging market economies—appeared to have some validity.
economies, would be relatively unaffected. South Africa’s During 2008 the domestic economy was beginning to show
banking system was only marginally exposed to the subprime signs of moderating, after 5 years of growth of some 5 percent
assets that initiated the crisis, and commodity prices acceler- or more. Consensus forecasts at the time indicated that growth
ated during the first half of the year. The U.S. dollar prices of was expected to average around 3.5 percent in 2008 and 2009,
South Africa’s commodity exports increased by some 26 per- before returning to rates of around 5 percent in 2010. This
cent between December 2007 and June 2008, while the slow-down was due in part to emerging electricity supply con-
domestic equities market reached an historic high in late May straints and a tightening of South Africa’s monetary policy
of that year. Initially the most significant direct impact of the stance. The repo rate had been increased by 500 basis points
global financial markets crisis on domestic markets was a 36 between July 2006 and June 2008 in response to a higher infla-
percent decline of the financial sector index on the domestic tion trend induced by sustained above-potential growth, real

COSATU (Confederation of South African Trade Unions) members march through the streets of Durban to protest against food, electricity and fuel hikes.

22 Development Outreach WORLD BANK INSTITUTE


household consumption expenditure growth of around 9 per- were felt in the first quarter of 2009 when 179,000 jobs were
cent in 2006, and higher oil and food prices. The higher lost in the formal nonagricultural sector. Exports of both
expenditure brought about a widening of the deficit on the cur- manufactured goods and primary commodities declined
rent account of the balance of payments which had reached a sharply. In the first quarter of 2009, total export values had
level in excess in 7 percent of GDP in 2007 and 2008. These declined by 21 percent compared to the previous quarter.
deficits were financed primarily through portfolio capital Fortunately, effective regulation and bank supervision
inflows. A prudent and conservative fiscal policy was also being shielded South African banks from direct exposure to the trou-
implemented, and in the 2008 budget, modest surpluses were bled securitized debt market in the U.S., and they remained
budgeted for the next three fiscal years. The public sector bor- well capitalized. Furthermore, South African banks are pre-
rowing requirement was projected to increase from a small dominantly funded by domestic deposits and not through for-
surplus to a deficit of 1.4 percent of GDP in 2010/11. eign-held structured products. Consequently, unlike many
The situation and outlook changed dramatically after other central banks, the South African Reserve Bank did not at
September 2008 in the wake of the demise of Lehman any time have to respond by injecting additional liquidity into
Brothers. The collapse of global confidence led to a flight of the domestic money market. The domestic interbank market
capital from emerging markets, a dramatic decline in com- continued to operate smoothly with no anomalies observed in
modity prices, and plummeting demand for exports from either the volumes or rates of interbank funding.
emerging markets. South Africa was not spared. Its relatively However, some deterioration in asset quality was observed
diversified export market and product base were insufficient in the course of 2008, which was probably attributable to the
to shield the economy from the fall-out of this synchronized monetary policy tightening of the previous period. But
global downturn. impairments increased significantly as the economy contract-
The effect was quickly felt in the financial markets. From ed. Although there is adequate provision for impaired loans,
its peak in May 2008, the domestic equities markets lost 36 banks have reacted to the downturn in a pro-cyclical manner
percent in value by the end of the year, and 22 percent from by significantly tightening credit criteria to both households
mid-September. The commodity price index of South Africa’s and the corporate sector, thereby exacerbating the downturn.
exports declined by over 30 percent by October compared Credit markets have therefore been affected by a reduction in
with its June levels, although the terms-of-trade blow was both the supply of and demand for credit. Credit extension to
cushioned to some extent by the fall in international oil prices the private sector, which was growing at rates of around 28
and the resilient gold price. Portfolio capital flows turned percent in January 2008, had declined to rates of around 4
sharply negative in the fourth quarter of 2008, although the percent in June 2009. Overall this represents a decline in real
overall financial account remained positive, partly as a result credit extension, although a number of components of credit
of repatriation of foreign currency balances held abroad by extension became negative in nominal terms as well.
domestic banks. Not surprisingly, these developments had an The official policy response was to allow for greater flexibil-
impact on the rand exchange rate which became highly ity in the application of monetary and fiscal policies. In
volatile and depreciated from a level of around R8.00 against December 2008, the Monetary Policy Committee (MPC) of the
the U.S. dollar in September 2008 to a low of around R11.80 in South African Reserve Bank reduced the repurchase rate by 50
November. However by December it had settled down at a basis points to 11.5 percent. In February the frequency of MPC
level of around R10 to the U.S. dollar. Because of the limited meetings was increased to monthly, to allow for a more contin-
exposure of the economy to foreign debt, balance sheet effects uous assessment of the rapidly changing situation. The repo
of these currency movements were relatively limited. rate was reduced further by 100 basis points at the February
These developments were reflected in the sudden and meeting and at each of the subsequent three meetings. The
sharp downturn in the domestic real economy. Having grown monetary policy stance was unchanged at the June meeting, but
at quarter-on-quarter seasonally adjusted and annualized at the August meeting the repo rate was reduced by a further 50
rates of 5.0 percent and 0.2 percent in the second and third basis points, bringing the total reduction to 500 basis points.
quarters of 2008 respectively, the economy contracted by 1.8 These actions were taken even though inflation, which
percent in the fourth quarter of that year, and by 6.4 percent measured 10.3 percent in December 2008, was well above the
in the first quarter of 2009. The mining and manufacturing target range of 3-6 percent. However, the forecasts were for
sectors of the economy were particularly hard hit: the manu- inflation to decline markedly over the next few months, and to
facturing sector recorded negative annualized growth of 22 return to within the target range by 2010. By July 2009, the
percent in both the fourth quarter of 2008 and the first quar- inflation rate had declined to 6.9 percent. The MPC main-
ter of 2009, while the mining sector recorded growth rates of tained a focus on inflation in a forward-looking flexible infla-
0.4 percent and -33 percent in these quarters. In the second tion-targeting framework: although inflation was outside the
quarter of 2009 the economy contracted at a rate of 3 per cent, target the committee was satisfied that it would return to with-
with the manufacturing sector recording a contraction of 11 in the target range over a reasonable time horizon. In addi-
per cent. The mining sector experienced a turnaround, with a tion, the widening output gap was seen to impart a high degree
growth rate of 5.5 per cent. Nevertheless the South African of downside risk to the inflation outlook.
economy appears to be lagging behind the recovery in a num- Nevertheless there were a number of upside risks to the
ber of the advanced economies. The effects on employment inflation outlook that constrained the monetary policy

D E C E M B E R 2 0 0 9 23
response. Some of the emerging upside risks included high
nominal and real wage demands and settlements, a turn-
G r ow t h i s D i s a p p e a r i n g
continued from page 21
around in the international oil price, stubbornly high food
price inflation despite a significant decline in agricultural
commodity prices, and high rates of increases in adminis- level of integration and interconnectedness of the financial
tered prices. These factors also contributed to deteriorating system in the EU and in the transition countries would make
inflation expectations. such a crisis even more devastating then the current one. This
The monetary policy stimulus was complemented by a con- is why the International Monetary Fund (IMF) has been called
tracyclical fiscal policy. South Africa was in the fortunate posi- back to support global financial stability—to bail out the banks
tion of having sufficient fiscal space—a result of past prudence in effect. It can be expected that many countries in transition
—to use fiscal policy in a manner that would not raise questions will end up with stand-by agreement before this crisis is over.
about sustainability. It is generally agreed that fiscal stimuli in In addition, the IMF is supporting the so-called Vienna
such circumstances should be reversible, with an emphasis on Initiative, which is a commitment by the banks in countries
increasing growth-enhancing capital expenditure. The prob- that have an IMF program to keep their credit exposure at
lem is that capital expenditure takes time to implement and so existing levels, which should help the process of orderly
may not be well-suited for cyclical purposes. It was therefore deleveraging. However, in the event of mishaps, financial
fortuitous that government had embarked on a large-scale failure would be transmitted through the interconnected
infrastructure expenditure program during the earlier part of banking system quite quickly (Arvai, Driessen, and Otker-
the decade (including road and rail infrastructure, telecom- Robe 2009).
munications, and more recently electricity generation), and The other risk is that these economies may experience
much of this was coming to fruition at a time when most need- stagnation in the medium run. That will have serious conse-
ed from a cyclical perspective. Government and state-owned quences for labor markets. Employment will decline anyway
enterprise expenditure on infrastructure is expected to average and slow growth will accentuate the already existing structur-
9.7 percent of GDP over the next three years compared with 4.5 al imbalances in these markets (high unemployment, signifi-
percent of GDP in 2005/06. The public sector borrowing cant segmentation, low employment), possibly leading to
requirement is now expected to increase to 7.5 percent of GDP social problems and to growing populism. There is little that
in 2009/10 before moderating to 5.3 percent by 2011/12. These the EU can do to address that eventuality, short of engineering
demands on the capital markets are sustainable because gov- a strong recovery with strong import demand, which is not
ernment debt to GDP is currently a modest 22 percent. something that is being forecasted at the moment.
There was also direct stimulus through the budget. The gov-
ernment had budgeted for a surplus of 0.6 percent for the Conclusion
2008/09 fiscal year, and with declining tax receipts the out-
come was a deficit of 1.2 percent. As a result of the slowing in the CESE has
T H E N E O C L A S S I C A L M O D E L O F G R OW T H
economy and a discretionary fiscal stimulus, a deficit of 3.9 been disrupted by the current crisis and it is not certain that it
percent of GDP was budgeted for the 2009/10 fiscal year. It is can be revived in the medium run. In addition, there are still
estimated that about half of this increase was due to lower significant risks that crisis may become even worse, especial-
expected tax receipts, implying an expenditure stimulus of ly if the process of deleveraging does not proceed in an order-
some 2 percent of GDP. More recently the minister of finance ly manner. Switching to the alternative growth model based
noted that tax revenues are likely to be somewhat lower than on higher domestic savings would be difficult and would
anticipated, and a higher deficit outcome is likely. However the depend on the recovery of EU demand for exports from coun-
government has projected deficits for the next two financial tries in transition. If that does not happen either, the return
years to decline to 3.1 and 2.3 percent of GDP respectively. to convergence growth rates may prove problematic in the
South Africa has not been spared from the impact of the medium run.
global crisis. However its policy response should to some
extent help to contain the contraction. Some internal and Vladimir Gligorov is Senior Researcher at The Vienna Institute for
external developments indicate that the worst may be over. International Economic Studies.
Portfolio capital inflows have resumed; the rand has appreci-
ated to almost pre-crisis levels; commodity prices have recov- References
ered from their lows, although still significantly below their Arvai, Zsofia, Karl Driessen, Inci Otker-Robe (2009), “Regional Financial
Interlinkages and Financial Contagion Within Europe,” IMF Working Paper
highs of last year; and most leading indicators show that pos-
WP709/6.
itive growth should be achieved during the latter part of this
European Commission (2009), “Impact of Current Economic and Financial
year. Nevertheless the recovery is likely to be slow and hesi- Crisis on Potential Output,” European Economy, Occasional Papers 49
tant, and dependent to a significant degree on the nature and (June).
speed of the global recovery. Gligorov, V. et al. (2009), “Final Report on Financial Risks in Candidate and
Potential Candidate Countries,” draft paper.
Brian Kahn is Head of Research and Policy Development at the South Gligorov, V., J. Poeschl, S. Richter et al. (2009); “Where Have All the
African Reserve Bank. ‘Shooting Stars’ Gone?,” wiiw Forecast Report 4 (July).

24 Development Outreach WORLD BANK INSTITUTE


SPECIAL REPORT

Small States Face Big Challenges


BY K. DWIGHT VENNER tures that are associated with such states and that influence
the impact of the crisis. Third, it presents as an example, the
Whether country size matters for economic prosperity depends on a case of the Eastern Caribbean Currency Union (ECCU)1 and
country’s degree of economic integration with the rest of the world. its response to the crisis. Finally, it puts forward a view on the
—Alesina and Spolaore, The Size of Nations role of the international community in assisting small states
to prepare for and mitigate the impact of such crises.
T H E C U R R E N T G L O B A L F I N A N C I A L and economic crisis is
having an enormous impact on all of the members of the What is a small state?
international community regardless of their size or stage of
development. Nevertheless, the impact can differ consider- S M A L L S TAT E S A R E 2 D E F I N E D
as those with populations of
ably, both in reality and perception, depending on its scale less than 1.5 million people. The World Bank has forty-eight
relative to the overall size of the particular state, as well as the such states in its current membership. These states are locat-
government’s financial capacity and ability to deploy a range ed in Africa (11), the Caribbean (12), Asia–Pacific (15), and
of policy instruments. other regions (10). They have varying geographic characteris-
This article is organized as follows. First, it defines and tics. Some are completely landlocked, while most are islands.
identifies small states. Second, it sets out the economic fea- Some are geographically distant from major regional centers

A taxi driver in Belmopan, Belize, waiting for customers.

D E C E M B E R 2 0 0 9 25
of development (Pacific) while others are closely connected; fore losing business because of the melt-down of the financial
both conditions have their advantages and disadvantages. sector in the United States and Europe and the prospect of
Some have valuable natural resources such as oil and dia- more restrictions in the future.
monds, while others have little. The situation with the offshore financial sector raises some
Small states suffer from three major handicaps: interesting and important issues for the international com-
■ Diseconomies of scale in production, marketing, distribu- munity, particularly the OECD, in the post crisis era.
tion, and public administration; At present, it would appear that these services are supplied
■ Exposure to high levels of risk because of small populations at competitive prices by many offshore centers located in
and limited physical space; and small economies that have few alternative economic activities.
■ Limited scope and capacity for negotiating with larger If we assume that there are appropriate and effective meas-
states and private sector entities. ures to combat money laundering, tax evasion, and terrorist
financing in all countries and that the demand for such off-
Economic factors shore services is still extremely large—a distinct possibility
given the fact that the movement and trading of financial
toward concentration of eco-
S M A L L S I Z E T E N D S TO L E A D instruments and services across borders far exceeds that of
nomic activities resulting in near monopolies or oligopolies. goods—then this activity constitutes a world market which
Exports are highly concentrated and imports highly diverse, should be accessible to all countries once the necessary regu-
giving them little room for price setting on either front. In latory safeguards are in place.
short, they are price-takers.
Small economies are highly open to external trade, linking How did ECCU respond?
them very closely with the fortunes of the international econ-
omy. The scope for their development therefore lies in two THE EASTERN CARIBBEAN CURRENCY UNION (ECCU)3, with
directions: deeper integration into the global economy, and a population of approximately 600,000, has been severely
concentration on those activities in which they have a relative affected by the crisis directly and by the collateral impact
comparative advantage that, with some effort, could be turned caused by the collapse of a regional insurance conglomerate
into a competitive advantage. because of imprudent investments in the U.S. and the fallout
Those countries that possess neither oil nor diamonds from the Securities and Exchange Commission (SEC) charges
have gravitated toward two activities—tourism and finance. against the Stanford Group of Companies.
These sectors, however, are inextricably linked to the global The scale of the direct impact of the crisis on the ECCU
economy, and have been greatly affected by the crisis. economies can be seen from the decrease in inflows of
There has also been a dramatic decline in foreign direct tourism receipts and foreign direct investment which have
investment in the tourism sector which, in turn, affects activ- accounted for, on average, 28 percent and 23 percent respec-
ity in the construction sector—a major contributor to employ- tively of GDP in the last three years. Travel receipts fell by 2.5
ment. Small states also have large segments of their popula- percent ($80.3 million) in 2008, in contrast to a 3 percent
tion living abroad who contribute to workers’ remittances increase in 2007; while foreign direct investment inflows
which have also been affected by the current crisis. contracted by 29 percent ($1 billion) in contrast to an increase
Empirical studies have indicated high levels of income and of 14.6 percent in 2007. This has had a negative effect on the
output volatility in small economies due to external shocks. central governments’ finances and debt. In particular in 2008
Also noted are the lack of technical skills and institutional the central governments realized a current account surplus of
arrangements to manage such shocks. $77.5 million (0.6 percent of GDP) substantially below that of
The food and energy crisis which immediately preceded $303.2 million (2.5 percent of GDP) in the previous year;
the current crisis had an adverse impact on small states and while their total outstanding debt rose by 2.4 percent to $9.3
lowered their capacity to deal with the current crisis. The fact billion (73.2 percent of GDP).
is that the current crisis is just the latest and most intense of a The ECCU countries, which are united by an integration
number of such events dating back to the demise of the arrangement through the Treaty of Basseterre (1981) and by a
Bretton Woods arrangements in 1971. The period since then common currency and central bank through the Eastern
can aptly be described as the Age of Volatility. Caribbean Central Bank (ECCB) Agreement (1983), have
These financial crises seem to have become more virulent responded at both the country and currency-union levels by
with the passage of time, and have occurred with increasing invoking the provisions embedded in the articles of both
frequency. The Asian crisis, which had a worldwide effect, put treaties.
pressure on the other area to which small economies had The Organization of Eastern Caribbean States (OECS)
gravitated, that is, offshore finance. In an effort to design a Authority and the ECCB Monetary Council, the highest deci-
new financial architecture a whole raft of standards and codes sion-making bodies of both arrangements, have intervened in
was developed, and a particularly stringent approach was both the banking and insurance sectors to take over and
taken to curtailing the activities of offshore financial centers. restructure ailing institutions. They have also accelerated the
The same situation is occurring again as the OECD is now process of implementing a comprehensive regulatory and
focusing its efforts on the offshore sector. This sector is there- supervisory regime to meet the current and future challenges.

26 Development Outreach WORLD BANK INSTITUTE


APPENDIX I: COMPARATIVE INDICATORS FOR SELECTED SMALL STATES—2007

COUNTRY POPULATION POPULATION COUNTRY POPULATION POPULATION


(thousands) (1=smallest) (thousands) (1=smallest)

EAST ASIA PACIFIC


Cape Verde 441 27 Brunei 338 24
AFRICA
Comoros 558 30 Cook Islands 20 5
Djibouti 632 32 Fiji 812 38
Equatorial Guinea 457 29 Kiribati 96 11
Gabon 1,230 42 Marshall Islands 52 7
Gambia, The 1,303 44 Micronesia, Fed. Sts. 118 15
Guinea-Bissau 1,199 41 Nauru 11 3
Mauritius 1,186 40 Niue 2 1
Sao Tome & Prin. 148 16 Palau 19 4
Seychelles 81 10 Samoa 170 18
Swaziland 1,045 39 Solomon Islands 447 28
Timor—Leste 800 36
COUNTRY POPULATION POPULATION Tonga 100 13
(thousands) (1=smallest) Tuvalu 11 2
Vanuatu 197 19
LATIN AMERICA

Antigua & Barbuda 68 8


Bahamas, The 303 23
COUNTRY POPULATION POPULATION
Barbados 267 21 (thousands) (1=smallest)
Belize 240 20
Dominica 73 9
OTHER REGIONS Bahrain 691 33
Grenada 98 12 Bhutan 805 37
Guyana 761 35 Cyprus 757 34
St Kitts & Nevis 41 6 Estonia 1,369 45
Saint Lucia 156 17 Maldives 276 22
St Vincent & the Gren. 115 14 Malta 390 25
Suriname 417 26 Qatar 585 31
Trinidad & Tobago 1,301 43

Source: ECCB

APPENDIX II: ECCU SELECTED DATA - 2008

REGION POPULATION NOMINAL GDP TOURISM FOREIGN DIRECT


(thousands) (ECSM) RECEIPTS INVESTMENT
(ECSM) (ECSM)

Anguilla 15 784.21 273.79 240.65


Antigua And Barbuda 68 3,299.81 902.42 684.08
Dominica 73 1,011.14 217.95 140.69
Grenada 98 1,831.92 283.32 435.26
Montserrat 5 135.65 19.02 5.15
St Kitts And Nevis 41 1,513.42 328.09 236.68
Saint Lucia 156 2,665.31 839.69 282.82
St Vincent and the Grenadines 115 1,571.06 243.98 326.64
ECCU 571 12,812.52 3108.26 2,351.97

Source: ECCB

D E C E M B E R 2 0 0 9 27
The ECCU authorities have also developed an Eight Point These first three programs, vigorously executed, are the pre-
Stabilisation and Growth Programme to address the immedi- requisites for approaching the international community to fund
ate global crisis which focuses on: and provide technical assistance for the next three.
■ Financial Programs Public sector investment programs, in the absence of
■ Fiscal Reform domestic fiscal space, would constitute the fiscal stimulus
■ Debt Management required to generate economic activity through quickly acti-
■ Public Sector Investment vated and disbursing projects.
■ Social Safety Net Social safety net programs through transfers and retrain-
■ Financial Sector Safety Net ing are considered important to protect the vulnerable and
■ Amalgamation of Local Banks unemployed.
■ Rationalisation of the Insurance Sector Financial safety net programs require financing to
restructure and recapitalize stressed institutions, and techni-
The role of the international cal assistance to facilitate the development of robust regulato-
community ry and supervisory regimes.
If these three are not adequately supported by external
DISCUSSIONS A R E O N G O I N G with the International sources then the difficulty of successfully executing the first
Monetary Fund (IMF) following Article IV consultations with three will increase significantly.
individual countries, and the IMF Annual Currency Union The amalgamation of local banks is critical to the creation
Review to identify the types of programs that would be appro- of a strong banking sector that is adequately capitalized and
priate in the current circumstances and to work out access to has the capacity to survive in difficult situations. The sector is
Fund resources under the new arrangements following the now overbanked with increased exposure of smaller and
G20 meetings. Most of the countries have already approached weaker banks and high overhead and unit costs.
the Fund under the Exogenous Shock Facility (ESF). The insurance sector is similarly overpopulated with
The financial programs which each country has already agency arrangements that have left the sector highly frag-
formulated would be the platform on which the Fiscal Reform mented and under-regulated.
and Debt Management Programs will be established. These initiatives, emanating from the currency union
The fiscal reform program had started prior to the crisis arrangements and supported by external assistance, should
with recommendations by a Tax Reform and Administration help alleviate the impact of the crisis on these countries.
Commission which resulted in the implementation of value
added taxes, property taxes, and adjustments to personal and Conclusions
business taxes. The current goal would be expenditure reform
and rationalisation of government expenditures to increase THE CONCLUSIONS that can be derived from the experience
the value added for critical sectors. The Caribbean of small states in general, and those of the ECCU in particular,
Development Bank, with its Policy Based Loans and the World are as follows:
Bank with its Development Policy Loans are critical partners ■ Financial stability, given its beneficial global effects, should
in the Fiscal Reform Program. be considered an international public good. Efforts should
Debt management is being given high priority as most be redoubled to ensure that meaningful reforms take place.
countries have extremely high debt to GDP ratios, which have ■ The international community, through the IMF and the
severely limited the fiscal space to respond to the crisis. The World Bank, should develop financial and social safety nets
Canadian government, the IMF, and the World Bank are sup- in consultation with the small states to address their par-
porting the ECCU member countries in taking a structured ticular problems.
approach to effective debt management. ■ Small states should use the crisis to experiment with fun-
damental and creative fiscal and monetary policies to mit-
igate the impact of exogenous shocks. Given the extreme
vulnerability of small states, these measures can contribute
significantly to their survival and advancement in an
increasingly volatile environment.

K. Dwight Venner is Governor of the Eastern Caribbean Central Bank.

Endnotes
1 The ECCU is comprised of the eight countries, which are members of the
Eastern Caribbean Central Bank, namely, Anguilla, Antigua and Barbuda,
Dominica, Grenada, Montserrat, St. Kitts and Nevis, Saint Lucia and St.
Vincent and the Grenadines.
2 See Table 1
The boardwalk of Belize City, the nation's principal port and its financial
and industrial hub. 3 See Table 2

28 Development Outreach WORLD BANK INSTITUTE


SPECIAL REPORT

Policy Responses to the


Global Economic Crisis
BY JUSTIN YIFU LIN economic and financial experts severely misjudged the timing,
and underestimated the speed and severity of the current
T H O U G H M A N Y K N E W that the risks of a severe financial cri- financial crisis. As a result, despite strong macro policy
sis were mounting, the necessary changes in policies and responses, the current situation (in July 2009) remains full of
practices, both in mature economies’ financial sectors as well uncertainties. Going forward, the key challenges will be to
as in many new emerging markets, were stymied by procrasti- accelerate the recovery with adequate macroeconomic policies,
nation during the 2003–2007 boom.1 No one was willing or to increase future productivity in developing countries, while,
capable of taking the punch bowl from the party2 and the glob- at the same time, enhancing the regulatory framework of the
al institutional set-up did not have the leverage to do so. Most financial sector to prevent new crises and avoid asset bubbles.

More than 200 enterprise managers signed a billboard that promises: "No job cuts. No salary cuts. Tide over difficulties," in Hangzhou City, China.

D E C E M B E R 2 0 0 9 29
The global economic crisis mid-2007 this process began with the crisis unfolding in the
subprime mortgage market in the U.S. The drop in the value
of the ori-
W E N OW H AV E A R E A S O N A B L E U N D E R S TA N D I N G of the off-balance sheet assets pushed many financial insti-
gins of the global financial crisis: lax macroeconomic policies, tutions into insolvency. Even worse, the financial innova-
in a context of weak prudential and regulatory oversight, led to tions of the past decade—many of which had been sold on the
excessive leverage, mispricing of risk, and the build-up of promise that they would diversify and minimize risk—turned
global systemic risk. The global financial crisis exposed a num- out to be the transmission mechanism for instability. The
ber of previously known, documented, but unresolved fragili- (relatively small) subprime mortgage crisis thus became a
ties within the increasingly integrated financial system. The full-fledged global financial crisis.
crisis also revealed that surveillance of macroeconomic and ■ The pre-crisis global build-up of capacity in the real econ-
financial sector policies must be even-handed for all coun- omy, specifically in the housing and manufacturing sec-
tries, developed and emerging markets alike. While emerging tors, will result in excess capacity even after the global
markets, having learned lessons from the crises of the 1990s, economy starts recovering. As households respond to the
were closely monitored both by markets and international sudden loss of wealth, by reducing consumption, and the
financial institutions (IFIs), their capacity to influence macro deleveraging of the financial sector reduces the funds
and regulatory policies in mature economies has proven to be available for investment, aggregate demand will decline.
limited. This has been particularly true in large economies The capacity utilization rate of the manufacturing sector
issuing a global currency which experienced little incentive to was 69.1 percent in the U.S. in March, 2009, the lowest
adjust domestic imbalances since external financing needs since statistics began to be collected in 1967. In Germany it
were matched by the excess savings attracted by the depth and was 72 percent and in Japan 65 percent—all record lows for
liquidity of U.S.-denominated asset markets. The global econ- recent decades. Once excess capacity appears, the economy
omy benefited from the strong 2003–2007 business cycle gets trapped in a vicious cycle, it becomes hard for firms to
which was clearly unsustainable. The losses precipitated by the find viable investment opportunities, investment demand
financial crisis have been enormous. Total capitalization of declines, and some firms are forced into bankruptcy. This,
world stock markets was almost halved in 2008, representing a in turn, threatens the income and job security of workers,
loss of nearly $30 trillion of wealth. So far in 2009, markets who then try to reduce spending, and so on.
have recovered about $2 trillion. In the United States alone, the ■ Finally, small, open developing economies typically use cur-
wealth loss for households related to the fall in home prices was rency depreciation and the resulting export-driven growth
roughly $4 trillion by the end of 2008. to come out of a crisis. However, this is impossible in a glob-
Losses of this magnitude have significant wealth effects on ally depressed environment. Policy instruments in both
consumption and savings. Indeed, the current global crisis is developed and developing countries are likely to be less
not limited to the financial sector and is now affecting real effective without coordination. And unless we deal with the
economic sectors. Industrial production in the first quarter of excess capacity, we will all experience a protracted crisis.
2009 fell 23 percent in Eastern Europe, 62 percent in Japan,
and 42 percent in Germany, at seasonally adjusted, annualized Beginning in mid-March 2009 amid signs of a recovery in
rates (SAAR). Globally, industrial production declined by 28 the United States, and confidence that no further major
percent in the first quarter following a 22 percent fall in the financial sector collapses were in the works, markets began to
final quarter of 2008, before easing to a pace of contraction of strengthen and capital flows to developing countries picked
19 percent in April (on a rolling quarterly, SAAR basis). up. Equity flows to developing countries in the first two
During the first quarter of 2009, for East Asian economies, months of the second quarter exceeded the total for the first
such as China and Japan, exports declined by 50 percent or quarter, while bank lending and bond issuance both acceler-
more, and 43 percent in Korea. This year we will encounter ated. Partly as a result, returns on emerging market assets
the largest trade contraction since 1929. surged. Since mid-March developing country markets are up
Commentators, papers, and reports3 have compared the 33 percent as compared with only 19 percent for high-income
nature and intensity of the present global recession with past countries. Nevertheless, markets remain well below pre-cri-
episodes such as the Great Depression of the 1930s and the sis highs. Equity markets, often considered an early indicator
Japanese Recession of the 1990s: of recovery, are pointing firmly to a pick-up, especially in the
United States5 and in a number of developing East Asian
■ Like the Great Depression, the current crisis originated economies. These developments are consistent with a turning
from the U.S. financial system. The size and interconnec- point in the crisis. The prognosis for Europe and Japan, how-
tivity of the U.S. economy facilitated the contagion of the ever, is less upbeat. Although surveys show that consumer and
crisis, following the bankruptcy of Lehman Brothers.4 business confidence are improving, economic statistics con-
■ Unlike the bank runs of the 1930s, this financial crisis tinue to deteriorate.
involved complex financial instruments, harder to re-price, Much uncertainty remains. Global output is now expected
and globally disseminated in the balance sheets of a variety to shrink by 2.9 percent in 2009, the first contraction since
of financial institutions. This created new channels for rapid World War II; world trade is likely to contract by 10 percent in
transmission. The boom was bound to turn to bust. And in 2009; and unemployment will soar in industrial countries, as

30 Development Outreach WORLD BANK INSTITUTE


high-income countries reel from an unprecedented asset- including: the sudden halting of financial flows (from mar-
market bust. kets); the limited room for additional concessional aid by
donors; the fall in remittances due to rising unemployment of
The policy responses unskilled workers; global trade contraction; increased need
for budgetary resources to contain the dramatic poverty
rapid and com-
I N C O N T R A S T TO T H E G R E AT D E P R E S S I O N , impact of this global crisis; the ensuing credit crunches
prehensive monetary6 authority interventions helped to avert (including trade-financing); the abrupt fall in commodity
a global financial collapse at the end of 2008. The broad prices for many exporters; the consequent exchange rate
nature7 and size of interventions—in most cases expanding the volatility due, inter alia, to portfolio composition shifts; mas-
public sector balance sheet, has been unprecedented in mod- sive deleveraging; and abrupt profit repatriation.
ern times. The size of interventions in the financial sectors The longer-term implications of the global financial crisis
during 2008–2009 was large, totaling on average for advanced for developing countries are more difficult to discern. The
economies about 50 percent of their purchasing power parity relative stability of developing country yields since the begin-
(PPP) weighted GDPs. Yet despite capital injections, special ning of the year suggests that the borrowing costs for these
liquidity facilities, monetary easing, provision of guarantees, countries may not rise by as much as feared. That said, capital
stress-testing, and the announcement of financial restructur- flows are much lower than in the past, and are not expected to
ing plans, the status of financial sector balance sheet repair is return to pre-crisis levels anytime soon. As a result, financing
still uncertain. of both private and government sector investment is likely to
In addition to support to the financial sector, the global be more difficult for some time, with implications for longer-
economy is facing an unprecedented problem of coordination. term potential output.
Addressing the crisis requires a broad, decisive, and globally Developing countries have been affected in varying
coordinated policy action in the form of a fiscal stimulus that degrees by the transmission of the global financial crisis
goes beyond national boundaries. In most cases, G20 countries depending on their level of integration in global financial
have adopted—in addition to support of their financial sec- markets and their specific external dependency, for example,
tors—fiscal stimulus measures that reached 0.5 percent of their on external financing by capital markets, on exports, on aid,
average GDP in 2008, 2 percent in 2009 and 1.5 percent in on expatriate labor income, and so forth. It is noteworthy that
2010. A particular emphasis was placed on discretionary several developing countries are navigating this crisis better
spending on infrastructure, given its higher multiplier effects. than previous episodes. Having translated the lessons of pre-
Conversely, there is much more certainty about the damage vious crises into robust policy frameworks and stronger fun-
done to the development efforts and prospects of developing damentals, they are now capable of implementing counter-
countries, where the room for policy maneuvers is smaller. The cyclical policies, whereas in the past (for example, during the
GDP growth rate in developing countries in 2009 is forecast to Mexican, East Asian, and Russian crises), the need for imme-
drop to 1.2 percent, a sharp decline from 8.1 percent in 2007 diate stabilization led inevitably to contractionary policy
and 5.9 percent in 2008. This decline alone will cause more frameworks to rebuild confidence and credibility.
than 30 million workers to lose their jobs according to the
United Nations International Labor Organization and, of Policy challenges ahead
course, poverty will rise. In fact, if we do nothing, this situation
could turn into the worst case scenario. With the crisis taking DESPITE SOME PRELIMINARY DISCUSSIONS about exit
its toll, it is estimated that total foreign direct investment (FDI) options, for the time being the primary policy challenges con-
and private capital flows will decline from $1.2 trillion in 2007 cern the need for interventions to sustain global demand and
to $363 billion this year. As a result of declining exports and policy coordination. On the one hand, developed countries
reduced capital inflows, developing countries may encounter a are focused on repairing their financial sectors, stimulating
financing gap of between $352 billion and $635 billion. the real economy, and trying their best to coordinate fiscal
Moreover, remittances are likely to fall by 7.3 percent in 2009 and monetary policy initiatives. Many are using the expansion
to a level of $305 billion. Estimates for 2009 suggest that lower of their public sector balance sheets, but also need to pay
economic growth rates would trap 53 million more people in attention to their credit ratings and medium- and long-term
poverty—those living on less than $1.25 a day—than was expect- loan (MLT) debt sustainability. On the other hand, we have:
ed prior to the crisis. If the $2 a day poverty line is used, 65 mil- (a) middle-income countries that have both excess capacity in
lion will stay trapped. If the recession is protracted, more and the production and export of manufactured consumer goods
more people will fail to get out of poverty. (to high-income countries) as well as with the need to import
Contrary to the predominant view during 2003–2007, capital goods; and (b) low-income countries that have excess
when some saw a “decoupling” of business cycles between capacity in the production of commodities. In both middle-
industrialized and emerging economies, the post-Lehman, income countries and low-income countries, there is evi-
end-2008 acute turmoil still produced contagion effects from dence that investment in infrastructure has lagged due to a
developed to all developing countries. The short-term conse- number of chronic problems such as past and present fiscal
quences of the global financial crisis have been extensive, constraints, quality of governance, technical capacity to iden-

D E C E M B E R 2 0 0 9 31
tify sound projects, political economy issues, and so forth. mostly exhausted in developed economies, in developing coun-
Hence, while there is uneven room for fiscal maneuvering in tries, by contrast, opportunities for investments that help break
developing countries, the crisis should, nevertheless, be an through bottlenecks to growth tend to abound. Although some
opportunity to identify targeted investment that would fraction of fiscal resources must be injected in developed coun-
increase future productivity and position these countries to be tries that are at the epicenter of the current crisis, the main pol-
more competitive in the aftermath of the crisis. Infrastructure icy objective should be to create demand as quickly and effi-
seems a logical sector in which sound projects could produce ciently as possible. This can be done by channeling investment
high returns and multiplier effects. to where it can be most effectively utilized: by investing in elim-
In 1998, because of the East Asian financial crisis, China inating bottlenecks to growth in the developing world. Lack of
encountered a situation very similar to the current one. The infrastructure in many developing countries, both domestic
Chinese government adopted a fiscal stimulus package in and regional, is the main bottleneck to growth. Increasing
1998–2002 to remove bottlenecks in infrastructure. In 1997 investments in infrastructure can raise the productivity of the
China had only 4,700 kilometers of highway, by 2002 this had private sector, improve the business environment, and gener-
increased more than five times to 25,000 kilometers. The ate high economic returns. This must be supported with
transportation capacity improved greatly as did port facilities increased financing and underpinned by improvements in the
and the electricity grid. With that kind of fiscal stimulus, efficiency and effectiveness of public spending.
China maintained its average annual growth rate at 7.8 per- Policy makers also need to prevent future crises in the
cent. More importantly, after the crisis the growth rate accel- financial sector. We know that this global financial crisis was
erated. Between 1979 and 2002, the average annual growth caused in part by failures of the pre-crisis regulatory and
rate in China was 9.6 percent. And between 2003 and 2008, supervision framework, especially in the G7. After the crisis,
the growth rate actually increased from 9.6 percent to 10.8 many reports and proposals8 are calling for a strengthening of
percent. This growth was made possible by investment target- prudential regulation, a more accurate evaluation of risk, and a
ed to freeing-up bottlenecks, that is, those sectors constrain- tightening of accounting standards. The pre-crisis regulatory
ing growth in the economy. As a result, though government framework allowed distortions in banks’ behavior and the
debt as a percentage of GDP initially rose from about 30 per- financial intermediation process and did not control financial
cent of GDP to 36 percent in 2002 it then declined as growth pro-cyclicality. There were strong incentives to bypass
increased. By 2006-2007, government debt had fallen to 20 required capital regulations by shifting loans off banks’ bal-
percent of GDP. ance sheets. Furthermore, the risk models did not take into
The lesson to take from China’s experience is that, if the account “extreme events” and mispriced risk, and there was lax
return is high enough to generate higher growth, sufficient rev- governance in the financial sector industry, including in its
enues can be generated to pay for the costs of the fiscal stimulus internal, short-term based compensation rules. Looking
itself. That is, the project may be “self sustainable.” Whereas ahead, some of the areas for reform include: changes in com-
opportunities for growth-promoting fiscal stimuli may be pensation schemes in the financial industry with more empha-
sis on evaluating long-term perform-
ance and results; better supervision of
excessive leverage and asset quality;
comprehensive registration of all
financial transactions, including
over-the-counter (OTC) operations
(especially for highly leveraged agents
and derivative markets); reassess-
ment of the role and oversight of rat-
ing agencies; and better capital
requirements rules (Basel II) that can
smooth business cycle fluctuations by
reducing pro-cyclicality.
The current crisis is the first “syn-
chronized” crisis in almost eight
decades and as a result, dealing with
it is beyond the capability of any sin-
gle country. Instead, decisive and
concerted actions are needed by the
international community as a whole.
In particular, there is a need for a
global, coordinated fiscal stimulus.
Applicants attend a job fair in the Makati financial district of Manila, Philippines. For example, in the spirit of building
our common global future, developed

32 Development Outreach WORLD BANK INSTITUTE


excess liquidity which, in turn, contributed to the large increases in real
countries need to consider, in addition to their domestic estate and equity investments in the United States, as well as private capital
efforts, using part of their resources to make investments in flows to the developing countries, supporting their investments in the manu-
developing countries. This will not only help the latter, but facturing sector. These events and actions, together with financial innova-
also the former. It would support short-term recovery, but tions induced by financial deregulation, created a boom in the housing mar-
also help lay the foundation for a sustainable, inclusive growth ket, which later became an equity bubble. As markets surged, the perceived
wealth effects prompted households to divert a steadily increasing share of
in the longer run. their income to consumption.
2 Perhaps the gradual tightening by the U.S. Federal Reserve beginning
Conclusion June 2004 represented the first calculated bet to try to smooth the cycle.
3 Among many sources, M. Wolf “The recession tracks the Great
(as of July 2009) some “green
W H I L E W E A R E O B S E RV I N G
Depression”, FT, June 16th, 2009 quoting B. Eichengreen and O’Rourke
shoots” pointing to a bottoming-out of the crisis, it is too soon “A Tale of Two Depressions”, June 2009, www.voxeu.org; The World
to speak of a recovery that includes stabilization of mature Economic Outlook (WEO), Spring 2009, especially Box 3.1 pg. 99, IMF;
economies and resumption of strong growth in developing the OECD Economic Outlook, Volume 2009/1, No.85, June; the World
countries. We can, however, identify some key forces that are Bank’s Global Development Finance (GDF) 2009, June 2009, etc.
likely to shape any future recovery and growth path. 4 The eruption of the financial crisis after Lehman’s bankruptcy in
The post-crisis global growth pattern may be slower than September 2008 included a widespread surge in pre-cautionary saving and
in the pre-crisis period, in part because of the need to rebal- flight to quality. As a result, virtually every currency in the world fell with
respect to the dollar, and the yield on U.S. government bonds dropped by
ance growth in the global economy and reduce excessive cur-
more than 200 basis points. Simultaneously, spreads on risky assets, includ-
rent account imbalances. This correction will take many ing developing country sovereign and corporate bonds, surged by as much as
forms (and some time), including changes in private con- 800 basis points. In the months immediately following the crisis, global
sumption in the U.S. and surplus countries, movements of financial markets remained volatile and uncertain, the Chicago Board of
relative prices (for example, energy, minerals, food, and so Trade’s VIX index almost quadrupled from a level of 20 in early September to
8 in November. Global equity markets effectively collapsed (with the Dow
forth), and better control of the financial industry through
Jones Industrial Average down some 30 percent by mid-November). Equity
lower leverage ratios and simpler financial products, all markets in developing countries were hit especially hard in this market fall-
potentially contributing to a lower trend growth for the next out, with the Morgan Stanley Capital International Emerging Market (MSCI-
cycle. Also, at some point, current stimulus policies (both EM) index falling 42 percent over September 2008 to a trough in early
monetary and fiscal) will need to be unwound. That will March 2009.
reduce the momentum of global growth to some extent and 5 In this overall context it is difficult to evaluate with precision recent move-
will have to be carefully timed to avoid both the dangers of ments in the yield on U.S. Treasuries. Their recovery to levels observed prior
inflationary pressure and a premature shock to aggregate to the crisis is consistent with a return to normality and the partial reversal of
the capital outflows from developing countries that characterized the most
demand. A rise in protectionist pressures would take a toll on acute phase of the crisis. This interpretation is consistent with the recent
trade and growth. Finally, investment may be dampened for tendency for the dollar to depreciate against other currencies and for the
some time by the need to absorb the high excess capacity that spreads on developing country bonds to fall. Indeed, as compared with the
currently exists in the world economy. movement in spreads, yields on developing country bonds have been relative-
The implications are clear for developing countries: those ly stable.

who will have tailored their fiscal stimulus well, removed bot- 6 See IMF Staff Position Note, “Fiscal Implications of the Global Economic

tlenecks to growth, and invested adequately in human and and Financial Crisis,” SPN/09/13, June 9, 2009

physical capital within the limits of their fiscal room for 7 There was, so to speak, no “countercyclical policy response” in the 1930s

maneuver, will be naturally better-off and ready to begin a with countries locked into “gold standard” regimes and balanced budget fis-
cal frameworks. Monetary policy was only gradually eased by 1932-33 and
new and more robust growth cycle based on their comparative
financial repair/restructuring started later after some 2-3 years into the crisis.
advantages in the global economy. For the IFIs, helping this By contrast, by the end of 2008, in the current crisis, policy-makers have
process unfold through lending and technical assistance while used almost every conceivable policy tool and more: capital injection, direct
also building global public goods will be a challenging agenda purchase of troubled assets and discretionary lending by treasury, central
for the next few years. bank support with treasury backing, liquidity provision and various other spe-
cial facilities by central banks, Guarantees, upfront government financing,
even sometimes outright nationalization and liquidation of financial institu-
Justin Yifu Lin is Senior Vice President and Chief Economist of the
tions, and so forth.
World Bank.
8 Financial Services Authority-FSA, “The Turner Review, A regulatory
response to the global banking crisis,” (March 2009); Global Financial
Endnotes Stability Report-GFSR, International Capital Markets Department, IMF
(2009); The High Level Group on Financial Supervision in the EU, report,
1 Although there were differences of viewpoints (Bernanke’s savings glut Chairman Jacques de Larosière, EU, Brussels, February 25th, 2009;
and preference for U.S. assets) numerous warnings were expressed by many International Monetary Fund, “Lessons of the Financial Crisis for Future
academics (Obstfelt, Rogoff, Krugman, Roubini, and others.) and IFIs on Regulation of Financial Institutions and Markets and for Liquidity
global imbalances and their possible abrupt unwinding with consequences Management,” Monetary and Capital Markets Department, IMF, February 4,
for exchange rate and asset price stability. The current crisis was preceded 2009; International Center for Monetary and Banking Studies, “The
by six years of boom in the global economy which can be traced to the burst- Fundamental Principles of Financial Regulation,” Markus Brunnermeier,
ing of the Internet bubble in 2001, and the subsequent expansionary mone- Andrew Crockett, Charles Goodhart, Avinash Persaud and Hyun Shin,
tary policy pursued by the United States Federal Reserve Board. This led to preliminary conference draft, January 2009.

D E C E M B E R 2 0 0 9 33
SPECIAL REPORT

Coming Out of Recession


The role of business in alleviating poverty
BY V. KASTURI RANGAN access to capital are causing a sharp contraction in the pro-
AND DJORDJIJA PETKOSKI duction and global trade of manufactured goods. Global
industrial production declined by 20 percent in the fourth
The post-crisis business climate quarter of 2008, as high-income and developing countries’
activity plunged by 23 and 15 percent, respectively.2
THE CURRENT FINANCIAL CRISIS is affecting developing Weak global demand is compounded by a decrease in trade
countries in two major ways: sharp reduction in capital finance as well as increased costs. International trade is likely
inflows and the collapse in global and local demand. Global to experience its largest decline in 80 years. Unemployment is
output is expected to shrink by 2.9 percent in 2009: while the rising with unprecedented job losses, in some countries
GDP growth in developing countries is projected to decline poised to hit double-digit rates. Furthermore, employment is
from 5.9 percent in 2008 to 1.2 percent in 2009 it will still out- increasingly moving out of dynamic export-oriented sectors
perform those of developed countries whose aggregated GDP into lower-productivity activities.
is projected to fall 4.5 percent.1 Lack of demand and limited

People in La Paz, on the outskirts of Mexico City, were able to buy construction materials for their houses in Chicago through CEMEX (Cementos Mexicanos)
programs.

34 Development Outreach WORLD BANK INSTITUTE


Foreign capital inflows—remittances, international syndi- The role of business in poverty
cated bank lending, private capital investments, and bond alleviation
issues—collapsed in the aftermath of the crisis. Global finan-
cial markets remain uncertain and unstable, and prospects for AFTER A DECADE OF STRONG GROWTH and significant
capital flows to developing countries are dim. Global investors poverty reduction, weaker growth in many developing coun-
retreating from developing countries resulted in a decline of tries will lead to an increase of some 46 million people living
total private capital flows in 2008 to $707 billion with an in poverty in 2009 .7 The world is facing another crisis—a
expected further decline in 2009 to $363 billion.3 MSCI poverty crisis that is going nearly unnoticed in the midst of the
Emerging Market Index sank 55 percent in 2008, erasing about financial crisis. While putting their “business house in
$17 trillion in market valuation. Net private debt and equity order,” corporations will likely face another dilemma—how
flows to developing countries are projected to decline to 2 per- much, if at all, can they help meet the needs of the poor, espe-
cent of GDP in 2009, compared to 8.6 percent of GDP in 2007. cially in developing economies. Our view is that the financial
At the same time, much of the external debt of approxi- crisis is an opportunity.
mately $1.2 trillion, raised by developing country banks and
firms between 2003 and 2007, is now maturing. The cost of Some strategies
external borrowing has increased to 11.7 percent, compared
to 6.4 percent in the pre-crisis years.4 A S S A L E S , P R O F I TA B I L I T Y, and investor confidence contin-
ue to deteriorate, for many companies the most urgent need is
Business response to reduce costs. According to a recent Ernst & Young survey,
cash remains a major concern for 82 percent of businesses
but companies as well were sur-
N OT O N LY G OV E R N M E N T S worldwide. Almost 9 out of 10 companies are looking for cost
prised by the speed and scope of the downturn. As demand for reductions, and 4 out of 10 companies accelerated significant
goods and services collapsed, and uncertainty about future employee reduction.8
demand is increased, companies have found it difficult to Companies looking for ways of preserving cash and pursu-
make any serious commitment to new investment. ing growth should reassess their tax positions, since taxes are
Governments can mitigate the impact of the crisis by helping normally their 3rd to 5th biggest expense. Many government
to stabilize the financial sector, preserving jobs, and protect- stimulus packages have included significant tax measures as a
ing people. The focus should be on restoring confidence in the response to the crisis. According to a recent OECD report, tax
financial system and supporting increases in aggregate measures represent 56 percent of the net effect of fiscal stim-
demand. By reducing the risk of doing business, governments ulus on average among OECD countries. However, the issue of
can stimulate the private sector to mobilize the substantial how favorable tax policy can support business development is
financial resources waiting to be invested. complicated by the increasing government deficits and rev-
Small and medium enterprises (SMEs) are especially enue needs.
affected by limited access to finance. It is critical for govern- Global GDP is forecasted to increase a modest 2.0 percent
ments to help entrepreneurs emerge from the crisis by facili- in 2010 and 3.2 percent in 2011. This will result in a very slow
tating access to finance for SMEs and microfinance institu- job recovery, and recession-like conditions will continue to
tions, and to support the recovery process through policies prevail. Companies are employing various strategies to deal
that promote growth and employment generation. A recent with employment issues. Some companies utilize their corpo-
study by the Kauffman Foundation indicates that many lead- rate social responsibility programs to create new jobs or pre-
ing companies today were formed in uncertain times. For serve existing ones through temporary salary cuts and intro-
example, more than half of the companies on the 2009 ducing shorter working hours. Some companies use more
Fortune 500 took shape during a recession or bear market. than one business model to achieve both profitability and job-
Although individual circumstances vary, companies gen- creation objectives. For example, the Grameen group has gen-
erally have a broad range of options for responding to the cri- erated significant profits through its GrameenPhone group
sis. One of the most urgent needs is to ensure rapid debt which employs only about 600, while at the same time creating
workouts. The financial crisis contributed to a sharp increase more than 100,000 through the GrameenTelecom group which
in corporate bankruptcies and “fire sale” of assets. The chal- yields lower profits.
lenge for many developing countries is that institutional con- The growth rates in emerging markets will continue to be
straints, such as weak judicial systems, make bankruptcy pro- higher than in OECD countries and more emerging-market
cedures inefficient and time consuming.5 The way in which multinationals are building very strong positions in their
corporations respond to this challenge—their ability to roll industries. Hyper competition will speed the declining growth
over their maturing debt—will have a big impact on the devel- and fast commoditization of high-income market segments,
oping countries’ ability to meet their external financial needs. thus putting an additional pressure on companies to expand
Companies account for some 75 percent of the medium- and their markets in developing countries. Furthermore, pressure
long-term private debt coming due in 2009. on companies to create jobs and do business with low-income
groups will increase. The traditional corporate response to
financial crises based on cost-cutting, restructuring and

D E C E M B E R 2 0 0 9 35
layoffs, aimed at preserving cash and increasing efficiency order to ensure the success of its main line of business: mak-
and productivity, should not be pursued alone and at the ing and selling bread and other edible foods and snacks.
expense of more innovative solutions. In a recent McKinsey & Because of the financial crisis, access to basic services, as well
Company survey more than 50 percent of the respondents said as their quality has deteriorated. Education is one example, since
that innovation is more important to growth now than it was school attendance tends to decline in low-income countries as
before the crisis.9 Long-term global prosperity and stability incomes drop. The potential for partnering with business in
need to be supported by expanding growth, especially among addressing these issues has not been fully tapped. Business can
the low-income segments. play an important role in reducing the number of school drop-
For example, because severe competition with local com- outs by implementing innovative programs. For example, Tetra
panies in India resulted in reduced profit margins at the high- Pack has a program in Nigeria that provides school meals as part
income market segment, Unilever felt pressure to cultivate of its philanthropic corporate social responsibility strategy;
low-income groups. The company has had outstanding suc- while Britannia has a similar program in India which, was ini-
cess in these markets, offering products in single-use packag- tially supported in part by the Global Alliance for Improved
ing (for example, sachets of shampoo and mini-size soaps), Nutrition (GAIN),10 but which is now primarily profit based.
that were affordable to consumers. By extending its distribu- The financial crisis creates unique opportunities for gov-
tion networks to rural towns through travelling sales agents ernment and companies to reassess their strategies and iden-
(on bicycles and even bullock-carts), the company has con- tify innovative solutions, including creative partnerships, to
tinuously increased its market share in countries like India, tackle the new economic reality the world is facing. Those who
Indonesia, and Brazil. react quickly and forcefully will most likely be the rule makers
The multinational cement producer CEMEX learned a sim- and winners in the post-crisis world.
ilar lesson during the last financial crisis in Latin America.
For CEMEX the crisis was an opportunity to reengage with V. Kasturi Rangan is Malcom P. McNair Professor of Marketing and
low-income market segments, and profitably provide housing Co-Chairman, Social Enterprise Initiative, Harvard Business School.
to the poor, while also creating jobs. CEMEX chose to put an Djordjija Petkoski is Lead Specialist, World Bank Institute
interdisciplinary team of its own employees on the ground in
Mexico to better understand the social and home-building Endnotes
practices of low-income communities, using that knowledge 1 “Global Development Finance: Charting a Global Recovery.”
to develop a successful product line of affordable housing just The World Bank. 2009
for the poor. This approach has also been used in several other 2 “Swimming Against the Tide: How Developing Countries are Coping with
Latin America countries and in Egypt. the Global Crisis.” The World Bank. 2009
Growth based on tapping into low-income markets should 3 “Global Development Finance: Charting a Global Recovery.”
aim primarily at wealth creation, including providing access The World Bank. 2009
to jobs, healthcare, education, and vocational training. This 4 “Global Development Finance: Charting a Global Recovery.”
objective should even precede the marketing of consumable The World Bank. 2009
goods and services that help improve the quality of life of the 5 Atish R. Gosh, Marcos Chamon, Christopher Crowe, Jun I. Kim, and
poor. Arguably, businesses that have provided jobs and Jonathan D. Ostry. “Coping with the Crisis: Policy Options for Emerging
income to low-income people have been the most successful. Market Countries.” International Monetary Fund. 2009
They have given people the ability to buy healthcare and edu- 6 “Global Development Finance: Charting a Global Recovery.”
cation for their children, and acquire property to improve The World Bank. 2009
their quality of life. They normally base their business models 7 “Swimming Against the Tide: How Developing Countries are Coping with
on a holistic assessment of how their labor policies and supply the Global Crisis.” The World Bank. 2009
chain relationships can shape their strategy. Nestlé’s Milk 8 “Opportunities in Adversity.” Ernst & Young. 2009.
District Model illustrates this approach. By providing oppor-
Ernst & Young interviewed a large number of managers and owners of com-
tunities for training, education, and a steady income to poor
panies around the world, first in January 2009 and again in June 2009. The
rural farmers in exchange for a consistent milk supply, Nestle main findings include: about 82 % of respondents still having difficulty in
effectively integrated poverty alleviation into a business accessing credit and this is impacting upon their investment strategy; com-
model that was mutually beneficial: the company has been panies are facing heightened concerns over risks while managing their assets,
able to increase its supply of fresh milk and poor communities and over the likelihood of more regulations; companies are using this crisis to
outsource (23%) and use strategic acquisitions (34%); about 32% are dis-
have benefited from job security, improved nutrition, and a
posing off assets to increase cash and liquidity; in January 2009, only 20%
better standard of living. Similarly, Bimbo in Mexico offers its planned for entering new geographic markets but by June 2009, 33% expect
30,000 travelling salespeople the opportunity for continuing to.
education, supplementary health care in addition to the gov- 9 “The crisis—one year on: McKinsey Global Economic Conditions Survey
ernment-supplied plan, and even a cooperative to help them results,” September 2009.
acquire housing material to upgrade their living environment. 10 GAIN has formed a Business Alliance to explore the space between phi-
The company has also attempted to bring microfinance to its lanthropy and strategic private sector interest by developing new business
100,000 small retailers, and acted as an agent for health and models to fortify foods with necessary vitamins and minerals and making it
property insurance. Admittedly all this has been done in available and affordable to the poor.

36 Development Outreach WORLD BANK INSTITUTE


SPECIAL REPORT

Trade Openness Is Now More


Important Than Ever
BY ANNE O. KRUEGER
Successes of trade liberalization
IN THE MIDST OF THE SEVERE CURRENT RECESSION, it is
easy to forget that the international economy has experienced A M A J O R FAC TO R contributing to the successes of the past
unprecedented growth over the past sixty years. Despite the sixty years has been the liberalization of international trade.
present downturn, living standards in almost every country At the end of World War II, tariffs were high and nontariff bar-
are higher than they have ever been; life expectancy is at an all riers proliferated. Through successive rounds of trade negoti-
time high, the growth rate of world real GDP has been higher ations under the General Agreement on Tariffs and Trade
on average than in any period in economic history, and some (GATT) and the World Trade Organization (WTO), the average
countries have adopted policies that have enabled them to level of tariffs on manufactures in industrial countries fell
grow at spectacular and unheard of rates. from 45-50 percent in l948 to an average of about 3 percent

A tire shop iin Beijing. China lodged a complaint with WTO over tariffs imposed by Washington on its tire products.

D E C E M B E R 2 0 0 9 37
today. Over the same period, quantitative restrictions on kets, and make little effort to learn about best practices in
imports were almost entirely dismantled, and many other other countries.
barriers to trade were reduced or eliminated. While work still Moreover, for most poor countries, where comparative
remains to be done, international trade in the first decade of advantage lies in abundant unskilled labor, an open economy
the 21st century has been freer than at any time in world his- with a realistic exchange rate provides incentives for growth of
tory. It is no accident that increased integration, “globaliza- export industries which can compete in international markets
tion,” in trading ties was accompanied by spectacularly suc- and employ workers. In the process, workers gain skills and, as
cessful economic growth. growth continues, producers can move “up the value added
The world economy was in a virtuous circle: trade liberal- chain.” This strategy has enabled the rapid growth of East
ization spurred economic growth, which in turn, made it eas- Asian and other countries; no country has maintained satisfac-
ier for politicians to take measures for further trade liberal- tory growth through inward-oriented development policies.
ization. The process was facilitated by falling transport and The rapid expansion of trade (and falling transportation
communications costs. and communication costs) has enabled a “chopping up” of the
Of course, a great deal remains to be achieved to improve value added chain as different parts and components are pro-
material well-being even after recovery from this recession. duced in countries where costs are lowest. This integration of
Poverty will still afflict many people, some countries’ living production across national boundaries has resulted in major
standards will have advanced only slowly, and other challenges productivity gains and accelerated growth, but has also made
will also persist. To address these issues, the robust growth any erection of trade barriers far more costly than in the past.
rates that characterized the past sixty years will have to resume. A final advantage is that an open economy greatly reduces
the ability of individual producing interests to influence
Need for further trade liberalization politicians to grant them special favors. The international
market is objective and performance in that market provides
and resuming those
B U T R E C OV E RY F R O M T H E R E C E S S I O N feedback to economic policy makers. By contrast, there is lit-
growth rates will both require further liberalization of trade in tle basis on which to evaluate the performance of domestic
goods and services in the international economy and would be monopolists, protected by high tariff barriers or import
retarded, if not prevented, by backsliding. Consider the ben- licensing requirements.
efits and opportunities that liberalized trade provides. For all
countries, liberalized trade creates an economic environment The threat of protectionism
in which there can be more competition than in a closed econ-
omy, and one in which domestic producers are exposed to a double threat. It can
P R O T E C T I O N N OW C O N S T I T U T E S
international best practice. Either of these benefits alone make recovery from the recession slower than it would other-
raises productivity in countries with open trading regimes; wise be. But it can also greatly reduce the growth potential of
imports are as beneficial in this regard as exports. the international economy once recovery has taken hold, and
Monopolists, and even comfortable oligopolists, generally especially harm the low-income countries by eliminating the
produce low-quality items at high cost in their protected mar- opportunities for more rapid growth that outer-oriented trade
strategies provide.
The current threat arises because protectionist sentiments
increase during recessions, along with greater pressures on
politicians to heed them. However, once a protectionist meas-
ure has been taken by a country or countries, others retaliate.
This has already happened to some degree in the current
recession. For example, once America provided support for its
automobile industry, Canada, Japan, and some European
countries took similar measures to protect their own auto
industries. This results in overcapacity in the industry, with
sizeable costs to taxpayers and a failure of the global industry
to restructure in an economically efficient way. The value of
WTO rules was demonstrated earlier this year when a propos-
al in the American Congress to insist on a “Buy American”
clause in the stimulus package was amended, under pressure,
to insure consistency with the government procurement
agreement negotiated under the WTO. China, not a signatory
to the WTO agreement, was not so constrained.

The Keffel container port terminal in Singapore. The nation's main T r a de O p e n n e s s


exports fell at a slower pace in 2009. continued on page 49

38 Development Outreach WORLD BANK INSTITUTE


SPECIAL REPORT

The Imperative for Improved


Global Economic Coordination
BY JOSEPH E. STIGLITZ The importance of coordinating the macroeconomic
response, which is the intervention needed to prevent the
the policy responses,
A LT H O U G H T H I S I S A G L O B A L C R I S I S , downturn from becoming even worse, is obvious. Each coun-
both to accelerate the recovery and to prevent a recurrence, try evaluates the costs and benefits associated with the impact
are taking place at the national level. That is why global coor- on its own economy. Although the costs are reflected in
dination has been strongly recommended by the UN increased debt, a well-designed stimulus that spends money
Commission of Experts on Reforms of the International on needed investments may arguably have a negligible net
Monetary and Financial System, on which I served as chair. cost. But because some of the extra income earned in a

Demonstrators protest against bailout funds outside of Bank of America in Washington.

D E C E M B E R 2 0 0 9 39
country is spent abroad, some of the value of the stimulus The North has every reason to lead a coordinated global
leaks to other countries, that is, some of the benefits accrue response to help the developing countries. In recent years the
outside the borders. This is why the global multiplier, the ratio developing countries have been part of the world’s engine of
of the increase in global income for each dollar of government economic growth, and it is hard to imagine a robust global
spending, is much higher than the national multiplier. Every recovery in which the developing countries did not play a role.
country focuses on its national multiplier which measures the A recovery in the North that was not matched by one in the
benefits that accrue internally. The result is that, without South could worsen global imbalances, including trade imbal-
coordination, there will be too little stimulus. ances which in turn could give rise to further protectionist
But matters may be even worse. Without coordination, pressures.
countries will try to design their stimulus packages to maxi-
mize the national multiplier, regardless of the adverse effects The G-20’s inadequate response
on the global multiplier. For example, even if a national
investment project had greater long-term benefits, the fact T H E G O O D N E WS I S T H ATthe G-20 has recognized the prob-
that it may require importing many of the critical inputs and lem. The bad news is that it has failed to respond effectively.
thereby diminish the national multiplier might cause the Most of the money provided has been in the form of loans, and
country to choose a domestic road project instead. the primary responsibility for disbursement has been given to
In an attempt to increase domestic multipliers still further, the International Monetary Fund (IMF). Many developing
many countries have engaged in protectionist measures. countries, just emerging from an overhang of debt, are reluc-
Indeed within a few months of the G20 resolving not to engage tant to get back into the debt trap. Moreover, while the IMF
in such measures, 17 of the 20 had done so. Since then, mat- has promised not to impose on “good countries” the counter-
ters have only gotten worse. Such measures are likely not only productive pro-cyclical conditionalities that have marked its
to be counterproductive, since others will take retaliatory lending in the past—and which would undermine the effec-
measures, but many of them also discriminate against devel- tiveness of any assistance—many developing countries won-
oping countries. The “buy America” provision of the U.S. der whether they will qualify. Some of the programs, while less
stimulus package illustrates this point. America included an stringent than those of the past, still seem austere. Besides, in
exception for countries with which it had procurement agree- many developing countries there is strong domestic opposi-
ments—mostly other developed countries. Thus, even though tion to turning to the IMF, regardless of IMF assurances.
the developing countries are innocent victims of the failure of Countries worry about losing their economic sovereignty, and
U.S. regulatory and macroeconomic policies, they are being in in democracies, governments have to pay attention to the
effect targeted for protectionism. Only through coordinated views of their citizens. Past IMF behavior has not earned it a
action can we prevent such self-destructive measures. great deal of affection, and many citizens are suspicious about
claims of reform. As its critics inside and outside the develop-
Developing countries are the worst hit ing countries are wont to point out, the IMF not only did not
take steps to prevent the crisis but it also had pushed those
T H E R E I S A T H I R D D I M E N S I O N of coordination. Developing deregulatory, financial, and capital market liberalization poli-
countries are among the innocent victims of this crisis which cies that played such an important role in the creation of the
is negatively affecting even many of those that did a far better crisis and its rapid spread. The result is that many countries
job of macromanagement and regulation than the U.S. are reluctant to turn to the IMF until they have no other
Indeed, those countries that are most closely integrated into choice, while others are engaged in bilateral borrowing in the
the global economy, having followed the advice of the interna- hope that they can “squeak” through. Global coordination of a
tional economic institutions and opened themselves up the much larger assistance program is needed, more in the form
most, have been among the worst hit. Developing countries of grants and disbursed through a variety of mechanisms, as
have been affected by unprecedented decreases in exports, a the UN expert commission urged.
drop in export prices, a decline in remittances, and a decrease In short, without coordination, we are likely to have a
in capital flows—in some cases even a reversal. And they do smaller and, from a global perspective, a much more poorly
not have the resources to protect their families who are losing designed global stimulus, resulting in a more prolonged
their jobs or to save their businesses that are threatened with downturn and slower recovery.
bankruptcy, let alone to provide an effective stimulus. While Agreement on a coordinated stimulus faces several obsta-
in the North, the crisis began in the financial sector and then cles. First, there is the question of enforcement. Under current
moved to the real sector, in the developing countries, the cri- arrangements, compliance rests on good will. This may be espe-
sis began in the real sector and is quickly moving into the cially problematic in presidential democracies, where parlia-
financial, starting a vicious downward spiral. A crisis of this ment or congress may not support the leader’s commitment.
magnitude is certain to generate follow-on effects in the Reaching an agreement may also be constrained by the var-
financial sector. Even banks that did a good job of credit ied circumstances in which different governments and
assessment could not have anticipated a downturn of the mag- economies find themselves. Although the United States boasts
nitude that many countries are experiencing in, say, the of a large stimulus, a significant fraction of Federal Government
export sector. expenditure increases is being offset by expenditure reductions

40 Development Outreach WORLD BANK INSTITUTE


and tax increases at the state and local levels. Moreover, the particularly disadvantageous position. Some even argue that
United States has fewer automatic stabilizers than many dumping duties are a “protectionist safety valve.” I would
European countries, with less progressive tax structures and argue that an increased use of dumping duties as advanced
smaller unemployment insurance systems. Similarly, practices industrial countries appear to be doing is, in fact, protection-
in the private sector, which may have been influenced by gov- ism. Many of the developed countries, however, view the
ernment policy, also contribute less to stability. For instance, in practice as totally legitimate, while at the same time, criticiz-
recent years the U.S. has moved from a defined benefits pen- ing developing countries for making use of the leeway they
sion system to a defined contributions system, which may lead have between current and bound tariff rates.
to greater volatility in consumption during a crisis such as this Of particular concern in the current crisis is financial protec-
one, as millions see their retirement accounts diminished. In tionism, often associated with the massive bank bailouts.
light of these differences, it is difficult to ascertain what one Financial market integration has meant that developed country
might mean by comparable “efforts.” banks play an important role, often a dominant role, in the
There may be disagreements too about whether all coun- financial markets of many developing countries. But as the crisis
tries should make comparable efforts (however that might be has heightened, some of these international banks have focused
measured). Should a country already heavily burdened by debt what limited lending they are willing to do on their home coun-
have to make a comparable effort as one with no inherited try, with obvious adverse effects on the developing countries.
debt? Should richer countries have a greater obligation? These problems are exacerbated when the government gives the
Should a small open economy have a greater obligation than a bank money in the expectation of an increase in lending at home.
large one? One might argue that the United States, with the While there has been much discussion of the consequences of
dollar as the principal reserve currency, can borrow more eas- financial market protectionism, little has been done.
ily, has a higher income and lower debt burden than many
European countries, and should therefore play a proportion- Coordination is essential for regulation
ately larger role in the global stimulus.
It could also be argued that the U.S. should take more in which coordination is
R E G U L AT I O N I S T H E S E C O N D A R E A
responsibility both in stimulus and assistance to developing absolutely essential, and for many of the same reasons. The
countries, because of the central role that its mistaken poli- actions of one country affect another. This global crisis has
cies played in generating the crisis. Yet, so far, the U.S. has very much a “made in USA” label: the U.S. exported its dereg-
lagged behind others in offering assistance. ulatory philosophy and then, when all guards were down, it
By the same token, agreeing on what is meant by protec- exported its toxic mortgages. To be sure, the U.S. economic
tionism may not be easy. There are some obvious examples, downturn would have been far worse had it not done so, but
such as the U.S.’s Buy America policy, mentioned earlier, and the crisis reminds us that globalization means that both good
tariffs; but subsidies and guarantees are just as distortionary as things as well as bad things can cross borders more easily. If
tariffs. They are even more unfair, since only rich countries we are to have globally integrated financial markets, there has
can afford them. Moreover, symmetric policies can
have asymmetric effects: a government guarantee in a
developing country is less credible than in the U.S.
And if the government charges a premium for the
guarantee, how can we know whether it is really at a
subsidized price? The U.S. and European bailouts
and bank guarantees have totally distorted the level
playing field—if there ever was one. Even firms that
have not received benefits can undertake riskier
investments, knowing that if they have large enough
losses they may be bailed out. Commitments that
governments will not engage in such bailouts in the
future have little credibility.

Hidden protectionism
agreements
M O R E OV E R , I N T E R N AT I O N A L T R A D E
contain “legal” forms of protectionism. Should all of
these be acceptable under the rules of the game, or
should some of them be viewed as abusive? For
instance, as tariffs have come down, nontariff barri-
ers have increased. The procedures used to deter-
mine dumping duties are not based on sound eco- Protestors in satanic costumes at the G-20 Meltdown Protests at the Bank of
England, London.
nomic principles and put developing countries in a

D E C E M B E R 2 0 0 9 41
to be some confidence that foreign institutions and financial markets. The systemic consequences of failing to do so are
products imported from abroad will not induce economic already too evident. Until confidence can be restored, there
devastation. This can only be the case if there is coordination will have to be reliance on host country regulation. Financial
in regulatory policy. But not just any kind of coordination will products and dealings originating from under-regulated
do. The world had been moving to a common “deregulatory” countries and even from countries with a problematic history
framework, and this framework bears considerable responsi- (such as the U.S.) which “promise” to be do better in the
bility for the current crisis. future, will have to be carefully supervised.
In the absence of such coordination, there was a risk of a There will be less financial market integration, but this is
race to the bottom. Financial firms told their governments that part of the price we will have to pay for the failure to adequate-
if they didn’t deregulate, they would move elsewhere. ly coordinate regulatory policy in the past.
Governments, worried about the loss of jobs and revenues, While coordination is absolutely essential, success in
gave in. Today, however, many governments are more aware of achieving it may prove difficult. As I wrote in Making
the costs of this race to the bottom. Iceland provides a telling Globalization Work, economic globalization—the integration
example: its citizens, many of whom never benefited from of the economies of the world especially through finance and
their banks’ irresponsible behavior, will be paying the price for trade—has outpaced political globalization. If we are to suc-
decades to come. Some argue that the high cost of America’s ceed in achieving globalization that leads to a more stable and
bank bail-out—with bondholders and in some cases even more prosperous world for all, we will have to manage it bet-
shareholders being protected, as the Obama Administration ter than we have in the past; and that means more and better
has created institutions that are too big to be financially coordination.
resolved—is the international ramification of a collapse. But
ordinary American citizens are paying a high price for a global Joseph E. Stiglitz is University Professor at Columbia University.
financial system from which they benefited little. He served as Chief Economist and Senior Vice President of the World
Moreover, governments with well-regulated financial Bank from 1997-2000. He was awarded the Nobel Memorial Prize in
institutions should rightly be wary of allowing these institu- Economics in 2001. He He was also chair of the Commission of
tions to deal in an unfettered way with institutions from coun- Experts of the President of the UN General Assembly on Reforms of
tries with inadequate regulation. They are aware that the International Monetary and Financial System.
American banks sold toxic products, not just the toxic mort-
gages, but also dangerous derivatives.
There is an obvious need for coordination in the regulato-
ry structures so that one country can trust the products pro-
duced in another. This will require not only good regulations
but effective enforcement. In the United States and else-
where, there were regulators who didn’t believe in regulation
and, not surprisingly, didn’t do a very good job in regulating.
There needs to be a restoration of confidence in the entire
regulatory system. It will be difficult to do this overnight.
Especially discouraging are the half-hearted attempts at
regulatory reform, for example in the United States. Yes, there
is a move in the right direction, but is it enough? Little is being
done about many of the underlying problems: banks that are
not only too big to fail, but too big to be financially resolved;
incentive structures that encourage short-sighted behavior
and excessive risk-taking; insufficiently transparent and over-
ly complex over-the-counter derivatives sold by banks with
depository protection; inadequate restrictions on risk taking
by depository institutions; too little being done about conflicts
of interest; accounting standards that may even be getting
worse. Indeed, some of the big banks are engaging in enhanced
risk taking—to make up for the losses of the last couple of years.

Conclusion
THE RISK IS CLEAR: if countries cannot rely on foreign
financial institutions and the products they produce, there
will be a marked weakening of global financial market inte-
gration. Governments have a responsibility to protect their
citizens and their economies from the dangers of financial

42 Development Outreach WORLD BANK INSTITUTE


SPECIAL REPORT

Lenders of Last Resort


and Global Liquidity
Rethinking the system
BY MAURICE OBSTFELD financial instability and are therefore a key component of the
central bank’s policy arsenal. The global scope of the current
balance sheet expanded
T H E F E D E R A L R E S E RV E SYS T E M ’ S financial crisis, however, is forcing a reassessment of the LLR
sharply after the Lehman Brothers collapse of September function and the nature of liquidity shortages in a world of
2008. At the end of August 2008 the United States monetary multiple currencies and largely unfettered cross-border
base stood at $843 billion; by the end of May 2009, the base financial flows.
was $1.770 trillion, more than double the earlier figure. A dramatic indicator of the international scope of the crisis
Other central banks have also increased their balance has been the direct extension of large-scale central bank cred-
sheets, albeit not as dramatically. In domestic financial crises, its to foreign central banks—in particular the Federal Reserve’s
lender-of-last-resort (LLR) interventions can help contain expansion of reciprocal swap lines with industrial-country and

Major newspapers heads after Lehman Brothers filed for bankruptcy and Merrill Lynch was sold to Bank of America on the same day.

D E C E M B E R 2 0 0 9 43
emerging-market central banks. In several cases, limits on the interest rates helped to inflate commodity prices, notably the
sizes of these swaps have been removed, allowing non-U.S. price of oil, helping to fuel the increased Russian, Middle
central banks such as the European Central Bank (ECB) and Eastern, and Latin American external surpluses. This interna-
Swiss National Bank to supply financial markets with poten- tional income transfer that may have put further downward
tially unlimited quantities of dollars.1 Although limited Fed pressure on world interest rates, as during the oil boom of the
swap lines were created under the Bretton Woods system in 1970s, which was prologue to the 1980s debt crisis.
1962 and have existed in some form ever since, the recent Low interest rates and booming commodity prices during
expansion of such facilities represents an unprecedented del- the mid-2000s contributed to a prolonged period of tranquil-
egation of the Fed’s powers to foreign policymakers. That ity for emerging markets. Many began to question the ongoing
development is a tacit admission that older notions of the LLR need for the International Monetary Fund (IMF), as that
role, while suitable for an insular world characterized primari- institution shrank under pressure of reduced lending rev-
ly by national finance, are ill suited to a twenty-first century enues. As is now evident, however, emerging markets were
environment of financial globalization. benefiting from an exceptionally favorable but temporary
constellation of external forces.
The central banks’ interventions Finally, low interest rates had a dramatic effect on real
estate prices. Low interest rates and the availability of cheap
W H AT M OT I VAT E D T hese central-bank policy actions? The foreign finance, interacting with distortions in markets for
fundamental trigger was a by-product of the process of global housing finance, fueled dramatic house-price appreciation.
deleveraging set off by the Lehman collapse: a shortage of hard- Higher levels of housing equity eased households’ liquidity
currency, especially dollar, liquidity in world financial markets. constraints and supported high consumption levels and
In turn, the dollar liquidity shortage—which has temporarily reduced levels of private saving out of GDP. While similar
slowed the dollar’s long-run depreciation trend—has its roots effects were seen in many other countries—there is a high sta-
in the international financial flows of the years 2003-07. tistical correlation over the 2000s between real estate appre-
Over the 2000s the United States has run a series of histor- ciation and current account deficits—the United States was the
ically large annual current-account deficits. Eastern Europe epicenter of the financial innovations and practices that
also ran large deficits (relative to GDP), as did several individ- sparked the collapse of 2007-08. This fact led to one of the
ual countries within the European Union, including Greece, ironies of the financial crisis: although several analysts had
Ireland, Portugal, and Spain. These deficits were naturally worried up until 2007 that a U.S. housing collapse might sig-
offset by surpluses elsewhere. Within the industrialized nal a compression of the U.S. external deficit and a collapse in
world, countries such as Japan, Germany, Norway, Sweden, the dollar’s value, the housing collapse, at several stages of the
and Switzerland had large surpluses. Within the set of emerg- crisis, actually led to an apparent shortage of dollars.
ing and developing economies, Asia (excluding Japan), the
Middle East, and the Commonwealth of Independent States The European banks and the dollar
ran sizable surpluses while the Western Hemisphere and
African countries did the same on a smaller scale. ONE REASON FOR THE DOLLAR SHORTAGE starting in
While the causes of these imbalances remain a topic of August 2007 was European banks’ high propensity to invest in
active debate, a number of factors stand out. First, the 1997-98 U.S. dollar assets over 2003-07. Initially around $4 trillion in
Asian crisis clearly was followed by an enduring rise in saving- 2003, European banks’ U.S. dollar assets exceeded $8 trillion
investment balances throughout Asia. In some cases, countries by the first quarter of 2007.2 These banks drew short-term
maintained undervalued exchange rates and compressed dollar funding from the interbank market, and also borrowed
demand to promote export-led growth, in the process accumu- nondollar currencies, swapping these funds into dollars on a
lating large stocks of liquid international reserves, mainly dol- short-term basis, to hedge their long dollar positions.3
lars. One clear motive for reserve accumulation was to self- European banking flows into the U.S. were invested heavi-
insure against liquidity shocks rather than depend on the ly in AAA-rated tranches of securitized assets such as sub-
International Monetary Fund as in past crises. Whatever the prime mortgage pools. The high credit ratings of these struc-
causes—the details differ from country to country—a conse- tured products reflected low expected loss, but ignored portfo-
quence of the increase in desired Asian surpluses was a down- lio risk. In fact, the assets carried significant systematic risk
ward pressure on world interest rates and price levels. due to the likelihood of default precisely when all global asset
But it takes two to tango, and both policy as well as institu- markets would be melting down simultaneously. In addition
tional responses in the industrialized world led to a significant to expected return, these structured products carried an
magnification of the volume of world financial flows. The col- important collateral benefit. By holding them instead of assets
lapse of the dot-com bubble, followed by the 9/11 attacks, led subject to idiosyncratic risk and therefore with lower credit
the Federal Reserve and other central banks to lower interest ratings, banks were able to reduce required regulatory capital
rates. Japan remained in the grip of a seemingly intractable ratios. The result was regulatory arbitrage on a large scale.4
deflation. Discerning a similar potential in the U.S. economy, European banks’ need to fund their U.S. purchases through
the Fed held interest rates quite low until embarking on a grad- short-term dollar borrowing made them susceptible to any
ual tightening cycle in mid-2004. Low industrial-country reduced availability of dollar liquidity. This is what happened in

44 Development Outreach WORLD BANK INSTITUTE


August 2007, and even more dramatically in September 2008. monopoly on money creation) to a selected set of foreign central
Interbank markets seized up, foreign exchange swap markets banks. These arrangements have been ad hoc and explicitly tem-
became illiquid, and U.S. money-market funds faced a run in porary. Most likely, more limited swap facilities will be main-
the fall of 2008 and retracted their foreign dollar lending.5 tained into the future—as in the past—with the option (at the cur-
Central-bank withdrawals during 2007-08 of dollar reserves rency issuer’s discretion) for greater flexibility in times of crisis.
that had been placed in commercial banks didn’t help.6 On top To the extent that nondollar currencies such as the euro and
of funding illiquidity, banks faced market illiquidity as they (eventually) the renminbi could be in short supply during future
attempted to sell their toxic assets. financial breakdowns, there is a strong case for crisis-elastic
The ECB initially had the tools to provide euro liquidity, but sources of those currencies as well. Even the central banks and
not dollar liquidity. European institutions needing dollars, but treasuries of industrial countries may choose to accumulate larg-
lacking access to the Fed through U.S. affiliates, sold euros for er stocks of liquid foreign-currency reserves, easily available for
dollars on the foreign exchange market. The result of these lending during episodes of turbulence.
aggregate sales was upward pressure on the dollar and a rela-
tively weaker euro. As a response, the central bank swap The systematic approach
arrangements for dollars were set up starting in December
2007. of the crisis, however, is the need
O N E I M P O RTA N T L E S S O N
Since that date the Fed has acted as a global LLR for dollars. It to take a systemic view of measures aimed at financial stability.
has done so by subcontracting its LLR function (along with its As numerous observers of the recent crisis have noted, meas-
ures that enhance the stability of a single institution, viewed
in isolation, could be inimical to the stability of the financial
system as a whole. There is a fallacy of composition, for exam-
ple, in asking financial institutions to augment their capital-
asset ratios in a crisis: a fire-sale externality could destabilize
all institutions as each one scrambles to unload assets in illiq-
uid markets.
A similar point applies to national efforts to self-insure
through increased holdings of liquid international reserves:
when a country draws down its dollar reserves held abroad, that
action might well have price or liquidity effects that increase
financial instability abroad. This is a familiar theme from time-
honored textbook examples of coordination failures in reserve
management ranging from the scramble for gold in the interwar
years to the Triffin problem. But the basic insight remains rele-
vant, in a different form, today. The implication is that the
world economy needs lenders of last resort capable of creating
and providing true outside liquidity.
The enhanced swap lines provided by the Fed starting in
2007 were indeed a source of outside dollar liquidity. Going
forward, however, it seems impractical and politically prob-
lematic for national central banks to subcontract emergency
lending over the long term on what is essentially a bilateral
basis. A more efficient solution would centralize last-resort
lending of foreign currencies in an institution whose opera-
tions would ideally approximate the outcome of a cooperative
equilibrium among policymakers.
The practical obstacles to designing and establishing such an
institution, ranging from the need for broad international
political support to the limitation of moral hazard, are daunting.
To start, an international LLR, if not endowed with suprana-
tional regulatory powers itself, would at least need ready access
to accurate, up-to-date, and internationally consistent data on
the health of member countries’ financial sectors. It is inadvis-
able for any LLR to delegate its functions blindly. The current
difficulty of agreeing an enhanced regulatory framework even
An angry investor in Singapore, who lost his savings, urges the among European Union countries offers a sobering counter-
central bank to help him recover his money. point on the possibilities for even broader international regula-
tory cooperation. Nonetheless, the need for progress is urgent.

D E C E M B E R 2 0 0 9 45
Journal of Economic Perspectives 13 (Fall 1999): 85-104.
At the moment, the International Monetary Fund—itself
McGuire, Patrick and Goetz von Peter. “The US Dollar Shortage in Global
the improbable product of a visionary postwar exercise in
Banking.” BIS Quarterly Review (March 2009): 47-63.
international political cooperation—is the closest thing we
have to an international LLR.7 The IMF has the capacity not Obstfeld, Maurice, Jay C. Shambaugh, and Alan M. Taylor. “Financial
Instability, Reserves, and Central Bank Swap Lines in the Panic of 2008.”
only to create outside liquidity, but also to channel inside liq-
American Economic Review Papers and Proceedings 99 (May 2009):
uidity agents with relatively ample liquidity to markets in 480-486.
which liquidity is scarce. IMF quotas represent outside liq-
uidity. When Pakistan borrows dollars from the IMF, for Endnotes
example, the dollars come from an IMF account at the Federal 1 For description and further references, see Obstfeld, Shambaugh,
Reserve. If the IMF borrows dollars from the government of and Taylor (2009).
Japan’s reserves, however, liquidity may simply be reallocat- 2 See Baba, McCauley, and Ramaswamy (2009), p. 66.
ed, not created. In a crisis situation, even such liquidity real- 3 See McGuire and von Peter (2009).
location by the Fund can help stave off economic disaster for 4 See Acharya and Schnabl (2009).
the borrower. A major structural advantage of the IMF is that
5 See Baba, Packer, and Nagano (2008) and Baba, McCauley, and
it can create liquidity in alternative national monies, thereby
Ramaswamy (2009).
meeting potential shortages of nondollar currencies.
6 See McGuire and von Peter (2009), p. 57.
In recent decades the IMF has intervened almost exclu-
sively with emerging and developing countries. It seems like- 7 Ten years ago Fischer (1999) made this case in detail. It is impossible to

ly that for some time, the IMF will continue to focus on the do justice to the arguments pro and con in the space available here.
group of less prosperous countries, with the LLR needs of
richer countries met through ad hoc bilateral or even multi-
lateral arrangements of the type seen recently. It is not incon-
ceivable, however, that the IMF’s role could someday extend,
as in the past, to the richer countries. Indeed, this develop-
ment seems natural in a world where the current emerging
economies are evolving toward eventual economic and politi-
cal parity with the current group of industrial economies.
Enhancing the IMF’s lending capacity has rightfully been
high on the agenda of policymakers seeking to address the
global financial crisis. Equally important, however, have been
moves to reform the political governance of the IMF in a way
that recognizes the increasing importance of the developing
countries in the world economy. Much remains to be done,
especially in the sphere of international regulatory reform,
and the difficulties cannot be overstated. Nonetheless, the
recent global financial crisis has underlined both the impor-
tance and the nontraditional nature of the lender-of-last-
resort function in a financially globalized world characterized
by multiple national currencies. As the twenty-first century
unfolds, the IMF seems certain to be an increasingly impor-
tant player in performing that function.

Maurice Obstfeld is Professor of Economics at the University of


California, Berkeley.

References

Acharya, Viral V. and Phillipp Schnabl. “How Banks Played the Leverage
Game.” In Viral V. Acharya and Matthew Richardson, editors, Restoring
Financial Stability: How to Repair a Failed System. New York: John Wiley &
Sons, 2009.

Baba, Naohiko, Robert N. McCauley, and Srichander Ramaswamy. “US Dollar


Money Market Funds and Non-US Banks.” BIS Quarterly Review (March
2009): 65-81.

Baba, Naohiko, Frank Packer, and Teppei Nagano. “The Spillover of Money
Market Turbulence to FX Swap and Cross-Currency Swap Markets.” BIS
Quarterly Review (March 2008): 73-86.

Fischer, Stanley. “On the Need for an International Lender of Last Resort.”

46 Development Outreach WORLD BANK INSTITUTE


SPECIAL REPORT

The Dollar Dilemma


BY BARRY EICHENGREEN Why the crisis prompted this flight toward the dollar rather
than away from it is clear. The U.S. treasury market has unri-
N OT A F E W O B S E RV E R S H AV E A S S E RT E D that the dollar’s valed liquidity which is a key attraction for central banks.
prospects as a reserve currency have been dimmed by the cri- Reserve instruments not readily convertible into cash are not
sis of 2007-2009. The crisis has diminished the attractive- easily deployed in market operations so it matters critically to
ness of the United States as a supplier of high-quality finan- reserve managers that the market in US treasuries is the most
cial assets, but at the same time has ensured that the U.S. will liquid in the world. This makes it difficult for other currencies
be issuing vast quantities of public debt for the foreseeable to compete.
future. Together these trends in supply and demand imply a
weaker dollar. The resulting capital losses on central banks’ The rise of the euro
outstanding dollar reserves will in due course cause them to
consider alternatives. are not especially
T H E A LT E R N AT I V E S T O T H E D O L L A R
There is only one problem with this argument: there has attractive. The pound sterling and Swiss franc each account
been no actual diminution of the dollar’s international role. for less than 2 percent of global reserves, reflecting the small
For evidence we need look only to the foreign exchange mar- size of their issuing economies. The yen accounts for barely 3
ket, where the dollar in fact became stronger following the percent, reflecting Japan’s past policies of discouraging the
outbreak of the crisis, as domestic and foreign investors fled currency’s internationalization and more recently, the coun-
to the safety of U.S. treasuries. try’s “lost decade” and extended period of zero interest rates.

And the winner is...

D E C E M B E R 2 0 0 9 47
The only serious alternative is the euro. The euro area pos- bank governor made a splash by arguing that the IMF’s Special
sesses the requisite scale, and also has a large government Drawing Rights (SDRs) should replace the dollar as the
debt market. But its various government bonds differ in their world’s reserve currency.
risk, returns, and liquidity. German government bonds have a The obstacles to making this happen are formidable.
reputation for stability, but the market for these bonds lacks Reserves, as noted above, are only attractive if they can be
liquidity since they tend to be held to maturity by institution- used. Making the SDR attractive would thus require develop-
al investors. Italian government bonds are the most important ing markets on which SDR claims can be bought and sold. It
euro area debt securities in value, but are not attractive as would be necessary to build a market on which governments
reserve assets because of the country’s economic problems. could issue SDR bonds at a competitive cost. Banks would have
Nevertheless, as neighboring countries forge deeper links to find it attractive to take SDR deposits and make SDR loans.
with the EU, they are likely to hold more euros. For example, It would be necessary to restructure foreign exchange markets
recognizing the growing importance of European trade and so that traders went through the SDR.
finance, Russia recently increased the weight of the euro in the Making this happen would require significant investments
basket of currencies used to guide its exchange rate policy. As over an extended period. To start with, if China were serious
the euro becomes more important to Russia as a reference cur- about elevating the SDR to reserve-currency status, it should
rency, its central bank will want to hold a larger share of its then take steps to create a liquid market in SDR claims. For
reserves in euro-denominated securities. In its 2008 annual example, it could issue SDR-denominated bonds. This would
report the Central Bank of the Russian Federation confirmed be a much more meaningful step than buying SDR bonds from
that it had reduced the share of dollars in its reserves from 47 the IMF, as it has indicated it will do.
to 41.5 percent between the beginning of 2008 and the begin- Then there is the question of who would be on the demand
ning of 2009 and raised the share of the euro from 42.4 to 47.5 side of the market. Government bonds are held by pension
percent. In June it indicated that it intended to reduce still fur- funds and insurance companies since the maturity of the
ther the share of dollar-denominated assets in its portfolio. bonds matches the maturity of these buyers’ liabilities. If the
This case illustrates that there is likely to be some further dollar depreciated against the euro, a European insurance
reallocation of reserves from dollars to euros by the countries company holding SDR-denominated bonds and euro-
on Europe’s periphery. The euro will become an increasingly denominated liabilities would find itself in deep trouble.
important reserve currency in that part of the world. Whether Potential investors would need markets on which to hedge
it can surpass the dollar globally, given the greenback’s head SDR currency risk—markets that can only be created at a cost.
start and the euro area’s own unfavorable demographics, is Finally, for the SDR to become an attractive form of
another matter. reserves, the IMF would have to be able to issue additional
SDRs in periods of shortage, much as the U.S. Federal Reserve
The China dollar paradox provided dollar swaps to ensure adequate dollar liquidity in
the second half of 2008. In other words, for the SDR to
R U S S I A ’ S R E S E RV E D I V E R S I F I C AT I O N is one thing, but become a true international currency, the IMF would have to
reserve diversification by China is another matter. Informed become more like a global central bank. Again, this is unlike-
guesses put China’s official dollar assets at roughly eight times ly to happen overnight.
Russia’s as of May 2009. Thus reserve diversification by China
would be a very big deal. An international Chinese currency?
It is not surprising that the issue has become a flashpoint
domestically since China’s foreign currency reserves amount for discount-
P E R H A P S T H E M O S T F U N DA M E N TA L R E A S O N
to $2,000 per Chinese resident. That said, Chinese officials are ing the SDR proposal is that China has a preferred alternative:
aware that they are trapped. The prices of treasuries would tank establishing the renminbi as an international currency. If the
if the People’s Bank of China sold them in sufficient quantities renminbi were to be widely used in international transactions,
to significantly alter the currency composition of its reserve China itself would no longer need to hold foreign currencies to
portfolio. To the extent that dollars still comprised a significant smooth its balance of payments. It could simply print more or
portion of its reserves, the People’s Bank would incur costly less of its own currency, as necessary, like the United States.
losses. One is reminded of Keynes’s aphorism: “When you owe But for now the renminbi remains unconvertible.
your bank manager a thousand pounds you are at his mercy. Foreigners can only use it to purchase goods from China. It is
When you owe him a million pounds, he is at your mercy.” used in cross-border trade only with China’s immediate
The sensible strategy in such circumstances would be to neighbors. Brazil and China recently announced the intention
make a series of small adjustments in portfolio proportions, to explore ways of using their own currencies in their bilater-
which is essentially what China’s reserve managers are doing. al trade. But this agreement is mainly useful for advertizing
This is yet another reason why the declining dominance of the Chinese-Brazilian trade. A Brazilian firm will take renminbi
dollar in reserve portfolios is more likely to be gradual than in payment for its exports only to the extent that it imports
sudden. from China—not your typical case.
Finding itself in this bind, China has, not unreasonably, Similarly, China’s recently concluded swap agreements
begun exploring other options. In March 2009 its central with Argentina, Belarus, Hong Kong, Indonesia, South Korea

48 Development Outreach WORLD BANK INSTITUTE


and Malaysia are mainly a way of signaling its global ambi-
tions. These countries cannot use renminbi to intervene in
T r a de O p e n n e s s
continued from page 38
foreign exchange markets. They cannot use it to import mer-
chandise from third countries or to pay foreign banks and
bondholders.
In time, China can strengthen the international role of the When countries try to protect their own industries, any
renminbi by developing liquid financial markets and liberal- short-run gains in a given industry are generally offset by
izing foreigners’ access to these markets. Over time, it can also losses in others; and industries using imports of the protect-
make its currency convertible for financial as well as mer- ed goods either face higher costs of production or must devel-
chandise transactions. The question is: how much time? op higher-cost domestic supply sources). The global economy
Reconciling financial stability with capital account convert- is worse off as a result of reduced productivity and output.
ibility has formidable prerequisites. Markets must first This happened in the l930s, when the Smoot-Hawley tariff
become more transparent. Banks must be commercialized. passed by the American Congress erected high tariff barriers
Supervision and regulation must be strengthened, and the in the United States. Other countries retaliated and interna-
exchange rate must be made more flexible to accommodate a tional trade shrank by an even greater proportion than world
larger volume of capital flows. GDP during the Great Depression. Economic historians
China, in other words, must first move away from a growth blame the high tariff barriers that were erected in the U.S. and
model in which bank lending and a pegged currency have been elsewhere as being a major contributing factor to the length
two of the pillars of its development policy. This is easier said and severity of the Great Depression. Because of the increased
than done. Witness how the Chinese authorities’ reaction to integration of the world economy, the costs of protection
the crisis was in fact to move in the other direction, relying today would be even greater than they were in the l930s.
more on directed lending to boost investment and hardening Politically it is relatively easy to erect protective barriers,
the renminbi’s peg to the dollar to sustain exports. but difficult to remove them. World output will be lower and
The year 2020 is the authorities’ target date for transforming the recession somewhat deeper if countries become more
Shanghai into an international financial center and thus, de protectionist. But the real question is how soon and how rapid
facto, for the capital account convertibility that is a prerequisite the upturn and the return to global economic growth will be.
for a reserve-currency role for the renminbi. But even if China And it is here that the dangers of protection are worst: if
grows at a 7 percent annual rate for the next decade (slower than exporters everywhere are confronted with trade barriers, they
in the past, reflecting less favorable demographics, but still will not invest in additional capacity to the same extent as they
exceptional), its GDP in 2020 will still be considerably smaller would in a more open global system, and resources will
than that of the U.S. at market exchange rates. The renminbi remain stuck in industries (such as autos and steel) where
will still have a smaller domestic platform than the dollar. In excess capacity exists and there is little incentive for further
turn this means that its market liquidity will not be comparable. investment.
Under these circumstances, the attractiveness of holding In such a post-recession world, poor countries’ prospects
reserves in renminbi will be limited. It will be most attractive for growth through an outer-oriented trade strategy would
to countries conducting the majority of their trade with China still be better than if they were to adopt protectionist barriers,
and doing their international financial business in Shanghai. but less favorable than if the world returned to an open, liber-
This suggests that the market for renminbi reserves will, at al, multilateral trading system.
least initially, be concentrated in Asia, much as the market for Policy makers’ concerns about the short run and the temp-
euro reserves is concentrated in Europe. tation of protectionism are understandable. But protection-
ism will invite retaliation and, once started, will increase
The resilient dollar pressures and temptations for even more protectionism.
Policy makers can reduce the threat by reviving and com-
I C O N C L U D E , BY P R O C E S S O F E L I M I N AT I O N , that the dollar pleting the Doha Round of multilateral trade negotiations
will remain the principal form of international reserves for the under the WTO. Such an action would strengthen the open mul-
foreseeable future. It will not be as dominant as in the past, for tilateral trading system, serve as a barrier against further pro-
the same reasons that the United States will not be as dominant tection (especially by reassuring those who argue for protection
economically as in the past. In the short run the euro will con- because “others will do it”), and provide producers with appro-
tinue to gain market share, especially in Greater Europe. In the priate signals that it is safe to invest in export industries
longer run there will be a role for the renminbi, especially in because they will still be operating on level playing fields.
Greater Asia. But as far into the future as I personally am able
to see, the dollar will remain first among equals. Anne O. Krueger is Professor of International Economics, SAIS, Johns
Hopkins University and Senior Fellow and Professor Emeritus,
Barry Eichengreen is George C. Pardee and Helen N. Pardee Professor Stanford University.
of Economics and Political Science at the University of California,
Berkeley.

D E C E M B E R 2 0 0 9 49
SPECIAL REPORT

Government Actions and Interventions


More harm than good?

BY JOHN B. TAYLOR

I N T H E S U M M E R O F 2 007 at the
annual Jackson Hole international
conference for central bankers
and financial officials I provided
evidence that excessively low
interest rates set by the United
States Federal Reserve in 2003-
2005 was a primary cause of the
housing boom and subsequent
housing bust which eventually led
to the financial crisis. The article
by Carmen Reinhart in this issue
delves deeper into this argument.
Here I review evidence that other
government actions taken in 2007
and 2008 unfortunately prolonged
and worsened the crisis.

Prolonging the crisis


THE FINANCIAL CRISIS became
acute on August 9 and 10, 2007
when money market interest rates
rose dramatically. Figure 1 illus-
trates this, using the spread
between the three-month Libor
and the three-month Overnight
Index Swap (OIS). The OIS is a
measure of what the markets
expect the federal funds rate to be
compared to the three month
Libor over the three-month peri-
od. Subtracting OIS from Libor
effectively controls for expecta-
tions effects which are a factor in
all term loans, including the
three-month Libor. The differ-
ence between Libor and OIS is thus
due to factors other than interest
rate expectations, such as risk and
liquidity effects.
Community activists demonstrate at the Federal Bankruptcy Courthouse in Santa Barbara, California.

50 Development Outreach WORLD BANK INSTITUTE


FIGURE 1: THE LIBOR–OIS SPREAD DURING THE FIRST YEAR FIGURE 2: COUNTERPARTY RISK EXPLAINED MOST OF THE
OF THE CRISIS VARIATION

Source: “A Black Swan in the Money Market,” (with John C.


Williams), American Economic Journal: Macroeconomics, Vol.1, Source: Author’s calculations based on research [3] in the references.
No.1, January 2009, pp. 58-83.

FIGURE 3: THE TERM AUCTION FACILITY HAD LITTLE IMPACT ON To assess the issue empirically, one can look at the differ-
THE SPREAD ence between interest rates on unsecured and secured inter-
bank loans of the same maturity. Examples of secured loans are
government-backed Repos between banks. By subtracting the
interest rate on Repos from Libor, you get a measure of risk.
Figure 2 shows the high correlation between the unse-
cured-secured spread and the Libor-OIS spread. There
seemed to be little role for liquidity. These results suggest,
therefore, that the market turmoil in the interbank market
was not a liquidity problem of the kind that could be alleviat-
ed simply by central bank liquidity tools. Rather it was inher-
ently a counterparty risk issue.
But this was not the diagnosis that drove economic policy
during this period. Rather the early interventions focused on
liquidity. As evidence I provide three examples of interventions
that prolonged the crisis either because they did not address the
problem or because they had unintended consequences.
Source: “A Black Swan in the Money Market,” (with John C.
Williams), American Economic Journal: Macroeconomics, Vol.1,
No.1, January 2009, pp. 58-83.
Term Auction Facility
Looking at the lower left of Figure 1 you see that on August TO M A K E I T E A S I E R F O R B A N K S to borrow from the Fed, the
9th and 10th of 2007 this spread jumped to unusually high lev- Term Auction Facility (TAF) was introduced in December
els. Bringing this spread down was a major objective of mon- 2007. Similar facilities were set up at other central banks. The
etary policy from the start of the crisis. main aim of the TAF was to reduce the spreads in the money
markets and thereby increase the flow of credit and lower
interest rates. Figure 3 shows the amount of funds taken up
Diagnosing the problem: Liquidity or (on the right scale) along with Libor and OIS spread (on the
counterparty risk? left scale). Clearly, the TAF did not make much difference.

D I AG N O S I N G T H E R E A S O N for the increased spreads was


Temporary cash infusions through the
essential to determining the appropriate policy response. If it
was a liquidity problem then providing more liquidity by 2008 Fiscal Stimulus
making discount window borrowing easier or opening new
windows or facilities would be appropriate. But if the issue was A N O T H E R E A R L Y P O L I C Y R E S P O N S E was the Economic
counterparty risk then a direct focus on the quality and trans- Stimulus Act of 2008 passed in February, which sent cash
parency of the bank’s balance sheets would be appropriate. totaling over $100 billion to individuals and families in the

D E C E M B E R 2 0 0 9 51
FIGURE 4: THE REBATES INCREASED INCOME, BUT NOT FIGURE 5: THE SHARP CUT IN INTEREST RATES WAS
CONSUMPTION. (MONTHLY DATA, SEASONALLY ADJUSTED, ANNUAL RATES). ACCOMPANIED BY A RAPID INCREASE IN OIL PRICES THROUGH
THE FIRST YEAR OF THE CRISIS. (LAST OBSERVATION IS JULY 2008)

Source: Author’s calculations based on research [4] in the references.


Source: Getting Off Track: How Government Actions and
Interventions Caused, Prolonged, and Worsened the Financial Crisis,
Hoover Institution Press, Stanford, 2009.

United States so they would have more to spend and thus


FIGURE 6: EVIDENCE OF THE CRISIS WORSENING DRAMATICALLY
jump-start consumption and the economy. Most of the checks FOURTEEN MONTHS AFTER IT BEGAN
were sent in May, June, and July. However, people spent little
if anything of the temporary rebate, and consumption was not
jump-started. The evidence is in Figure 4. The top line shows
how personal disposable income jumped at the time of the
rebate. The lower line shows that personal consumption
expenditures did not increase.

The initial sharp cuts in interest rates


through April 2008

A THIRD POLICY RESPONSE was the sharp reduction in the


federal funds rate. The federal funds rate target went from
5.25 percent when the crisis began, to 2 percent in April 2008.
The so-called Taylor rule also called for a reduction in the
Source: Getting Off Track: How Government Actions and
interest rate during this early period, but not as sharp as the Interventions Caused, Prolonged, and Worsened the Financial Crisis,
federal funds rate. The most noticeable effects of the cut in the Hoover Institution Press, Stanford, 2009.

federal funds rate, were the sharp depreciation of the dollar


and the large rise in oil prices. During the first year of the
financial crisis oil prices doubled from about $70 per barrel in The crisis worsens in the panic of the
August 2007 to over $140 in July 2008, before plummeting fall of 2008
back down as expectations of world economic growth declined
sharply. Figure 5 shows the close correlation between the fed- F I G U R E 6 S H OWS how dramatically the financial crisis wors-
eral funds rate and the price of oil during this period using ened in October 2008. Many commentators have argued that
monthly average data. The chart ends before the global slump the reason for the worsening of the crisis was the U.S. govern-
in demand became evident and oil prices fell back. ment’s decision not to intervene to prevent the Lehman
Clearly this bout of high oil prices hit the economy hard as Brothers bankruptcy on the weekend of September 13 and 14.
gasoline prices skyrocketed and automobile sales plummeted The timing of events suggests that the answer is more compli-
in the spring and summer of 2008. When it became clear in the cated than this and, in my view, lies elsewhere.
fall of 2008 that the world economy was turning down sharply, Figure 7 focuses on a few key events from September 1
oil prices then returned to the $60-$70 range. But by this time through mid October. Since then conditions have improved as
the damage caused by the high oil prices had been done. the graph illustrates. But the question here is what led to the
worsened conditions. You can see that the spread moved a bit
on September 15th, which is the Monday after the weekend

52 Development Outreach WORLD BANK INSTITUTE


that conditions were much worse than many had been led to
FIGURE 7: EVENT STUDY OF THE DRAMATIC WORSENING OF THE believe. At a minimum, the rollout of the TARP revealed a great
CRISIS
deal of uncertainty about what the government would do to aid
financial institutions, and under what circumstances, and
thereby added to business and investment decisions at that
time. Such uncertainty would have driven up risk spreads in the
interbank market and elsewhere.
This lack of predictability about Treasury-Fed intervention
policy and recognition of the harm it could do to markets like-
ly increased in the fall of 2008 when the underlying uncertain-
ty was revealed for all to see. What was the rationale for inter-
vening with Bear Stearns, and then not with Lehman, and then
again with AIG? What would guide the operations of the TARP?
Worries about the lack of clarity were raised in many quar-
ters. At a conference held at Stanford in July to address the
new interventions, I argued that the U.S. Treasury and the Fed
urgently needed to develop a new framework for exceptional
Source: Getting Off Track: How Government Actions and access to government support for financial institutions. The
Interventions Caused, Prolonged, and Worsened the Financial Crisis, more policy makers could articulate the rationale and the pro-
Hoover Institution Press, Stanford, 2009.
cedures the better.

Conclusion
decision not to intervene in Lehman Brothers. It then
dropped back down a little on September 16 around the time I N T H I S A RT I C L E I have provided empirical evidence that
of the AIG intervention. While the spread did rise during the government actions and interventions prolonged and wors-
week following the Lehman Brothers decision, it was not far ened the financial crisis. They prolonged it by misdiagnosing
out of line with the events of the previous year. the problems in the bank credit markets and thereby respond-
On Friday of that week the Treasury announced that it ing inappropriately by focusing on liquidity rather than risk.
would propose a large rescue package. The package was put They made it worse by providing support for certain financial
together over the weekend and on Tuesday September 23, institutions and their creditors but not others in an ad hoc way
Federal Reserve Board Chairman Ben Bernanke and Treasury without a clear and understandable framework. While other
Secretary Henry Paulson testified in Congress that the pack- factors were certainly at play, these government actions should
age would be $700 billion. They provided a two and a half page be first on the list of reasons for what went wrong.
draft of the legislation, specifying little oversight and few What are the implications of this analysis? Most important is
restrictions on its use. They were that government fiscal and mon-
questioned intensely and the etary policy interventions, how-
public reaction was quite nega- ever well-intentioned, can make
tive, judging by the large volume things worse if they are based on
of critical mail received by many faulty diagnosis of the problem
members of the United States and do not follow clear pre-
Congress. As shown in Figure 7 it dictable principles. Establishing
was following this testimony that a set of principles to follow will
one really begins to see the crises help prevent such misguided
deepening. actions and interventions.
The main message in Figure 7
is that it is questionable to identi- John B. Taylor is Mary and Robert
fy the decisions of the weekend of Raymond Professor of Economics at
September 13 and 14 as having Stanford University and Bowen H.
increased the severity of the cri- and Janice Arthur McCoy Senior
sis. Not until more than a week Fellow at the Hoover Institution.
later did conditions deteriorate.
Moreover, it is plausible that This essay is drawn from John B. Taylor,
Getting Off Track: How Government
events around September 23
Actions Caused, Prolonged, and
actually drove the market, includ- Worsened the Financial Crisis, Hoover
ing the realization by the public Artist Laura Gilbert's "The Bailout Bill." Gilbert created an Press, Stanford, California, 2009.
that the intervention plan had not edition of 5000 copies to give away.
been fully thought through and

D E C E M B E R 2 0 0 9 53
KNOWLEDGE RESOURCES

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E-LIBRARY is an electronic on international cooperation issues. Euforic is a not for
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including access to the World Bank’s two statistical together to achieve a goal no
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improves people’s lives by private and public sectors: developing world and donor
providing information and governments, private sector philanthropists, the financial
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These include scientific publishing, development projects AITIC is an intergovernmental
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taged countries (LACs, i.e.
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Union by making long-term least-developed countries) to have more effective trade-
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appraise each investment project thoroughly and follow it COOPERATION FOR PEACE
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involved in Europe’s international cooperation; and

54 Development Outreach WORLD BANK INSTITUTE


BOOKSHELF

TOO BIG TO FAIL: The Inside Story THE IDEA OF JUSTICE, by Amartya Sen,
of How Wall Street and Washington Belknap Press of Harvard University Press,
Fought to Save the Financial System— 2009.
and Themselves, by Andrew Ross Sorkin. Social justice: an ideal, forever beyond
Viking Adult, 2009. our grasp; or one of many practical
Andrew Ross Sorkin delivers the first possibilities? At the heart of Sen’s
true behind-the-scenes, moment-by- argument is a respect for reasoned
moment account of how the greatest differences in our understanding of what
financial crisis since the Great a “just society” really is. People of different persuasions
Depression developed into a global tsunami. From inside might each reasonably see a clear and straightforward
the corner office at Lehman Brothers to secret meetings in resolution to questions of justice; and yet, these resolutions
South Korea, and the corridors of Washington, Too Big to would be completely different. In light of this, Sen argues
Fail is the definitive story of the most powerful men and for a comparative perspective on justice that can guide us in
women in finance and politics grappling with success and the choice between alternatives that we inevitably face.
failure, ego and greed, and, ultimately, the fate of the
world’s economy.
THIS TIME IS DIFFERENT:
Eight Centuries of Financial Folly,
GLOBAL DEVELOPMENT FINANCE, by Carmen M.Reinhart and Kenneth S.
The World Bank, 2009. Rogoff. Princeton University Press, 2009.
Global Development Finance—the Throughout history, rich and poor
World Bank's annual report on the countries alike have been lending,
external financing of developing borrowing, crashing, and recovering
countries—provides monitoring and their way through an extraordinary
analysis of development finance, range of financial crises. Each time, the
identifying key emerging trends and experts have claimed that the old rules of valuation no
policy challenges in international longer apply and that the new situation bears little
financial flows that are likely to affect the growth similarity to past disasters —“this time is different.”
prospects of developing countries. Over the past two years, This book proves that premise wrong. Covering sixty-six
the world has seen turmoil in a relatively small segment of countries across five continents, it presents a
the U.S. credit markets morph into a severe global comprehensive look at the varieties of financial crises,
economic and financial crisis. Although aggressive and guides us through eight astonishing centuries of
monetary policy, fiscal stimulus, and guarantee programs government defaults, banking panics, and
to shore up the banking industry have begun to stabilize inflationary spikes.
financial markets and slow the pace of economic
contraction, policy makers face an extended battle to
revive the global economy. MOVING OUT OF POVERTY:
The Promise of Empowerment and
Democracy in India, by Deepa Narayan.
INVESTING WITH CONFIDENCE: Palgrave Macmillan, 2009.
Understanding Political Risk India has experienced accelerating
Management in the 21st Century, edited growth in the last decade, yet why do
by Gero Verheyen, Srilal M. Perera and millions of people remain mired in
Kevin W. Lu. The World Bank, 2009. poverty? This book brings together
Coinciding with the Multilateral the voices of the poor from 300 villages in the Indian
Investment Guarantee Agency's states of Andhra Pradesh, Assam, Uttar Pradesh, and
(MIGA) twentieth anniversary, this West Bengal, during the decade from 1995 to 2005. It
book examines key political risk issues documents the entrepreneurialism of the poor,
including claims and arbitration, perspectives on pricing arguing that responsive local government, when
from the private, public and multilateral providers, as well combined with access to information, market access
as exploring new frontiers in sovereign wealth funds and and collective action, can do much to facilitate poor
Islamic finance. people’s movement out of poverty.

D E C E M B E R 2 0 0 9 55
CALENDAR

NOVEMBER 2009 JANUARY 2010

Nov 30– Seventh WTO Ministerial Conference 27–31 World Economic Forum Annual Meeting
Dec 2 Geneva, Switzerland Davos-Klosters, Switzerland
www.wto.org www.weforum.org

DECEMBER 2009 FEBRUARY 2010

1–3 Routes out of the Crisis: Strategies for Local 18–20 Migration: A World in Motion. A Multinational
Employment Recovery and Skills Development Conference on Migration and Migration Policy
in Asia University of Maastricht, Maastricht,
Malang (Java), Indonesia Netherlands
www.ilo.org www.appam.org/conferences/international/
maastricht2010/index.asp
7–18 United Nations Climate Change Conference
Copenhagen, Denmark MARCH 2010
http:/en.cop15.dk
19–21 2nd Annual Meeting on the Economics of Risky
11–12 Institute for the Study of Labor, IZA Workshop: Behaviors (AMERB)
Unemployment Insurance and Flexicurity Stone Mountain, Georgia, USA
Bonn, Germany www.iza.org
www.iza.org
APRIL 2010
12–13 2009 International Symposium on
Contemporary Labor Economics 10–11 The Third International Forum on the Rights
Xiamen University, Xiamen, China of Persons with Disabilities
www.wise.xmu.edu.cn/Labor2009 Hilton Hawaiian Village, Honolulu. Hawaii
www.pacrim.hawaii.edu

12–13 The 26th Pacific Rim International Conference


on Disabililties
Hawaii Convention Center, Honolulu, Hawaii
www.pacrim.hawaii.edu

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