Ten Commandments for Fiscal Adjustment in Advanced Economies

Posted on June 24, 2010 by iMFdirect

By Olivier Blanchard and Carlo Cottarelli
(Version in
Franais Espaol)
Advanced economies are facing the difficult challenge of implementing fiscal adjustment strategies
without undermining a still fragile economic recovery. Fiscal adjustment is key to high private
investment and long-term growth. It may also be key, at least in some countries, to avoiding disorderly
financial market conditions, which would have a more immediate impact on growth, through effects on
confidence and lending. But too much adjustment could also hamper growth, and this is not a trivial risk.
How should fiscal strategies be designed to make them consistent with both short-term and long-term
growth requirements?
We offer ten commandments to make this possible. Put simply, what advanced countries need is clarity of
intent, an appropriate calibration of fiscal targets, and adequate structural reforms. With a little help from
monetary policy, and from their (emerging market) friends.
Commandment I: You shall have a credible medium-term fiscal plan with a visible anchor (in terms
of either an average pace of adjustment, or of a fiscal target to be achieved within fourfive years).
There is no simple one-size-fits-all rule. Our current macroeconomic projections imply that an average
improvement in the cyclically-adjusted primary balance of some 1 percentage point per year during the next
fourfive years would be consistent with gradually closing the output gap, given current expectations on
private sector demand, and would stabilize the average debt ratio by the middle of this decade. Countries
with higher deficits/debt should do more, others should do less. Such a pace of adjustment must be backedup by fairly specific spending and revenue projections, and supported by structural reforms (see below).
Commandment II: You shall not front-load your fiscal adjustment, unless financing needs require it.
For a few countries, frontloading may be needed to maintain access to markets and finance the deficit at
reasonable ratesbut, in general, a steady pace of adjustment is more important than front-loading, which
could undermine the recovery and be reversed. Nonetheless, a non-trivial first installment is needed:
promises of future action will not be enough.
Current fiscal consolidation plans in advanced G-20 countries imply on average a reduction in the cyclically
adjusted deficit of some 1 percentage point of GDP in 2011, with significant dispersion around this
according to country circumstances. This seems broadly adequate, and consistent with commandment I, at
least based on current projections on the recovery of aggregate demand. This said, while front-loading fiscal
tightening is, in general, inappropriate, front-loading the approval of policy measures (which would become
effective at a later date) will enhance the credibility of the adjustment.
Commandment III: You shall target a long-term decline in the public debt-to-GDP ratio, not just its
stabilization at post-crisis levels.
High public debt tends to raise interest rates, lower potential growth, and impede fiscal flexibility. Since the
early 1970s, public debt in most advanced countries has been the ultimate absorber of negative shocks,
going up in bad times, not coming down in good times. In the G-7 average, gross debt was 82 percent of
GDP in 2007, a level never reached before without a major war. The current fiscal doldrums are due not only
to the crisis, but also to how fiscal policy was mismanaged during the good times. This time, it must be
different: the final goal must be to lower public debt ratios, gradually but steadily.
Commandment IV: You shall focus on fiscal consolidation tools that are conducive to strong
potential growth.
This will require a bias towards (current) spending cuts, as spending ratios are high in advanced countries
and require highly distortionary tax levels. Some cuts should be no brainers: for example, shifting from
universal to targeted social transfers would involve significant savings, while protecting the poor. Containing
public sector wageswhich have risen faster than GDP in several advanced countries in the last decade
will be necessary.
This said, nothing should be ruled out. Countries with low revenue ratios and large adjustment needslike
the United States and Japanwill also have to act on the revenue side. Promising no new taxes, in all
countries and circumstances, is unrealistic.
Commandment V: You shall pass early pension and health care reforms as current trends are
unsustainable.
Increases in pension and health care spending represented over 80 percent of the increase in primary public
spending to GDP ratio observed in the G-7 countries in the last decades. The net present value of future
increases in health care and pension spending is more than ten times larger than the increase in public debt
due to the crisis.
Any fiscal consolidation strategy must involve reforms in both these areas. This includes Europe, where
official projections largely underestimate health care spending trends. Given the magnitude of the spending
increases involved, early action in these areas will be much more conducive to increased credibility than
fiscal front-loading. And will not risk undermining the recovery. Indeed, some measures in this areawhile

politically difficultcould have positive effects on both demand and supply (for example, committing to an
increase in the retirement age over time).
Commandment VI: You shall be fair. To be sustainable over time, the fiscal adjustment should be
equitable.
Equity has various dimensions, including maintaining an adequate social safety net and the provision of
public services that allow a level playing field, regardless of conditions at birth. Fighting tax evasion is also a
critical component to equity. For VAT, a tax that is relatively resilient to fraud, tax evasion averages about 15
percent of revenues in G-20 advanced countries. Evasion for other taxes is likely to be higher.
Commandment VII: You shall implement wide reforms to boost potential growth.
Strong growth has a staggering effect on public debt: a one percentage point increase in potential growth
assuming a tax ratio of 40 percentlowers the debt ratio by 10 percentage points within 5 years and by 30
percentage points within 10 years, if the resulting higher revenues are saved. An acceleration of labor,
product and financial market reforms will thus be critical.
In the current context of weak aggregate demand, reforms that increase investment are more desirable than
reforms that increase saving. While both have positive long-run effects, investment friendly reforms
increase demand and output in the short run, while saving friendly reforms do the opposite. A word of
caution, though: the timing and magnitude of the effects of structural reforms on growth are uncertain: fiscal
adjustment plans relying on faster growth would not be credible.
Commandment VIII: You shall strengthen your fiscal institutions.
Sustaining fiscal adjustment over time requires appropriate fiscal institutions. The current ones allowed a
record public debt accumulation before the crisis. They are insufficient. This requires better fiscal rules,
including in Europe; better budgetary processes, including in the United States, where, at least for
Congress, the budget is essentially a one-year-at-a-time exercise; and better fiscal monitoring, including
through independent fiscal agencies of the type recently created in the United Kingdom.
Commandment IX: You shall properly coordinate monetary and fiscal policy.
If fiscal policy is tightened, interest rates should not be raised as rapidly as in other phases of economic
recovery. Calls for an early monetary policy tightening in advanced economies are misplaced.
Commandment X: You shall coordinate your policies with other countries.
In a number of advanced countries, the reduction in budget deficits must come with a reduction in current
account deficits. Put another way, if the recovery is to be maintained, the initial adverse effects of fiscal
consolidation on internal demand have to be offset by stronger external demand. But this implies that the
opposite happens in the rest of the world.
In a number of emerging market economies, current account surpluses must be reduced, and these
countries must shift from external to internal demand. The recent decisions taken by China are, in this
respect, an important and welcome step. Policy coordination will also be important in some structural areas:
for example, over the medium term, it will be critical to protect fiscal revenues from rising tax competition.
Obey these commandments, and chances are high that you will achieve fiscal consolidation and sustained
growth.

A Marriage Made in Heaven or Hell: Monetary and Financial Stability

Posted on July 20, 2010 by iMFdirect
By Jos Vials
Monetary stability seems almost a given today, even taken for granted. It wasnt always like that. Not
so long ago, high and volatile inflation routinely raised its ugly head and threatened living standards. Some
of us even remember those days! It wasnt pleasant. But since then, an effective antidote has pretty much
wiped out rampant price instability. Over the past three decades, better monetary frameworks have caused
the level and volatility of inflation to fall sharply. These frameworks enshrined price stability as the main
monetary policy objective, and provided independence and constrained discretion in the pursuit of this
objective, often set out through formal inflation targets.
As I said, it worked out well. Or did it? In reality, there was a gaping hole in the system. While monetary
policy frameworks fortified the castle against inflation at the front, they didnt pay much attention to back
door vulnerabilities. Im talking about financial stability.
Quite simply, price stability and financial stability are not always aligned, and are even sometimes at odds
with each other. Financial stability comes under threat when rising credit feeds asset price bubbles, which in
turn feed unsustainable booms in consumption and investment. But the monetary policy frameworks might
not sound the alarm, as consumer prices might be stable while this is happening. This can continue for a
number of years, until the financial bubble bursts and threatens not only the financial system, but the real
economy and price stability too. We saw this clearly in the current crisis.
So how can we align price and financial stability? One answer is to simply add financial stability as a
separate objective for monetary policy. But this marriage of convenience could easily end in divorceit
would cause conflict, and both objectives could be missed, making a serious dent in the central banks
credibility.
There is a better way. This involves linking prudential tools to macrofinancial developmentsthis is an
important part of what we mean by macroprudential policy. Prudential tools should be sharpened to
counter the build-up of financial imbalances at their root. Policy frameworks should make effective use of
these tools. This way, monetary and prudential policies will live in harmony.
While prudential policy comes first in the pursuit of financial stability, monetary policy also supports financial
stability when consistent with price stability. But to do this, policymakers must get a better grasp of how
monetary policy ultimately affects output and inflation and how this is in turn affected by financial
developments, both domestically and globally. Increasing global trade and financial linkages over the past
two decades have complicated things across a variety of dimensions. For a start, in many economies
domestic long-term rates are now determined more by international demand for domestic financial assets,
and central banks ability to move them is more limited. Second, the pressure from foreign-financed
consumption can be released through current account deficits rather than inflation. And third, it was global,
not local, liquidity that mainly lay behind the build-up of financial imbalancesespecially in smaller
countries, differences between local and global rates enticed capital inflows, and this only fueled the fire.
This is all complicated, and needs further analysis. In the meantime, I think we can derive the following
broad conclusions:
Prudential policies must be the first defense against credit-fueled asset booms. This is a powerful
tool, and it doesnt depend on whether the boom is driven by capital inflows or funded domestically.
Monetary policy can help by non-mechanistically leaning against the build-up of financial
imbalances, such as credit booms which finance asset bubbles. Of course, it should not lean too far
everything must stay consistent with price stability.
In general, the response depends on circumstances. Its less about mechanics and more about
judgment, making use of all available information.
By paying closer attention to financial stability in the pursuit of price stability over the medium term,
monetary policy can become more symmetric during the cycle. This means more leaning in good
times and the need for less cleaning in bad times once bubbles explode.
So then, there is still much work to be done in developing a new policy framework to marry monetary and
financial stability. Of course, each policy framework has its own naturemonetary policy aims mainly at
price stability and prudential policies strive after financial stability. But we need a better and more enduring
relationship between the two, and this will be the great challenge going forward.

Emerging Market Countries and the Crisis: How Have They Coped?
Posted on April 19, 2010 by iMFdirect
By Reza Moghadam
How time flies: only a year ago, we were in the throes of the biggest global crisis since the Great
Depression. As the extent of the damage to institutions in financial centers became evidentstarkly
highlighted by the Lehman bankruptcyand the crisis started to affect emerging market economies (EMs), a
timely and coordinated countercyclical response was launched.
This helped stave off the worst of the crisis. The IMF supported the global response by increasing its
resources and overhauling its lending framework to help those facing financing pressures. A recovery is now
taking hold in many parts of the world.
Six months ago, we took a preliminary look at the design and performance of IMF-supported programs in
emerging markets. In a forthcoming paper, we are casting a wider netexamining factors that determined
the extent to which a broader group of EMs were affected by the crisis, the policy measures they have
taken, factors shaping the ongoing recovery, and sustainability considerations over the medium term.
In a nutshell, we find that countries that improved their policy fundamentals and reduced their vulnerabilities
in the pre-crisis period generally came out ahead during the crisis: they experienced smaller growth
collapses, had more space to take countercyclical policy measures, and are recovering faster from the
crisis. I describe below our results in more detail.
Impact
The initial impact of the crisiswhether measured in terms of output contraction or widening of sovereign
spreadswas, as expected, more pronounced in EMs that were more integrated with the global economy
through trade and capital flows. However, accounting for these linkages, the impact was less intense in
countries with better pre-crisis fundamentals and lower external vulnerability indicators.

Holding more reserves helped, but only up to a point. Emerging markets with greater pre-crisis holdings of
international reserves relative to external financing needsperceived insurance against external
vulnerabilitysaw smaller output contractions. But this effect was pronounced only when reserves cover
was low or moderate. For countries with ample reserves, having more reserves carried little additional
benefit.

Avoiding excesses in the banking sector also helped. Countries that had domestic credit booms in the run
up to the crisis tended to experience credit busts during the crisis; these busts were more pronounced in
countries with fixed exchange rate regimes.
Response
Countries that entered the crisis with more policy space and less binding financing constraints were able to
react with more aggressive fiscal and monetary stimuli. Those with lower public debt and better budget
balances going into the crisis were able to accommodate the economic downturn better by letting their fiscal
positions ease more substantially.
Similarly, those with lower pre-crisis inflation and sovereign spreads were able to cut interest rates more.
There is also evidence that the exchange rate regime matteredflexible regimes were able to provide
greater monetary stimulus.
Recovery
There is evidence that countries that were able to increase public spending more rapidly have experienced
faster recoveries, providing a concrete example of how better fundamentalsor more policy spacehave
helped. The positive role of the exchange rate as an adjustment mechanism is also becoming evident:
countries with more flexible exchange rate regimes are recovering faster.

Exit
As emerging markets exit the crisis, they will need to tackle sharply different policy challenges. Those that
entered the crisis with high vulnerabilities face larger output losses (relative to pre-crisis projections). If
current account deficits persist, their external debt-to-GDP ratios could remain elevated.
Thus, this group of EMs will need to sustain adjustment over the medium term to bring vulnerabilities back
down to more moderate levels.

On the other hand, those with better pre-crisis fundamentals are already facing a cyclical conundrum: while
recovery in output and emerging inflation pressures would normally imply higher policy rates (in a Taylor rule
framework), such actions in the face of continued accommodative policies in the advanced economies could
prompt excessive capital inflows, possibly fueling asset price bubbles. This may be why many fastrecovering emerging markets are taking a cautious approach in withdrawing monetary stimulus.
Lessons
Fortunately, a crisis of this magnitude is a rare event. But the varied experience of emerging markets during
this crisis underscores an important lesson: good policies beget good outcomes.
Investing during good times to develop a sound policy framework that delivers stronger fundamentals and
lower vulnerabilities yields large dividends during crises. In the current crisis, low-vulnerability countries had
lower output declines, more space to undertake countercyclical policies, and quicker recoveries.

IMF Draws Lessons from the Crisis, Reviews Macro Policy Framework
Posted on February 12, 2010 by iMFdirect
As the crisis slowly recedes, the IMF has started to reassess the conduct of macroeconomic policy.
The Fund has just published a paper, Rethinking Macroeconomic Policy, part of a series of policy papers
prepared by IMF staff reassessing the macroeconomic and financial policy framework in the wake of the
devastating crisis. Several of the papers will be discussed at a conference to be held in Seoul, Korea, later
this month.
IMF Survey magazine has interviewed the Funds Chief Economist Olivier Blanchard on the reason for the
rethink. It was tempting for macroeconomists and policymakers to take much of the credit for the steady
decrease in cyclical fluctuations from the early 1980s on and to conclude that we knew how to conduct
macroeconomic policy. We did not resist temptation. The crisis naturally forces us to question our earlier
conclusions and thats what we are trying to do in this paper, hes quoted as saying.
Paul Krugman dubbed the paper interesting and important in his New York Times blog, while Richard
Adams in the Guardian described it as a break with years of economic orthodoxy and a stunning
turnaround.
Intellectual guidance
An editorial in the Financial Times said the paper demonstrates that the IMF intends to offer intellectual
guidance to a profession confounded by its failure to see the crisis coming.
The short paper, the FT argues, cuts to the heart of what macroeconomics got wrong before the
crisis and what it teaches us about how policy must change.
The paper also treads controversial ground, the FT writes. To speed up fiscal policy it moots automatic
tax cuts or transfers triggered by thresholds such as a given rate of unemployment. It says central banks
might aim for higher inflation to make room for more aggressive cuts. If not always convincing why seek
higher inflation instead of tools to enable negative nominal rates? such high-calibre brainstorming is
welcome. No less is needed to reform a failed orthodoxy of which the IMF was once the guardian.
Weighing in, the Economists Free Exchange blog says: Perhaps the important thing to take away from this
discussion is that to central bankers, inflation is a bogeyman. But to good economists, inflation is merely a
variable, an economic indicator over which governments have some control and which they can manipulate
to good or ill effect.
Better performance
Another interesting quote comes from Joseph Stiglitz in the French economic daily La Tribune.
Asked how the IMF handled the current crisis compared with the Asian crisis of the 1997-98, he said Much
better than last time! He attributed the improved response partly to the Managing Director Dominique
Strauss-Kahn, known as DSK.
We have been lucky that DSK, who was not wedded to past policies, was at the helm of this institution
when the crisis occurred. The IMF advised large economies to implement stimulus policies whereas, during
the crisis in [Asian] emerging markets at the end of the 1990s, the Fund had imposed austerity policies.

Getting Ready to Join the Eurozone Club

Posted on February 1, 2010 by iMFdirect
By Marek Belka
The conventional wisdom is that, when the seas get rough, its better to be in a big boat. But being in
the European Monetary Union (EMU) hasnt exactly been smooth sailing for all its members. On the
contrary, as I argued in my blog posted January 21, the crisis has highlighted that sound policy frameworks
are more important than ever.
Lets look at this experience from the perspective of the European Unions new member states in the East,
who are still outside the EMU but are set to join sooner or later. Should they accelerate or delay their
applications? And what are the conditions for success, once they have gained entry?
Fixers and floaters
The answer to the first question depends in large part on the currency regime. For small and very open
countries with fixed exchange ratesthe three Baltic republics and Bulgariathere is really no alternative to
seeking EMU membership as fast as possible. They have been particularly hard hit by the crisis, partly
because of their currency regime; in fact, Latvia had to rely on massive external support to pull through the
crisis. But they all have managed to hold on to their long-standing currency pegs against the euro. Once in
EMU, their economic policy frameworks would remain virtually unchanged. At the same time, euro adoption
would remove residual currency and liquidity risks, which during the recent crisis have driven up borrowing
costs, dented investor and consumer confidence, and contributed to their sharp output contractions. So for
the peggers, joining the club is all gain and no (additional) pain.
The picture is less clear cut in the larger new member states, who on the whole have been served well by
their flexible exchange rate regimes. During the boom years, currency appreciation and monetary tightening
helped prevent overheating, and their recent downturn was relatively muted. Some, notably Poland,
benefited from a temporary boost to exports as their currency depreciated during the crisis.
But when foreign capital inflows suddenly dried up in the wake of the Lehman bankruptcy, several of the
floaters found themselves short of euro liquidity needed to supply banks, households, and enterprises
indebted in foreign currency. To fill this funding gap, Romania and Hungary drew on balance of payments
support from the IMF and the European Union; Poland, too, topped up its available foreign currency
resources with the IMFs new Flexible Credit Line. These extraordinary actions helped stabilize the situation.
But the unpleasant experience of sudden euro shortages and currency volatility will weigh on policymakers
minds as they decide how quickly to move toward euro adoption.
The euro is for the agile
More fundamentally, however, potential new applicants should ask themselves: are we ready for life in the
eurozone? Here I dont mean meeting Maastricht criteria, which in any event are ill suited to assess rapidly
converging economies (as many observers, including myself, have pointed out over the years). Rather, what
I have in mind is a more profound question: are institutions and society as a whole prepared to make the
adjustmentspainful at timesthat continue to be necessary once the country has stepped on board the
EMU? In particular, what is the political feasibility of fiscal and structural reforms of the kind now required of
EMU member countries like Greece and Ireland? If anything, the crisis has confirmed that the euro is for the
agile, as aptly observed by Alan Ahearne and Jean Pisani-Ferri already in 2006.
While there are differences between countries, the new member states on the whole do not score badly on
this account. Over the past years, they have proven nimble in adjusting their trade and production structures
to new opportunities, and they have become increasingly integrated both with EMU members and other new
member states; productivity levels have increased; job markets are flexible; and labor mobility, including
across borders, is high.
But what I find most impressive, especially in the fixed exchange rate countries, is the ability to maintain
fiscal discipline and take tough adjustment measures when needed. Take Estonia, which is hoping to
introduce the euro in January 2011. Despite losing almost one-fifth of its output, it has kept its public deficit
below the required 3 percent of GDP. As documented in the IMFs recent Article IV report, this reflects swift
adjustment when the crisis hit, sound institutions and, importantly, prudent policies during the boom years.
Having been at the helm of government myself, I can appreciate how truly remarkable this accomplishment
is.
Policymakers in the West, who are often struggling to push through relatively modest changes to entitlement
and subsidy programs, may wonder how their Baltic colleagues have been able to pass tax hikes and
spending cuts worth some 10 percent of GDP in a single year without prompting mass protests on the
streets. Lets not forget that economic and political pain is a relative concept. People in Eastern Europe,
having only recently gone through the wrenching experience of transition from planned to market economy,
know that there is a price to pay to preserve stability and sustainability. Nowhere is this insight stronger than
in the Baltics.
Of course, not all new member states share such determination, instilled by running a currency board for
almost two decades. Policymakers need to do more to explain that euro adoption is not a goal in itself and

that sacrifices will need to be made to fully reap its benefits. For whether pegger or floater, a countrys ability
to adjust in the face of new challenges is the true test of whether it is fit for life in the eurozone.

Emerging EuropeLessons from the Boom-Bust Cycle

Posted on October 20, 2010 by iMFdirect
By Ajai Chopra
Almost unnoticed, amid the difficulties in western Europe, the other half of the continent has begun
to recover from the deepest slump in its post-transition period. The emerging economies in central and
eastern Europe will grow by 3 percent this year and nexta relief after the 6 percent decline in 2009.
Why was the crisis so severeand how do we avoid a repeat? We consider just that question in our fall
2010 Regional Economic Outlook: Europe. While the crisis was triggered by external shocks, it is clear that
domestic imbalances and policies also played a key role.
After Lehman Brothers defaulted in September 2008, global trade collapsed, capital inflows into the region
plummeted, credit growth suddenly stopped, and domestic demand plunged.
But pre-crisis domestic imbalances and policies made a difference in how these shocks affected each
countrys economy. Some countries saw declines in gross domestic product (GDP) similar to those in the
Great Depression (Estonia, Latvia, Lithuania, Ukraine), while others avoided declines altogether (Albania,
Poland).
Origins of the crisis
The seeds of the crisis were sown, in large part, in the five years before the crisis. Between 2003 and
2008, much of the region experienced a boom in bank credit, asset prices, and domestic demand. This
boom was fueled and financed by large capital inflows.
With low interest rates in advanced countries, banks in western Europe expanded aggressively into
emerging Europewhere returns were higher. And, while the influx of capital boosted growth, it also led to
rising imbalances and vulnerabilities.
Current account deficits increased to unprecedented levels in some countries, and inflation
accelerated.
Substantial vulnerabilities emerged in bank and household balance sheets, particularly because
much of the borrowing was in foreign currency.
The boom years had left much of the region addicted to foreign-financed credit growth, making it very
vulnerable to a disruption in capital inflows.
High-cost experience
The first lesson of the crisis is one that is unfortunately not new. Boom-bust credit cycles can be very
costly, so it is essential to prevent credit booms from getting out of hand.
Indeed, countries that experienced the fastest credit growth during the boom years saw the deepest
recessions. And it now appears that average GDP growth over the full business cycle in this group was no
higher, and in some cases was lower, than in countries with more modest credit growth.
How to restrain credit booms
Controlling credit growth is not easy. Prudential measures alone rarely do the trick, particularly in small
countries easily overwhelmed by foreign capital inflows. Fixed exchange rates often impose further
constraints. Indeed, it is striking that the strongest credit growth during the boom years took place in
countries with fixed exchange rate regimes. This is partly because countries with fixed exchange rates dont
have the full range of monetary policy tools to restrain credit booms once they set in.
Fixed exchange rates are not the cause of credit boomsthere were also some countries with fixed
exchange rate regimes that did not have a credit boom. But fixed exchange rates do make it harder to stop
credit booms, particularly in the presence of large capital inflows.

Closer cooperation with supervisors in western Europe can help prudential measures become more
effective. Credit booms driven by capital flows from western European parent banks are hard to stop,
especially when faced with supervisors only from the (often smaller) recipient country.
Building up fiscal buffers
The second major lesson is the need for more prudent fiscal policy. This is a policy of saving money
when revenues are growing instead of increasing spending and boosting public wages. Prior to the crisis,
fiscal positions in emerging Europe looked goodbetter than in other emerging market regions. But those
good-looking headline numbers masked a deterioration of the underlying fiscal position. Public expenditure
was surging, financed by a temporary revenue boom. This not only further contributed to overheating; it also
set the stage for large fiscal deficits. So when revenue plummeted in 2009 and fiscal deficits increased
sharply, many countries had no choice but to cut spending precisely when this was most painful.

When revenue takes off during the next boom, it should be used to build up fiscal buffers rather than
boost expenditure. Politically, this may be very challengingwhen revenues abound there is strong pressure
to increase expenditure or cut taxesbut this will help dampen the boom and create fiscal space that can be
used to soften the impact of the next recession.
In search of balanced growth
Going forward, growth in the region should become more balanced, and less dependent on
domestic demand and capital inflows. Much of the shift will come about through private sector actions.
Now that profits in the nontradable sector (finance, real estate, construction) have shrunk, investments will
seek more promising venues. More balanced macroeconomic policies and wage restraint can also help
maintain balanced growth by preventing the overheating that pulls resources from the tradable to the
nontradable sector.
Above all, it will be importantwhen the next boom comesto be wary of claims that this time will
be different. Such narratives often have some plausibility and attractiveness in the heat of the moment.
But a careful analysis of the drivers of growth, current account deficits, asset price developments, and credit
growth should always be used as a reality check.

Macro-Prudential Policies: Putting the Big Picture into Financial

Sector Regulation
Posted on October 22, 2010 by iMFdirect
By John Lipsky
The devastating impact of the global financial crisis created a consensus that pre-crisis financial regulation
didnt take the big picture of the system as a whole sufficiently into account and, as a result, supervisors in
many markets missed the forest for the trees. In other words, they did not take into account the macroprudential aspects of regulation, which has now become the focus of many authorities.
Consensus regarding the need for macro-prudential regulation is particularly strikingpreviously this type of
regulation had been used relatively little and, at present, there are no agreed standards that can be applied
internationally.
Thus, each of the countries that have adopted a new structure for the macro-prudential approach following
the global crisis including the United States, the euro area, and the United Kingdom have created
somewhat different forms of organization. In contrast, traditional micro-prudential regulations that focus on
the status of individual financial institutions and on the conditions prevailing in markets for specific financial
instruments long have been formed through cooperation in international standard-setting bodies. It is not
surprising, therefore, that post-crisis reforms in traditional regulation already have made substantial
progress, with improved international accords in many sectors being agreed in time for the upcoming summit
for the leaders of the Group of Twenty industrialized and emerging market economies (G-20) in Seoul.
Macro-prudential conference in Shanghai
Recognizing the need to reach greater understanding about the

potential roads to internationally-consistent and effective macro-prudential regulationand in an effort to

make sure that an appropriately broad range of views are taken into accountearlier this week, the
Peoples Bank of China hosted an IMF-sponsored conference in Shanghai. The conference brought together
central bankers and senior financial officials from Asia and around the world to examine and discuss key
issues regarding macro-prudential policies. The conference, titled Macro-Prudential Policies: Asian
Perspectives, allowed international participants as well as Fund staff attendees to benefit from the views of
key Asian policymakers. And vice versa.
What are the aims?
At the conference, there was wide agreement that the first step in designing macro-prudential policies ought
to be a convergence of views regarding the objectives of such policies.
Of course, the most basic objective is straightforwardto prevent a crisis like the one just experienced.
As the recent crisis unfolded, troubles in one institution spread quickly to related institutions as well as
across national borders, rapidly and dramatically undermining the complex global web of financial
relationships. The crisis thereby demonstrated that examining only the safety and soundness of individual
financial institutions was inadequate. Supervisors need to be aware of, and respond to, the build-up in
system-wide risks.
Thus, a key challenge is to put in place a regulatory framework that ensures the safety and soundness of the
entire financial system, and captures how the economic and financial systems affect each other.
A basic objective of reform is to design and implement policies that will short-circuit cross-institution or
cross-market knock-on effects that magnify problems. A second objective is to reduce the likelihood that the

system as a whole will experience such knock-on effects. This means seeking to dampen the swings in
credit and financial cycles that can produce financial system volatility that can damage both the stability of
financial markets and the broader economy.
Means of implementation
A basic practical issue is how macro-prudential policies can be incorporated with the traditional set of policy
tools.
One option would be some type of capital surcharge or levy based on the degree of systemic risk created by
any specific financial institution. In addition to classic micro-prudential requirements for minimum capital to
back individual institutions, the new approach would add a new capital layer that takes into account the
systemic importance of an institution. The idea would be to modulate an institutions behavior by making it
more costly to pursue those activities that contribute to the build-up of systemic risk.
Other proposals to control systemic risk focus on quantity rather than price-based restrictions, including
constraints on size or legal structure or certain activities by financial institutions. In general, however, pricebased instruments tend to be more effective because quantity-based instruments may be more subject to
gaming and regulatory arbitrage.
Because systemic risks refer not only to institutions but also to markets, new measures should be
considered that would make key markets more resilient.
Effective Implementation through Cooperation
Like so many other policy challenges facing modern, globalized markets, a cooperative solution is required.
Policymakers need to ensure that macro-prudential policies in differing countrieswhen designed and
implementeddo not contradict or offset each other.
Supervisors also need to focus on cross-border exposures. The effective resolution of large and complex
financial institutions that operate in multiple jurisdictions will need to rely on a clearly-designed cross-border
framework to reduce moral hazard and support financial stability. On this point, the IMF has proposed a
pragmatic approach. We hope a small set of countries that house the most interconnected firms will begin to
make progress in this area.
For many countries, an open question remains regarding which agency should design and implement
macro-prudential policies a new global body, a central bank, or the existing micro-prudential regulatory
body? In general, participants in the Shanghai conference favored this job being awarded to central banks.
Whatever path is chosen, however, the regulators must be supported by good information gathering, clear
mandates and powers, effective tools, and, perhaps most important, cooperation between authorities
nationally, and across borders.

This Time Is DifferentFiscal Policy in Low-income Countries

Posted on November 25, 2009 by iMFdirect
By Carlo Cottarelli
When it comes to the crisis, most of the media attention is focused on advanced and emerging
market countries. But low-income countries have been badly hit too, reflecting their growing
integration in the world economy. We can see sharp declines in exports, FDI, tourism, and remittances.
Output growth in 2009 will be less than half of the pre-crisis rate of over 5 percent. Sub-Saharan Africa is the
worst affected, with a contraction of real per capita GDP of almost 1 percent.
This is the bad news. But there is some good news in all of this. Low-income countries have been able to
use fiscal policy as a countercyclical tool this time around, far more than in the past. Fiscal deficits are
expected to increase in three-quarters of low-income countries in 2009, with an average expansion of 3
percent of GDP. Revenues have grown slower than GDP, reflecting the disproportionate impact of the crisis
on trade and commodity revenues, as well as weakening tax compliance. Expenditures are expected to
increase by about 2 percentage points of GDP.

The crisis has also confirmed the importance of debt relief and donor assistance in creating fiscal space,
and in supporting the fight against poverty (photo: Zohra Bensemra/Reuters)
Almost one-third of the low-income countries are augmenting their automatic fiscal loosening with a
discretionary stimulus, mostly through current spending. Many low-income countries have sought to
preserve or increase social spending, and IMF-supported programs have shown flexibility by allowing
automatic stabilizers to work and by accommodating fiscal stimulus.
Room for larger deficits
The fiscal easing has been more prevalent in countries with low or moderate risk of debt distress prior to the
crisis. The combination of debt relief and sound policies led to falling debt ratios before the crisis, providing
room to accomodate larger deficits during the crisis. We can see this in both Central America and subSaharan Africa. Countries with higher risks of debt distress had more limited room to expand deficits
because of financing constraintsand many of these countries tightened fiscal policy by cutting non-social
spending.
This experience confirms the importance of following prudent fiscal policies in good times, to be able to use
fiscal policy to cushion shocks in bad times. And so, as the global economy recovers, countries will need to
rebuild their fiscal space.
The crisis has also confirmed the importance of debt relief and donor assistance in creating fiscal space,
and in supporting the fight against poverty. But major donor countries now face large deficits and rising debt
of their own. In these circumstances, they could scale back support to low-income countries, in spite of
Gleneagles commitments to double aid to sub-Saharan Africa.
Continued support to low-income countries must remain a priority. These countries still face daunting social
and infrastructure challenges. Some still have elevated risks of debt distress that predate the crisisIm
thinking here of countries like the Democratic Republic of Congo, Tajikistan, or Togo. Lets face itsupport
to low-income countries is still a small fraction of total spending in advanced countries (a mere 1 percent of
expenditures, on average).
While the advanced countries will need to tighten fiscal policy in the future, cutting funds for aid would cause
severe harm to low-income countries, without making a significant difference to their own fiscal problems. At

the same time, the onus is on low-income countries to continue improving the way foreign aid is spent,
through strengthening public financial management, fighting corruption, and better prioritizing expenditure.

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Balancing Fiscal Support with Fiscal Solvency

Posted on November 18, 2009 by iMFdirect
By Carlo Cottarelli
As I noted in my last post, government deficits in many countriesparticularly in advanced
countrieshave jumped dramatically in the wake of the global crisis, and government debt has
reached levels that could jeopardize longer term macroeconomic stability and growth. These
countries will need to tighten fiscal policy significantly sometime down the road, especially where
demographic trends are pushing up health and pension spending.
But fiscal deficits cannot be lowered in the immediate future. For the time being, fiscal (and monetary)
policies must continue to support economic activity. The economic recovery is uneven and could be
threatened by any premature withdrawal of policy support. Private demand is still unable to stand on its own
two feet.
This gives rise to a policy conundrum. How can we reconcile the competing requirements of short-term
support for the economy and longer term fiscal solvency?
Fiscal solvency strategies
The challenge for policymakers is to formulate strategies for fiscal solvencywhat we often call exit
strategiesand communicate these strategies to the general public. The G-20 countries recognized this
requirement in their recent communiqu. This will be important, but words may not be sufficient. Are there
actions that governments can undertake today to enhance their credibility without negatively affecting
aggregate demand? Yes, there are.

Studies say increasing retirement age in European Union by two years could save equivalent of 40 percent
of GDP in net present value terms (photo: Johannes Eisele/AFP)
First, governments can reform their institutional fiscal framework to make it more likely that fiscal adjustment
takes place when the time for action arrives. The precise framework will depend on country-specific
circumstances. Possible reform options include fiscal responsibility laws, numerical fiscal rules (to take effect
only when conditions normalize), fiscal councils tasked with monitoring fiscal developments, improvements
in budgetary procedures, and increased fiscal transparency.
The example of Germany is worth noting. In June, the German parliament adopted a new constitutional
fiscal rule that limits the structural deficit of the federation to 0.35 percent of GDP from 2016 onward and
requires structurally balanced budgets in the states from 2020.
Health, pension reforms
Second, various reforms in health and pension entitlements, though politically not easy, can be undertaken
without jeopardizing economic recovery.
These reforms will not have a large impact on the todays deficit, but can dramatically improve long-term
fiscal trends and signal commitment to fiscal sustainability. They will not undermine demand if well
structuredwith a focus, say, on increasing the retirement ageor if they are passed now but implemented
gradually.
These reforms can have powerful effects. For example, it is estimated that increasing the retirement age in
European Union countries by two years can save the equivalent of some 40 percent of GDP (in net present
value terms).
In sum, postponing fiscal tightening does not mean postponing fiscal action.

Post-Crisis: What Should Be the Goal of a Fiscal Exit Strategy?

Posted on November 16, 2009 by iMFdirect
By Carlo Cottarelli
One obvious fallout of the global financial crisis is a huge deterioration in fiscal conditions,
particularly in advanced countries. The numbers are nothing short of staggering. Gross general
government debt in the G-20 advanced economies is projected to approach 120 percent of GDP by 2014,
up from about 80 percent in 2007, and this is even assuming no renewal of fiscal stimulus beyond 2010.
Some might think that this comes from an exotic form of fiscal policy whereby governments opened their
coffers to prop up financial institutions. But only a small part of this debt spike is matched by a rise in
financial assets. It really boils down to plain vanilla deficitsrevenue losses from the recession, fiscal
stimulus, and some underlying spending increases that would have occurred even without a recession.
A first step
Pretty much everybody agrees that something has to be done about this, and that fiscal policy needs to be
tightened once the economic recovery has firmly established. The first step is to stabilize the debt-to-GDP
ratio.
Even this will not be easy, given trend increases in pension and health spending, often reflecting population
aging. But is stabilizing debt ratios at their post-crisis level enough?
The temptation will be strong. Just look at the numbers.
Lets assume that advanced countries want to reduce gross debt to 60 percent of GDP (the median precrisis level) by 2030. To do this, they will need to improve their structural primary balance by 8 percentage
points of GDP over the next decade, and keep it there for another decade. Obviously, this is a tall order.
Simply stabilizing debt at its post-crisis level means half the workan adjustment of 4 percent. This is still
ambitious, but much more manageable.
Easy path not the best
Still, taking the easy path is not the best idea. Governments need to do whatever they can to lower debt
ratios, for at least three reasons.
First, they need space for fiscal responses to possible future crises. If you start with high debt, its
really hard to let fiscal policy cushion the shockjust look at Italy.
Second, high debt pushes up real interest rates, with pressure on a limited pool of private savings.
We have computed that raising government debt ratios by 40 percentage points (exactly what is
projected to happen on current trends) would increase real interest rates by a sizable 2 percentage
points. This may even be an underestimation as it is based on backward-looking estimates from a
world where only a few countries were running high debt ratios, which could partly be financed
abroad. With so many large economies borrowing at the same time, the effect on interest rates may
be larger.
Third, high-debt countries tend to grow more slowlyjust look at Japan and Italy. While other
factors were certainly at play, the experience of several emerging market countries confirms the
existence of debt overhang effects.
Altogether, I believe that living with 100 percent government debt ratios is not a good idea. Fiscal exit
strategies in advanced countries should target a reduction of government debt to prudent levels.
If a debt ratio not exceeding 60 percentas noted, the pre-crisis median levelwas regarded by many
countries as an appropriate norm before the crisis, it should continue to appear so after the crisis. And while
it is too early to tighten fiscal policy today, the plans should certainly be put in motion.

Creating Breathing Room in Low-income Countries

Posted on September 3, 2009 by iMFdirect
By Hugh Bredenkamp
In my previous postings this week, I have talked about the double whammy that low-income countries have
faced over the past 2-3 yearsthe surge in food and fuel prices and global financial crisisand how the
IMF has stepped up its support to help them cope with these shocks. Without this support, and that of other
agencies and rich-country donors, governments would have to slash spending as their tax revenues
slumped. This, of course, is the exact opposite of what any government should be doing in a recessionit
would add fuel to the fire.
But preserving or even increasing spending when revenues are declining means larger budget deficits, and
more borrowing. Doesnt the IMF always preach tight budgets? The answer is not always. Fiscal discipline
and carefully-managed borrowing policies are essential for long-term economic health. But when economies
are hit by temporary shocksand the current recession, though severe, will surely be temporaryit makes
sense for governments to use policy to limit the short-term damage.
Indeed, the IMFs Managing Director, Dominique Strauss-Kahn, was among the first (as early as January
2008) to advocate a global fiscal stimulus as recession loomed. Some commentators suggested that this
advice was really meant only for rich countries. Not so. What matters is whether the country could afford the
stimulus, and those that cant include some advanced countries as well as some low-income countries. But
every country that can afford it should do it.

Farmers inspecting drought-affected corn in Kenya (photo: AFP)

Fine, you might say, but has the IMF put its money where its mouth is? In low-income countries that have
programs supported by the IMF (lets call them program countries for short), have we actually adjusted the
targets to allow more spending and higher deficits?
The experience to date suggests that we have (we plan to publish a paper on this later in September).
Budget deficits in program countries should get bigger this year, on average 2 percent of GDP higher than
before the crisis. Some countries are preserving spending, and borrowing more to cover the recessiondriven drop in tax revenues. Others have been able to take more active fiscal stimulus measuresabout
two-thirds of program countries have been able to increase government spending despite declines in
revenues. Inevitably, countries with more vulnerable debt positions had less room for maneuver, but this is
consistent with our advice. And even for these countries, programs provide for some expansion in budget
deficits in 2009.
When the recovery arrives, countries will need to reverse temporary stimulus measures, and bring budget
deficits down to sustainable levels. But they should not be forced into doing this prematurely, before it is
clear that the recovery is underway, simply because they cant get affordable financing. This is a serious
constraint. Low-income countries often have fewer borrowing options and their borrowing costs tend to be
higher than in advanced and emerging economies. This is why scaled-up financial support from the IMF and
donors is so important, especially this year and next, when the needs will be greatest.
In all of this, the welfare of the poor must top our agenda. Countercyclical fiscal policy can certainly help
protect jobs. But for many of the most vulnerable, when food prices triple, or remittance lifelines are cut
dramatically, public social benefits are the only answer. We have therefore encouraged governments to
safeguard social protection and other core social spending, and in most instances programs were able to
increase this spending, targeted toward the most vulnerable. This being said, both the food and fuel price
shocks and the global recession have exposed weaknesses in the fabric of social protection systems in
most low-income countries. They need better mechanisms to channel support to the most needy, quickly
and efficiently. This is an area where more work is needed before the next crisis hits.
Conditions cut by one third
We have also been trying to streamline the policy conditions attached to programs, to make them more
effective. Drawing on lessons from the Asian crisis, the IMF made a strategic decision that programs should
focus only on structural reforms that are essential to support sustainable, growth-oriented macroeconomic
policies.

Recent experience suggests we have made some progress in this direction. The number of conditions we
use to monitor structural reforms in low-income country programs has fallen by a third compared with the
early 2000s. Around 40 percent of these conditions are focused on measures to improve public resource
managementbetter expenditure control systems, auditing and publication of government accounts, more
efficient tax administration, and so onthat almost everyone agrees are critical to policy effectiveness. And
it should be no surprise that, as we have streamlined, more reforms are being implemented now than in the
pastownership in action.
Theres one more step. Earlier this year, we redesigned the way that conditionality is applied to structural
reforms in all IMF-supported programs. From now on, loans will no longer include conditions on specific,
timebound measures. Instead, progress will be assessed as part of the regular program reviewsthis will
encourage more focus on the objectives of the envisaged reforms, and give governments more flexibility in
attaining their goals.
In my final posting tomorrow, I will talk about another aspect of the IMFs more flexible approach in lowincome countries, which has to do with how IMF-backed programs monitor and control countries debt
burdens.

Potential Output: Worrying About What Cannot Be Observed

Posted on August 13, 2009 by iMFdirect
By Ajai Chopra
Potential output seems to be on everybodys mind these days, at least if you talk to economists. What would
be merely a curiosity during better timesafter all, potential output is a largely abstract concept measuring
the level of output an economy can produce without undue strain on resourceshas become a particular
worry in the context of the global economic crisis.
So what is all the fuss about? In a nutshell, policymakers across Europe are concerned that the deep and
long recession will affect supply capacity and weigh down the prospects for recovery.
But even if the danger seems clear and presentpeople are still losing their jobs and businesses are still
closing down with alarming speedthere is little clarity about just how big the drop in potential output is
likely to be. For instance, Davide Furceri and Annabelle Mourougane at the OECD estimate that potential
output in a typical financial crisis will drop between 1.5 percent and 2.5 percent for most countries. And Gert
Jan Koopman and Istvn Szkely at the European Commission reckon that the level of losses for the
European Union as a whole during the current crisis could be between 0.5 percent to 4.5 percent.
Policymakers dislike this kind of uncertainty because it muddies the waters and makes it harder for them to
make the right decisions. Right now, budget planners across Europe are scrambling to estimate the strength
of the blow the crisis has dealt to public finances, and not knowing the growth potential of their economies
greatly complicates their task. If they overestimate potential growth, they would underestimate the need for
fiscal adjustment once the crisis has dissipated, raising thorny issues of fiscal sustainability in the longer run.
Central bankers, too, are looking for guidance on the path of potential output. Their decision on when to start
winding down current crisis policies depends on the difference between potential and actual output, the socalled output gap. If the output gap is closing faster because of a drop in potential, policymakers might
decide to increase interest rates a little earlier and a little higher to prevent inflation from rising. Although this
might sound farfetched at a time of falling headline inflation in Germany, the United Kingdom and elsewhere,
those who are charged with safeguarding price stability have to look ahead to when the recovery will finally
happen.

Central banks' decision on when to start winding down current crisis policies depends in part on the
difference between potential and actual output. Photo shows Bank of England (photo: Shaun Curry/AFP)
So what are policymakers to do? The first step is to ask economists to do their best to correctly estimate
potential output in the aftermath of the crisis. The more that is known about what is happening to potential
output, the less reason there is to worry about getting it wrong. The IMF is one such source of independent
advice on potential output. Recent country reports produced by IMF staff have used a variety of
methodologies to produce such estimates. Examples from the European Department include reports on
France (Box 3 of the report), Ireland (Box 1), Sweden (Box 5), the United Kingdom (Annex 3), and similar
work is in the pipeline for other countries. Another example is the report on the United States.
Naturally, the assessments by individual country desks take into account specific country circumstances. For
instance, the hit to potential output in the United Kingdom is estimated to be larger than in, say, France
because of the larger role of the financial sector as an engine of growth of value added in the United
Kingdom in recent years, implying a bigger hit to the capital-labor ratio and total factor productivity after the
crisis. Complementing such individual country analysis, the forthcoming World Economic Outlook and the
Regional Economic Outlook for Europe, both to be released in early October 2009, will have a deeper
discussion of the impact of the crisis on potential output in a cross-section of countries.
The second step for policymakers is to deal with the unavoidable uncertainty. For fiscal policy, there is a
good case to err on the side of caution. Enough is known about the fiscal costs of the crisis to suggest that
the need for consolidation is large, even if its precise size is still debated. In light of the looming fiscal
pressures from Europes aging societies, this calls for decisive action as soon as the cycle allows.

As for central bankers, they should also act on the information they have, although researchers such as
Athanasios Orphanides (now Governor of the Central Bank of Cyprus and member of the ECBs Governing
Council) have sensibly suggested that central banks should tread carefully by reducing the importance of the
output gap in their decision making.
More generally, policymakersbe they in the central bank or in the ministry of financewould do well by
communicating their assumptions about potential output growth to the public. When the time comes to wind
down stimulus packages and raise interest rates, the public will be better prepared to understand why fiscal
adjustment has become necessary and will better absorb the guidance they receive on inflation
expectations.
Again, these issues will be discussing more fully in the forthcoming October issue of the Regional Economic
Outlook for Europeso stay tuned.