CIGI's annual policy conference, which was held last weekend, featured a vigorous and thoughtful debate on the short-term risks to the global economy and the impact of crisis "legacies" on our ability to deal with these risks (full disclosure: I wrote the background paper and chaired the session). These risks include the threat of further deterioration in the outlook for Europe from the continuing euro crisis—or worse, a "Lehman-like" moment that would have potential systemic effects on the global economy, the U.S. fiscal cliff, and possible geopolitical tensions leading to significantly higher oil prices. The problem is that the global financial and economic crisis and the policy response to it have bequeathed a number of legacies that cloud the global outlook and impair efforts to address these risks.
What are these legacies?
First, obviously, is the marked deterioration in public finances in most advanced economies that were forced to assume the liabilities of failing financial institutions and which engaged in counter-cyclical fiscal policy. (The exception here is Canada, which did not bail out a single bank.) In several of these countries, fiscal policy has not been used aggressively to support the recovery either because of political gridlock or a misplaced faith in "expansionary austerity." Elsewhere (a.k.a. the euro zone), the delegation of monetary autonomy to a supra-national body has reduced the scope for counter-cyclical fiscal action; indeed, fiscal policy has subtracted from growth in countries that have lost access to the bond markets and de facto exchange rate risk (euro exit) premia have re-emerged after a decade or so.
Second, a disproportionate burden of adjustment has been placed on monetary policy to restore advanced economies to full employment: With one stabilization instrument (fiscal policy) missing in action, the remaining instrument (monetary policy) has to work extra hard to restore equilibrium. But with interest rates already at very low levels and traditional channels of the monetary transmission mechanism malfunctioning because of ongoing balance sheet de-leveraging or dysfunctional financial markets, several advanced economy central banks have had to resort to "unconventional" monetary operations, including quantitative easing. The objective, in my view, is to "incentivize" investment — though in an environment of inadequate financial regulation, the danger is that it encourages reckless risk-taking of the kind that preceded the crisis. However, these measures taken for domestic reasons have external effects: rather absorbing the full exchange rate impact of the resulting capital flows, emerging market economies have introduced prudential capital controls to attenuate the appreciation of their currencies (and have warned of a return of the "currency wars" that were waged in the 1930s).
The third legacy reflects the origins of the crisis in the pervasive mispricing of risk and excessive risk-taking by financial institutions. As a result of these failures, reforms have rightly focused on raising capital requirements and limiting imprudent risk taking. But for many institutions already under-capitalized as a result of the crisis, and facing a high cost of capital given the uncertain outlook, higher capital standards constrain their lending capacity, or, more problematically, require them to shrink their balance sheets. In either case, the net effect on the recovery is unambiguous.
These legacies are clearly inter-related. Moreover, there is, unfortunately, an element of time inconsistency associated with them: policy responses required to support recovery in the near term may be inconsistent with what is needed for medium-term sustainable growth. In this respect, dealing with the legacies of the crisis requires a more forward-looking orientation to policy than, arguably, has been the case in key core economies and credible policy rules to anchor expectations. Of course, policy rules that are not credible ex ante, or which lack the flexibility required in the event of large shocks and may be viewed incredible ex post can make a difficult situation worse.
At the same time, creating an environment conducive to the timely, orderly resolution of these difficult adjustment challenges requires international cooperation to facilitate global re-balancing. Here's the rub. Members of the panel agreed that it is exceedingly difficult to get cooperation absent the clear and present threat of a crisis; yet, the question can be asked, if there is a crisis, is there sufficient policy capacity to respond?