Commentary Type

The Policy Priority Is to Act Decisively

Guest column in the Financial Times


Panic has gripped world financial markets since mid-September and threatens to transform global economic prospects from mild stagnation into the worst world recession in more than 30 years.

The panic began three weeks ago, when short-term credit markets in both Europe and the United States froze in the aftermath of the failure of Lehman Brothers and the rescue of AIG on punitive terms.

A sharp and coordinated cut in policy interest rates would apply a useful defibrillatory shock to financial markets in a virtual state of cardiac arrest.

Fear intensified with interventions by European governments to rescue or nationalize five large banks. Equity markets sold off, in many cases erasing years of gains. Emerging equity markets were particularly hard hit, and spreads for several emerging market borrowers rose sharply along with the general explosion in credit market risk spreads.

A severe downturn in the US housing market and similar problems in some European countries (including the United Kingdom, Ireland, and Spain) underlie some of the stress in financial markets.

But the panic has grown far out of proportion to a deterioration in economic conditions. The primary threat is that continued extreme stress in financial markets will become a self-fulfilling prophecy, driving the global economy into steep recession.

Even if the financial crisis abates over the next few weeks, significant economic damage has already been done. Rather than my forecast of 3.4 percent world real GDP growth for 2009 made two weeks ago, I would now forecast only 2.6 percent growth on a year-over-year basis.

Most of the big industrial countries, including the United States, will be in outright recession late this year and early next, and the forecast for year-over-year growth for the industrial countries is cut to 0.4 percent-the lowest since 1982.

Growth for the emerging market economies will slow below 5 percent for the first time since 2002.

If the financial crisis does not abate soon, it is likely to deepen, as fears about the weakening economy replace or reinforce panic. The outcome would then become an outright decline in world GDP that has not been seen since the collapse of the inflationary boom of the early 1970s and the first world oil-price shock.

The policy priority is to act decisively to stem the panic and restore something closer to normal functioning to key financial markets, especially the main markets for short-term credit.

Usually, coordinated monetary policy actions by leading central banks are not a good idea, because of differences in economic circumstances and policy priorities. Wisely, the European Central Bank (ECB) did not heed plaintive calls late last year and early this year that it join the Federal Reserve in monetary easing.

Now, however, with headline inflation headed down in the face of falling world commodity prices and with GDP growth in the euro area turning negative since the first quarter, the ECB's policy priority must be to calm panic and forestall an unnecessarily deep recession.

This priority is shared with the Federal Reserve and other central banks. A sharp and coordinated cut in policy interest rates would apply a useful defibrillatory shock to financial markets in a virtual state of cardiac arrest. The surprise element in such coordinated action would probably enhance its shock value.

Continued cooperation among central banks in pumping liquidity into key interbank markets and ensuring its effective distribution is also essential. A general agreement to intervene effectively to prevent systemic disruption from problems at individual financial institutions is equally vital. The means of intervention need not be commonly agreed, but governments should normally take responsibility for injecting capital, while central banks deal with issues of liquidity.

In structuring and implementing interventions, concerns about limiting moral hazard should be kept in mind but should not dominate the paramount need to calm the panic.

Coordination of fiscal policies is less important, more difficult to achieve, and poses the danger that failure of announced efforts to achieve it would further undermine confidence.

Emerging market countries that export heavily to industrial countries, are highly dependent on commodity exports, or require substantial capital inflows, are likely to feel considerable stress.

The IMF may need to resume lending to some of these. Other emerging markets, such as China, should use the room they have for domestic expansionary policies but must avoid competitive depreciation as a way to boost growth.

More generally, emerging market countries will complain that they are innocent victims in the present crisis and will insist on a voice in discussions of reforms to reduce the risk of future crises.

They are right on both scores. The time is past when serious discussions of the international financial system can legitimately be limited to the G7 or G10. Symmetrically, the time has come when emerging market countries must live up to their responsibilities as full and cooperative members of the international community-whether the issue is finance, trade, or global climate change.

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