Speeches and Papers

The Global Financial Crisis: Lessons Learned and Challenges for Developing Countries

by Edwin M. Truman, Peterson Institute for International Economics

Remarks at the Eighteenth Cycle of Economics Lectures, Banco de Guatemala
June 16, 2009

© Peterson Institute for International Economics

 


Almost two years ago, the global economy and financial system entered a severe crisis. The incidence and ramifications of the crisis were obscure. Even now, the full dimensions and consequences are not known, but almost certainly this crisis will prove to be the most severe in the extent and severity of its global impact and depth since the end of World War II. Because the crisis is not yet over, among other reasons, we lack the perspective to develop a full catalog of the lessons from the crisis, either in general or for developing countries in particular. However, I thank the Banco de Guatemala for inviting me to share my thoughts on this important and complex subject from the vantage point of June 2009.

In these remarks, I first offer my perspective on the causes of this crisis and how this crisis differs from previous global financial crises. This is a necessary precondition to learning the appropriate lessons from the crisis. Otherwise our lessons will be off-target or incomplete. Second, I offer some key relevant lessons under five headings: too good to be true is probably false; be better prepared; the myth of self-insurance; the role of the International Monetary Fund (IMF); and the future of globalization.


Causes of the Crisis

I concluded six months ago (Truman 2008) that there was no shared diagnosis of the origins of this crisis. Nothing that I have heard or read since then has convinced me otherwise. If anything, disagreements have become more intense, in the meantime. This fact hampers our ability to learn the proper lessons from this crisis. This fact also means that it is useful for me to declare my own biases in advance. Conventionally, causes of this financial crisis include some or all of the four following elements: macroeconomic policies, financial-sector supervision and regulation, financial engineering, and the global activities of large private financial institutions. The context for each element is the United States or other similarly advanced countries.

In my view, macroeconomic policies in the United States and the rest of the fully developed world were jointly responsible for the crisis we are now experiencing to a substantial degree. In the United States, fiscal policy contributed to a decline in the US saving rate, and monetary policy was too easy for too long. In Japan the mix of monetary and fiscal policies distorted the global economy and financial system. Finally, many other countries also had very easy monetary policies in recent years, including other Asian countries, energy and commodity exporters, and, in effective terms, a number of countries within the euro area. The impressive accumulation of foreign exchange reserves by many countries also distorted the international adjustment process, including but not limited to taking some of the pressure off of the macroeconomic policies of the United States and other countries.

The result was not just a housing boom in the United States, but also housing booms in many other countries, some to a greater extent than in the United States.1 However, in addition to housing booms, there was a global credit boom fueling increases in the prices of equities and other manifestations of financial excess.2

Financial-sector supervision and regulation, or the lack thereof, over several decades also played a role. However, without the benign economic and financial conditions that prevailed in the wake of the dot-com boom and the associated belief that "this time it is different," this crisis would have taken a different form.

Benign conditions lead to lax lending standards, just as the night follows the day. In principle, financial-sector supervision could have helped to curb the excesses, but it did not do so in the United States or in many other countries around the world.

In some cases, including importantly the United States in this regard but again elsewhere, regulation and supervision were incomplete. The rise of what is now known as the shadow financial system had been going on for decades in many countries: money market mutual funds, special purpose investment vehicles, hedge funds, private equity firms, etc. In many cases, these entities were highly leveraged and/or used short-term funding to finance longer-term investments. We saw a gradual shift over several decades in financial intermediation from traditional banks to other types of financial institutions that were less well capitalized and subject to less close supervision. Traditional banks themselves gradually, but radically, transformed their business models in order to compete with the less-regulated institutions. The global financial system became overleveraged, particularly in the United States, but also to varying degrees in other countries. When confidence waned, funding dried up and structures collapsed.

Part of the overall picture was new forms of financial engineering, but innovations have been a feature of domestic and international finance for decades. In many cases, the associated innovations were poorly understood, resulting in a failure of risk recognition, which is a necessary precondition for good risk management. Financial engineering contributed to the market dynamics once the crisis got underway, but it was not "the cause" of the crisis.

Finally, some argue that the lack of comprehensive supervision of about 50 large private financial institutions with operations around the world caused the problems faced by the global economy today. In this view, no single national financial supervisor or regulator could possibly understand the full scope of the operations of these institutions. True, some major financial institutions have failed, or the authorities have decided to rescue them, which is tantamount to failure from a market perspective. However, they did not fail because they had multiple national supervisors and thus escaped appropriate supervision. Size has been a problem, and complexity has led to some decisions to rescue particular institutions in whole or in part, but the global scope of the operations of these institutions was not a major contributing factor to the crisis per se.

Thus, in my view the two major causes of the global financial crisis of 2007–09 were failures in macroeconomic policies and in financial supervision and regulation. I would assign principal blame to failures in macroeconomic policies by a small margin. I do not see this as inconsistent with the view that there are structural flaws in national and global financial regulatory and supervisory systems, which had been building for years and should be addressed in the wake of the crisis. It may well be that a crisis of this magnitude was necessary to uncover those flaws. Whether they would have been revealed without the macroeconomic failures is at least a debatable question.

Whatever the fundamental or proximate causes of this crisis, three features distinguish it from many other international financial crises in recent decades.

First, the proximate origins of the crisis were in the United States to a greater degree than with other crises. Regardless of the amount of blame for the crisis one places on US macroeconomic policies on the one hand, or US financial regulatory policies on the other, the fact is that the United States led the way into the crisis. Activity in the US residential construction sector peaked in the fourth quarter of 2005. The actions of US financial institutions were central to the unwinding of financial positions that began in the summer of 2007. Activity in the US economy peaked in the fourth quarter of 2007. For the rest of the world, all this meant that the US economic and financial engine eventually went into reverse.

Second, if the largest economy in the world, whose currency and institutions are at the core of the global financial system, stops functioning, the fact that the resulting crisis becomes global should not be surprising. However, many observers and policymakers were surprised. At the beginning of the crisis, "decoupling" was in fashion. In particular, the emerging-market economies in Asia and elsewhere were going to rescue the United States from recession.3 In fact, globalization has linked all financial systems and economies, but the extent of that linkage was poorly understood prior to the crisis. As a result, comprehensive global solutions have been slow to emerge.

What we have learned is that deleveraging is a process that does not discriminate even among economies and financial systems that are less leveraged than others. Similarly, at the start of the crisis, trade links were stronger than they had been for a century. The US economy drove much of the recent expansion in trade with its external deficits, and that process has reversed. According to IMF projections (2009b), world trade in goods will decline this year by 11.5 percent in volume and by 25 percent in value. Therefore, we should not be surprised that only 17 of the 182 economies that the IMF follows are expected to grow faster this year than they did last year, or that 71 of them are projected to shrink, including 30 of the 34 advanced countries. In this crisis, the citizens and authorities of a country can run, but they cannot hide.

Third, it is not unusual for a crisis to begin in the financial sector, spread to the real economy, cycle back to further weaken the financial sector, and thereby further weaken the real economy. However, this sequence is debatable if one wants to say the United States was the epicenter of the crisis and trace the trigger of this sequence exclusively to the US financial sector. If the proximate cause of the financial crisis was the US housing boom, housing is a feature of the real economy. Subprime mortgages were a manifestation of financial excess or worse, but they were not the principal cause of the housing boom, which was easy credit and low interest rates. What is real and what is financial? In this case, we really can not say.

What we do know is that the US financial sector motored on for some time after the housing sector turned down. We also know that once the US financial system began to implode in the summer of 2007, it took more than a year for the financial crisis to reach its climax in the fall of 2008 and for the real economy to enter its nosedive. The full extent of the crisis took a while to unfold.

Diagnosis of the economic and financial situation was even more complicated in the rest of the world. During much of 2008, economic growth appeared to be holding up in general, and inflation, particularly in commodity prices, was still rising. In April 2008, eight months into the global crisis if we date its start as August 2007, the IMF (2008) was forecasting only a mild slowdown in global growth in 2008 and 2009 to 3.7 and 3.8 percent, respectively, from the 4.9 percent that then was estimated for 2007.4 Median consumer price inflation in the advanced countries was projected to rise to 2.9 percent in 2008 from 2.1 percent in 2007. In fact, median inflation rose to 3.2 percent. Recall that the European Central Bank (ECB) raised the target for its key refinancing rate on July 3, 2008, and the ECB was not alone in its inflation concerns at that time.

It is possible to have a mild economic downturn without an associated financial crisis. It is also possible to have a financial disruption without an associated economic downturn. What is rare, but not impossible, is a significant economic downturn without a severe financial crisis, affecting a broad set of asset prices and credit markets, or vice versa. Policymakers were slow to learn that they were dealing with dual severe crises on a global scale.

As a participant in debates in the 1990s about the Japanese economy and financial system, I was struck at that time by the lack of consensus about this chicken-or-egg question: What should be addressed first, economic recovery or financial repair? I finally decided that the best answer was both! That lesson was not widely agreed then, and it is not agreed now.


Lessons from the Crisis

Based on the lack of consensus about the causes of the crisis, I suspect that, for the next several decades, scholars and policymakers will be debating the many lessons of this specific crisis and whether the right lessons have been learned. Moreover, the list of possible lessons already has filled hundreds of pages of reports.

Against the background of that reality, I have limited myself to 11 lessons grouped under five headings: too good to be true is probably false; be better prepared; the myth of self-insurance; the role of the IMF; and the future of globalization.

Too Good to Be True Is Probably False

From 2003 to 2007, the global economy grew at an average annual rate of 4.7 percent, substantially above the average rate during 1991–2000 of 3.1 percent. (IMF 2008) The average growth rate in emerging and developing countries was 7.4 percent, more than double the 1991–2000 average, and the average growth rate for emerging and developing economies in the Western Hemisphere was 4.9 percent (though 5.5 percent for the 2004–07 period), compared with 3.3 percent for the earlier period.

In April 2007, the IMF's World Economic Outlook projection (IMF 2007) was that global growth would continue in 2007 and 2008 at 4.9 percent, substantially above the previous historical trend. To a considerable extent, the IMF projection was correct. Global growth is now estimated at 5.2 percent in 2007 and 3.2 percent in 2008.5

In April 2008, the IMF (2008) forecasted not only a continuation of these trends into 2008 (3.7 percent) but also into 2009 (3.8 percent), largely because average growth rates for emerging and developing economies were projected to slow only marginally to 6.7 and 6.6 percent in 2008 and 2009, respectively. The IMF forecasters embraced a moderate version of the decoupling story in which growth in emerging and developing countries would not dip substantially but would be insufficient to prevent recessions or very low growth rates in the advanced countries. For the advanced countries, the IMF marked down its forecast for 2008 by 1.4 percentage points from that of a year earlier, while marking down its forecast for the emerging and developing economies by only 0.4 percentage points, and for the Western Hemisphere the forecast was raised by 0.2 percentage points (table 1).6

Table 1 Progression of IMF April forecasts of real GDP


 
Average
Forecast for 2007
Forecast for 2008
Forecast for 2009
Forecast for 2010
 
1991–2000
2007
2008
2009
2007
2008
2009
2007
2008
2009
2009

World
3.1
4.9
4.9
5.2
4.9
3.7
3.2
na
3.8
–1.3
1.9
Advanced Economies
2.8
2.5
2.7
2.7
2.7
1.3
0.9
na
1.3
–3.8
0.0
Emerging and Developing Economies
3.6
7.5
7.9
8.3
7.1
6.7
6.1
na
6.6
1.6
4.0
of which Western Hemisphere
3.3
4.9
5.6
5.7
4.2
4.4
4.2
na
3.6
–1.5
1.6

Source: IMF, World Economic Outlooks published in 2007, 2008, and 2009.

In April 2009, the IMF (2009b) projected 2009 growth of minus 1.3 for the world, minus 3.8 percent for the advanced countries, 1.6 percent for the emerging and developing economies as a group, and minus 1.5 percent for those in the Western Hemisphere, and a tepid recovery in 2010.

What happened? The IMF forecasts were wrong, but they were broadly in line with other forecasts. Very few forecasters successfully predict turning points in the economic cycle, in particular its peaks. The slowdown that was predicted in many of the advanced countries occurred, and for a good number of those countries it was welcomed initially because of rising inflation concerns. However, in retrospect we know that the economic and financial imbalances in many parts of the global economy were much larger and more intractable than almost anyone appreciated in late 2007 or early 2008.

What are the lessons? First, if something is too good to be true, it probably is not true or eventually will not be true. This lesson for macroeconomic policies also extends to policies for the financial sectors in many economies. Policymakers and the heads of financial institutions extrapolated the good times far into the future, often without qualification. In my view, central bankers around the world, at least in retrospect, did not do their job in 2003–06 as effectively as they should have. Whether or not one agrees with that proposition, one lesson of the crisis is that all good things have to come to an end. If the times are extraordinarily positive, and they continue for an extended period, there is a high probability that the end will be painful.

A second lesson is that there was essentially no decoupling. The reduction in growth has not been limited to the advanced economies. The decline from the actual growth rate for 2007 to the growth rate now projected for 2009 is essentially identical for all four groups of countries: 6.5 percentage points for the world on average, the same for the advanced economies, 6.7 percentage points for the emerging and developing economies, and 7.2 percentage points for those in the Western Hemisphere.7 The expected cumulative shortfall from actual 2007 growth rates for the years 2008–10 is 11 percent for the advanced countries and 12.8 percent for the emerging and developing countries in general, as well as for those in the Western Hemisphere (table 1).

The broader lesson of this crisis is that globalization of trade (in both goods and services, such as tourism), finance (in both the availability and cost of credit), and labor (in terms of the direct and indirect demand for labor and the flow of remittances) had tied countries together to a much greater extent than they had been for about a century, since the early 1900s. This reality was underappreciated. The consequence is that in today's world any crisis that affects a major country or group of countries in the global economy or financial system will have some, largely adverse, effects on all other countries. It follows that the citizens and authorities of all countries, large and small, have a common interest in the quality of the economic and financial policies in other countries, in particular in the systemically important countries.

Be Better Prepared

The conventional wisdom is that the global economic and financial crisis began in the United States and essentially was caused by some combination of the economic, financial, regulatory, and supervisory policies in the United States and possibly those in other traditional industrial countries. Conventional wisdom also contrasts this crisis with other international financial crises during the past four decades with their origins in developing and emerging-market economies in Latin America, Asia, or the region dominated by the former Soviet Union. It follows from these two bits of conventional wisdom that the emerging and developing economies should be held blameless for the crisis and that they have been adversely affected by the crisis through no fault of their own policies.

These two elements of the conventional wisdom are respectively incomplete or incorrect. The first bit of conventional wisdom is incomplete because the policies of systemically important countries other than the traditional industrial countries played a role in the crisis, in particular the exchange rate and other policies of countries with very large current account surpluses, such as China and a number of the oil-exporting countries.

The second bit of conventional wisdom is incorrect because many international financial crises of the past four decades had their origins in or linkages to developments in the traditional industrial countries, for example, the stock market crash of 1987, the collapse of the Exchange Rate Mechanism in Europe in 1992–93, and the tightening of financial conditions in 1998. In the current context, the most relevant example was the global debt crisis of the 1980s. That crisis was associated with overly easy macroeconomic policies in the 1970s in the traditional industrial countries, in particular the United States, that contributed to global inflation and the subsequent global recession, after the US authorities learned their painful lesson. The crisis also was associated with inadequate supervision of the lending activities of internationally active banks.

Whatever the merits of the two bits of conventional wisdom, the conclusion that emerging and developing countries should be held blameless also does not follow so neatly. It is true that many countries have been caught up in this global crisis as a consequence of no precipitating policy actions by their own authorities other than endeavoring to participate fully in the global economy and financial system. However, the central lesson of this crisis, as with any crisis of any scale that I have witnessed for the past 40 years, is "be prepared." The better prepared a country is for the foul weather that is inevitable, the more likely that country is to be able to deal with the crisis with a minimum of economic and financial damage.

Being better prepared has two broad consequences. First, a country will be better off in the face of a global crisis if its own vulnerability is limited, for example, if its fiscal affairs are reasonably stable, if its inflation rate is low, its internal and external debt position is sustainable, and if its exchange rate is flexible. Second, a country will be better off, if it has preserved the room to maneuver to respond to external shocks through the use of domestic policy instruments, primarily fiscal and monetary policies.

The good news is that many emerging and developing countries in many regions of the world in 2007–08 found themselves in dramatically better positions to deal with the external shocks associated with this crisis than had been the case in the past. Ask yourself what would have been the impact on countries, such as Brazil and Mexico, if going into the crisis their economic policy fundamentals had looked more like they were in 1982 at the outbreak of the Global Debt Crisis, in 1995 at the time of the Tequila crisis, or in 1997 at the start of the Asian financial crisis. The impacts on those economies would have been much more severe, following from their greater vulnerability to shocks. In addition, a number of the countries would not have had the capacity to adopt countercyclical measures. For most emerging-market and developing countries, this capacity was largely absent in other global economic crises in recent decades. The scope to use countercyclical policies has limited not only the direct negative effects of the crisis on these countries, but also the indirect effects on other countries.

It should be noted that not all countries were equally prepared for the global financial crisis. The policies and circumstances of some countries not only made them vulnerable to contagion, but they also had little or no room to cushion the effects of the slowdown in the global economy, the deleveraging of the global financial system, and the increase in risk aversion. Thus, for example, a number of countries in Eastern Europe and elsewhere have found it necessary to turn to the IMF for assistance designed to support strong programs of economic policy reform that in most cases would have been needed eventually in the absence of this crisis. In some cases, these countries probably would have had their own crises without the contribution of the global meltdown.

A second group of countries, including three in Central America, is in a second category. They have been adversely affected by the global crisis, and their ex ante economic and financial policies and circumstances, while generally prudent, were not sufficiently robust to provide absolute assurance that they would be able to withstand the effects of the crisis. These countries have found it wise to turn to the IMF for precautionary stand-by arrangements, some with high access, that involve adjustments in economic and financial policies, as well as countercyclical measures in some cases, and the possibility of drawing on the Fund if their circumstances worsen.

A third group of countries are those that have applied for IMF flexible credit line (FCL) arrangements: Colombia, Mexico, and Poland. These are countries whose past policy records and current economic circumstances have qualified them for potential financial assistance without the immediate need to make policy adjustments.

The clear be-better-prepared lessons from the crisis are two: First, those countries that were better prepared in advance of the crisis have been better able to deal with its effects. Second, going forward, more countries should endeavor to adjust their policies so that they are prepared, or better prepared, to deal with the inevitable global crises of the future, including through the adoption of countercyclical measures.

The Myth of Self-Insurance

Should countries seek to self-insure against future crises by building up their foreign exchange reserves in order to prepare better for future crises? In my view, this is the wrong lesson to learn from this global crisis. Countries should self-insure against future crises by putting in place as best as they can robust economic and financial policy frameworks. One element of that type of self-insurance should be adequate holdings of foreign exchange reserves, but alone that is insufficient.

Large holdings of foreign exchange reserves provide an expensive buffer against a global financial crisis. They also can lull the authorities and economic agents into a false sense of security while potentially distorting the functioning of the global economy and financial system.

Take the case of South Korea. This country is now classified by the IMF as an "advanced country." In February 2008, its foreign exchange reserves were $264 billion, the fifth largest holdings in the world, equal to 25 percent of GDP and more than seven months of imports. Korea added $96 billion to its reserves in 2004–07. Korea had a current account surplus in each of those years that totaled $54 billion. Net capital inflows accounted for the rest of the increase in reserves.

However, these developments were insufficient to protect the Korean economy from a sharp growth slowdown in 2008 to an IMF-estimated 2.0 percent, a recession in 2009 of minus 4.0 percent, and the prospect of little growth in 2010—a cumulative shortfall from 2007 growth of 15.6 percent. From the start of the global financial crisis in August 2008 through February of this year, the Korean won depreciated on a real effective basis by 36 percent, according to the BIS data. (The depreciation was 24 percent from July 2007.) Although the won has since recovered by about 10 percent, the central lesson is that Korea's massive build-up of foreign exchange holdings did not self-insure that country against severe economic and financial strains as a consequence of the global financial crisis.

The Korean experience points to a second lesson: Gross financial flows are more relevant than net financial flows. Korea's current account surpluses in 2004–07 did not stop it from going into deficit in 2008 as global trade collapsed and prices of imported commodities soared. During the 2004–07 period, in addition to its current account surpluses, Korea had a cumulative net surplus on its external financial account of $46 billion. However, gross capital inflows of portfolio investments and other financial liabilities were $200 billion. As the global financial crisis evolved, those inflows reversed, putting pressure on Korea's exchange rate, reserves, and economy. These reversals have given rise to huge refinancing needs. It should be noted, moreover, that while Korea did not draw on the IMF or apply for an FCL arrangement, the Bank of Korea has drawn on its swap arrangement with the US Federal Reserve, which is the functional equivalent of the FCL. Thus, it was the gross inflows that mattered, not the net surplus on the current account or the net accumulation of international reserves.

Of course, Korea would have suffered more if it had had large current account deficits in the period before the crisis, or if it had held negligible foreign exchange reserves when the crisis hit, but its huge reserve holdings alone were inadequate to self-insure Korea from the crisis. It was the gross financial inflows not the net surpluses that were the warning sign.

The Role of the IMF

A year ago, the International Monetary Fund was on the sidelines of the global financial crisis. Some observers bemoaned that fact. Other observers saw it as proof of the Fund's irrelevance in the 21st century. As the crisis developed, those of us who had been pressing for years for meaningful IMF reform to reestablish its legitimacy and relevance saw opportunity in crisis (Truman 2008). The global financial crisis has produced three major lessons on the role of the IMF for its members, including the developing countries: on financing, on adjustment, and on the global financial system.

On IMF financing, the clear lesson from the crisis for members of the Fund is that the IMF has an important, continuing role in providing potential financing to member governments in precrisis, incipient-crisis, and actual-crisis situations. At the end of September 2008, IMF credit outstanding was $11.5 billion. At the end of May 2009, the figure was $32.5 billion, and more importantly total IMF commitments were $155 billion.

The lesson is that in today's global economy and financial system, financial crises are inevitable. We can hope that efforts to improve the global adjustment process and to implement financial reforms at the national and international level will be successful in limiting the virulence of future financial crises, but that is the most we can expect. Meanwhile, the IMF must have adequate resources to assist its members when crises occur. The days of starving the IMF for financial resources should be behind us.

Fortunately, the G-20 countries and the general membership of the Fund through the International Monetary and Financial Committee have signaled that they have learned this lesson. They have endorsed temporary IMF borrowing of $250 billion. They have endorsed an increase in the New Arrangements to Borrow (NAB) by up to $500 billion. They have embraced the issuance of $250 billion in Special Drawing Rights (SDRs).

However, if the members of the IMF stop at this point, they will not have fully learned the lesson from this crisis. Unfortunately, I expect that, as the economic and financial effects of this crisis wane, IMF skeptics and critics will reemerge and once again renew their campaign to starve the IMF of the financial resources needed to allow the Fund to deal with financial crisis. The challenge for all IMF members and, in particular, for emerging and developing countries will be to overcome this resistance in the context of the accelerated review of IMF quotas and governance arrangements that is to be completed by January 2011. The resulting agreement should contain three major financial elements: a doubling of IMF quotas; the establishment of a presumption that in the future IMF quotas and the NAB will be indexed to the expansion of global economic activity, growth, and financial transactions; and consideration of substantial annual SDR allocations.8

If the IMF's financial role can be solidified for the future in an agreement reached 18 months from now, the benefit to emerging and developing countries as well as all members of the IMF will be substantial. However, in order to achieve this agreement, another lesson from the crisis for the role of the IMF must be learned and applied by its members: improving the global adjustment process.

Achieving an improvement in the global adjustment process must start with a global economic recovery and expansion over the next decade that is better balanced than was the case over the past ten years in which, to cite the usual example, there was too much reliance on demand from the US consumer. The major advanced economies must follow more-responsible fiscal and monetary policies than was the case over the ten years prior to the outbreak of the global financial crisis.

However, improved policies of the major advanced countries (the G-7 countries) will be insufficient by themselves to achieve the necessary balance in an expanding global economy unless other systemically important countries, including the large emerging-market economies, also follow responsible fiscal, monetary, and exchange rate policies. In particular, the latter group of countries must eschew policies directed at building up large foreign exchange holdings via the competitive nonappreciation of their currencies. The pursuit of such policies would distort the global adjustment process and undermine the sustainability of the global expansion.

Thus, the lesson from the financial crisis for the role of the IMF in adjustment is that the members of the Fund must allow the management and staff of the IMF to aggressively promote policies supporting balanced global economic expansion and police the adherence of all members of the IMF to their exchange rate obligations. Moreover, unless all members of the IMF commit themselves to learn this lesson, it will be difficult to reach international agreement to apply the first IMF lesson and ensure the IMF has sufficient financial resources for the future. This points to the need for a grand bargain.

Turning to the global financial system, the overarching lesson for the IMF members is that the financial system is global. As a global institution, the IMF has a major role to play here as well, in cooperation with other institutions such as the Financial Stability Board and the World Bank. Developing countries have a strong interest in the Fund's success in this area. That is one of their challenges. All developing countries have been affected indirectly by the financial tsunami that has swept the global financial system. In addition, a number of developing countries have been directly affected by failures of national and global financial supervision and regulation. For example, the IMF (2009a, 20–21) has detailed the "unwelcome surprises of the global financial crisis" for Brazil, Mexico, and other emerging-market economies with respect to corporate losses on foreign-currency derivative contacts.

Financial supervision and regulation will remain for the foreseeable future predominantly a national responsibility, but with international consequences as we have seen. Successful coordination of those efforts via the Financial Stability Board will benefit all countries. Moreover, the IMF has a major role in monitoring the adherence of member countries large and small to agreed international standards and in exercising surveillance over the stability of national financial systems. That is a major lesson from the global crisis.

In addition, in this area the members of the IMF should reconsider the role of the IMF on capital account issues. These issues include the monitoring of international capital flows gross and net, establishing a better understanding of the role and effectiveness of restrictions on capital movements, and examining the possibility of amending the IMF Articles of Agreement to update the role of the IMF in this area, which currently is somewhere between obscure and ambiguous.

The Future of Globalization

An underappreciated and dangerous area of lessons from the global financial crisis involves the future of globalization. The lesson is: Don't turn back on globalization. I have no doubt that the progress, and I use that word deliberately, of globalization was an important contributor to the scope and scale of the 2007–09 global financial crisis. The growing integration of the world economy via trade, financial, and other channels guaranteed that any economic and financial crisis on the scale that the United States and other advanced countries have experienced would become global in scope. The question is: What lessons are being learned about globalization, in contrast with lessons about the economic and financial policies of the major advanced countries? And are the right lessons being learned?

Statements of global political leaders, for example at the Washington and London G-20 summits, have explicitly rejected rolling back the globalization trends over the course of the sixty years following World War II. By agreeing to new measures to support and enhance the roles of the international financial institutions, such as the IMF, the World Bank, regional development banks, and the Financial Stability Board, the leaders have given substance to their good intentions, though they have not yet delivered on all their promises.

In addition, in G-20 meetings and other forums leaders and ministers have pledged to resist protectionist pressures in trade and finance. In this regard, actions have fallen substantially short of pledges, but the situation could be worse given the collapse of world trade and financial flows and the wrenching effects of the overall crisis on national economies and financial systems around the world.

Many of the lessons that I have outlined in these remarks, if I am correct and if those lessons are learned, would be consistent with a continuation of the globalization trends of recent decades albeit with the application of a substantial amount of mid-course correction. However, there is no assurance that these lessons will be learned.

If these lessons are not learned, then I fear that the course of globalization could well go into reverse. The risk is that the globalization trend will be replaced with inward-focused regionalism, selfish nationalism, and disguised and overt protectionism.

Learning the right lessons from the global financial crisis of 2007–09 is a challenge not only for the leaders of the advanced economies and the larger emerging economies whose policies individually and collectively will determine the evolution of the global economy and financial system over the next several decades. Learning and applying the right lessons is a challenge for the leaders of smaller emerging and developing economies that will have to live with the consequences. Their own words should be clear, and their policies should be examples for all of us. This is the most difficult lesson.


References

Bank of England. 2008. Financial Stability Report, no. 24 (October). London: Bank of England.

IMF (International Monetary Fund). 2007. World Economic Outlook (April). Washington: International Monetary Fund.

IMF (International Monetary Fund). 2008. World Economic Outlook (April). Washington: International Monetary Fund.

IMF (International Monetary Fund). 2009a. Western Hemisphere Regional Economic Outlook (May). Washington: International Monetary Fund.

IMF (International Monetary Fund). 2009b. World Economic Outlook (April). Washington: International Monetary Fund.

Issing, Otmar, Jörg Asmussen, Jan Pieter Krahnen, Klaus Regling, Jens Weidmann, and William White. 2008. New Financial Order: Recommendations of the Issing Committee Preparing the G-20. Photocopy.

Truman, Edwin M. 2008. On What Terms Is the IMF Worth Funding? Peterson Institute for International Economics Working Paper 08-11 (December). Washington: Peterson Institute for International Economics.


Notes

1. See, for example, IMF (2008) for a broader treatment of recent housing booms.

2. The Bank of England (2008) and Issing et al. (2008) offer similar interpretations of the macroeconomic contributions to the global crisis.

3. Decoupling is again fashionable in describing prospects for the global recovery. I think we should have learned our lesson. It is natural that some countries will emerge from recession before others, but that is not quite the same.

4. The latest estimate is that global growth, on a purchasing power parity (PPP) basis, was 5.1 percent in 2007; see table 1.

5. The IMF forecasts that I have used in these remarks are year-over-year forecasts. They tend to obscure the precise timing of underlying trends even for forecasts made in April. However, the broad contours of these forecasts are illustrative of the evolution of forecasts during this period.

6. It is true that these were reductions in the growth rates for 2008 of 1.4, 1.2, and 1.2 percentage points, respectively, from the growth rates that were then estimated for the previous year, 2007.

7. There must be some effects of rounding in these figures because the weighted average of the advanced economies and the emerging and developing economies equals the global economy.

8. It is also essential that the agreement include new revised formula for IMF quotas, a significant redistribution of voting power from the traditional industrial countries to the emerging-market and developing countries, and other governance reforms. However, those issues are beyond the scope of this paper.



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