The state of the world economy

Olivier Blanchard interviewed by Romesh Vaitilingam, 05 November 2010

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<p><em>Romesh Vaitilingam&nbsp;interviews&nbsp;Professor Olivier Blanchard&nbsp;for Vox</em></p>
<p><em>November 2010</em></p>
<p><em>Transcription of an VoxEU audio interview []</em></p>
<p><strong>Romesh Vaitilingam</strong>: Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam, and today's interview is with Professor Olivier Blanchard, who is currently Economic Counselor and Director of the research department at the International Monetary Fund. Olivier and I met in London in early November 2010, where he was delivering the first in a series of lectures to celebrate 21 years at the Centre for Economic Performance at the London School of Economics. His lecture was entitled, &quot;The State of the World Economy&quot; and I began by asking him about progress on the two rebalancing acts that the IMF has called for on the world economy.</p>
<p><strong>Professor Olivier Blanchard</strong>: First, I think there's a question of whether that's the way to think about things. And we introduced that way of thinking maybe a year and a half ago, and I think it has turned out to be very, very useful. In short, to caricature, we were in a world in which US consumers were spending too much, and this had all kinds of implications for the current account deficits of the US, the current account surpluses of other countries and so on, and they are now largely gone. And the result is that the world has to rebalance in many ways. Hopefully, they're not going to go back to their old ways, which would be very good in the short run but surely an issue in the long run.</p>
<p>And so this implies two things, right? What we call internal rebalancing, which is that, as private demand went down, the governments just came in, increased spending, decreased taxes. But it cannot go on forever. So you basically need to increase private demand and slowly phase out fiscal. So that's the internal rebalancing, which is very important in advanced countries, right?</p>
<p>But that's not enough, because private domestic demand in a country like the US is not going to go back to anything like what it was before. If US consumers spend less of their income, housing is going to be dead for a long time. And so the demand has to come from somewhere else. It has to come from higher net exports. Or another way of saying it is the current account deficit of the US has to decrease, which means that the current account surplus of the other countries has to increase.</p>
<p>There is this identity, which is very unpleasant but we have to deal with. And so this is the external rebalancing, which is, in general, the way the world will get back to health is by having this rebalancing of demand, which means a change in exchange rates, an appreciation of many emerging market surplus countries, and a depreciation of the deficit countries.</p>
<p>So these are the two processes, right? And the hope is that they just happen, and the world gets back to shape and things are fine. The problem is it's happening slowly, maybe not terribly surprisingly. So if you look at internal balance, getting consumption up to reasonable levels is hard because many people are still constrained. Housing, as I said, in a number of countries, is a mess, so housing investment is very weak. So there is only so much you can do. And the result: private demand is not growing very fast, which means it's very difficult to do fiscal consolidation without taking the risk that growth is going to stop, which would be bad.</p>
<p>So, on internal rebalancing, it's fairly slow. What could save things would be the external rebalancing happening faster. But again, here there are many constraints. China probably wants to rebalance, but it wants to do it slowly. It doesn't want to do it all in 2011, which is what the rest of the world would dream of. It surely intends to do it over 2011 to 2015, 2020. I think it's serious about doing it, but it's happening at a relatively slow speed.</p>
<p>So the question is, in terms of policy, can we do things to increase private domestic demand and, therefore, be able to consolidate a bit faster? And can we basically accelerate the process of the external rebalancing? I think these are the challenges.</p>
<p><strong>Romesh</strong>: We can come back, perhaps, to these broad, global issues, but it might be very helpful if you could outline the three big regions, for the US, Europe, and the emerging markets, what the state of things are at the moment, if we could perhaps start off with the US, which has a very interesting position. Yesterday the election results, clearly a reaction to the bad economic data there, very high levels of unemployment. And then, at the same time, we've got the Fed embarking on a second round of quantitative easing.</p>
<p><strong>Professor Blanchard</strong>: The US is the country which probably had misbehaved the most before the crisis, so that not only are there effects of the crisis, but there are things which happened before the crisis which have to be corrected. So this is really a country in which, again, private domestic demand, consumption in particular, just is very slow. And so that's what they are fighting, and the result is we expect growth to be such that unemployment remains basically, more or less, constant. So for the US, that's the big issue. The other issue is fiscal consolidation. What we think countries should be doing is not necessarily to consolidate a lot today but put in place plans which credibly get you to some stable level of debt. The US really had not done that very much until now, and it's not going to be easier as a result of the elections. So these are the uncertainties for the US.</p>
<p>Europe, in some ways, is in better shape, in the sense that in most countries consumers had behaved decently. In many countries, the housing problem is less serious. So in principle, private demand could become stronger. I think a country like Germany, was actually - there had been no crisis - was on the verge of a very strong expansion, and I think we're seeing signs that this may actually happen.</p>
<p>So these are reasonably good news, although, in general, even when Europe is in good shape, the rate of growth of Europe is not very impressive. But going to that or a bit higher seems reasonable, except that Europe has this problem in a number of countries. Greece, Portugal, Ireland have very a serious competitiveness problem, a very serious fiscal problem.</p>
<p>And I think they have all embarked on very ambitious adjustment programs. But reestablishing competitiveness within the euro is tough, and so there are going to be many years, and probably a few bumps along the way. The worry is that the bumps not only affect the country, which they may well, but affect Europe in general, and maybe even the world. So I think that's the issue.</p>
<p>Emerging market countries are facing a different set of issues. Putting all of them in the same basket is probably not right. Asia is basically back to potential, to their own path, signs of even overheating. Latin America is not very far from that. In general, emerging market countries are nearly back to their old output trend.</p>
<p>And there the urgent question is how to handle the capital flows. Now, again, these countries need an appreciation. They need to rebalance, increase domestic demand, decrease their reliance on exports. It varies across countries. It's clearly most relevant for China.</p>
<p>So they have to accept some appreciation, but they are worried that these capital flows, which are triggered both by fundamentals and by interest rate differentials, may happen much too quickly and much too strongly, and they are very reluctant to let the exchange rate appreciate a whole lot, which I understand. So their problem is a bit different. It's to avoid overheating, control capital flows, and try to avoid bubbles and various other things which may happen.</p>
<p><strong>Romesh</strong>: Can we talk about the issue of fiscal consolidation and its relationship with growth? Because this seems to be one of the most contentious areas in economic discourse at the moment, the question of whether fiscal consolidation can be expansionary or whether it's going to be contractionary, and when you should be implementing the austerity packages in a country to deal with the public debt issues.</p>
<p><strong>Professor Blanchard</strong>: There is no question that the deficits were needed, or at least the fiscal stimulus was needed when it was done. But there is also no question that this had led to levels of debt, not so much the stimulus but the fact that output is far below potential for a long time, which implies that there has to be fiscal consolidation. Now, could it be that consolidating today is going to be expansionary? I think the reasonable answer is, in general, no. There are a few cases. There are cases in history which have been well documented: Denmark, Ireland. If you start with a risk premium, which is, say, 1, 000 basis points, and you put in place a program which convinces markets that it's going to be OK, then with a bit of luck, your interest rate goes down by 1,000 basis points. Well, that can help a whole lot, right?</p>
<p>So there are cases where you're basically so close to the abyss that you do something and people say, &quot;OK, it's not going to be the end of the world. It's going to work.&quot; Then you may actually have expansionary effects, even in the short run. But this is the case for very few countries at this point. So when a country like the UK does it, it doesn't start with a large risk premium. It may reassure people that the future is brighter, but in the short run, it's probably going to affect aggregate demand in a negative way.</p>
<p>I think that has to be accepted. Then the question is, how much do you want to consolidate now? The point that you made at the front is the important thing is, again, to reassure markets. So it's much more to put in place what we've called a medium term credible plan. Maybe we don't do a whole lot today, but we put in place all kinds of rules and changes which, five years from now or 10 years from now, will make that stable and maybe lower. That's the way to go. Once you have this in place, then you probably have a bit more leeway at the short end.</p>
<p><strong>Romesh</strong>: The crisis that we're, I guess, still in began in the financial sector, and the IMF have talked about the need for financial repair and then for financial reform. I'd be interested in your reflections on where we've got to in terms of that process. Have we done the repairs, and are we making enough progress with the reforms?</p>
<p><strong>Professor Blanchard</strong>: I think we've made some of the repairs, but there are clearly places where more repairs are needed, and some banks are still under capitalized. The housing situation in the US, with a very large number of people underwater, is a big issue. It really is leading to an overhang and very little spending by these people. So repairs have taken place. Capitalization has improved. So we're not there, but I think progress is being made.</p>
<p>On reform, it's infinitely complex. I don't think we understood exactly how regulation interacted with decisions of banks. We clearly have learned a lot. But what regulation to put in place is not clear. I think that Basel III has a kind of simpleminded approach to it, which is the right one, which is increase capital ratios and, if everything goes well, increase liquidity ratios. These are rough tools, but we kind of understand how they work. We can probably do much more refined work. Let's also explore various ways.</p>
<p>We're going in that direction. I think various countries are going to explore different things. It's going to take many years, I think, before we converge on either one way of doing it or a few ways of doing it and knowing what we're doing. So it's happening.</p>
<p><strong>Romesh</strong>: You said that a key part of the rebalancing globally is about currencies appreciating and depreciating against one another. But of course, a lot of talk at the moment is about countries getting very defensive about that and getting involved in currency wars, wanting to protect their currencies, either to keep them from rising too much or keep them from falling too much. Where are we on these currency wars? Do you feel they are a real threat to getting a proper global policy coordination to tackle these global problems?</p>
<p><strong>Professor Blanchard</strong>: I think, first, words matter. It's not a very good idea to use the word. I don't think it's a war in the sense that there's one winner and one loser. I think that, basically, there can be only winners. The question is how to achieve that. And as I've said before, we are in a world in which there is a need to readjust parities. And in general, emerging market countries should appreciate, not all of them, but many of them, and then the advanced countries should depreciate relative to them. That has to happen. And the question is how to do this in an orderly way. Now, the capital flows are going in the right direction. They are going, typically, to the emerging surplus countries. But again, they are happening at a rate which is such that these countries are scared.</p>
<p>So I think the solution there is to say, &quot;Look, some appreciation is needed. You have to accept it. You have to basically take the structural measures which will make it work.&quot; But if the flows become too large, then it is understood that other measures can be taken. So it can be macro prudential measures, restrictions on foreign exchange borrowing, for example, or it could be some form of capital controls. I think we just have to define the rules of the game. And if we do, which I hope we do, then I think everybody can be&nbsp;better off.</p>
<p><strong>Romesh</strong>: And where are we, generally, in terms of global policy coordination, in terms of the institutions of the international economy that bring countries together to try and work out solutions collectively rather than to fall into dangers of talking about wars, for example?</p>
<p><strong>Professor Blanchard</strong>: I think we're in a much better place than we were before the crisis. But it was easier during the acute phase of the crisis because, in a way, most of the countries had to do the same thing, where now it's clear that there are these relative price adjustments, and some countries feel that they are reluctant to do it, at least at the speed at which the markets force them to, and so and so on. So we are now seeing more disagreement as to what needs to be done. I still think the G20 process is incredibly useful in showing how it can be done. Now, whether it is actually done, whether the G20 agrees on everything, or at least on a set of things, we'll see. But I think the process is incredibly useful in terms of mutual understanding, agreeing as to what needs to be done, agreeing about what we disagree about. So I see it every day. I think the discussion is infinitely more productive than it was; there was no discussion, in effect.</p>
<p>Now, again, it's very hard to agree. So in most of these meetings, decisions are taken in the 11th hour, or the 12th hour, or the hour. After that, we suspend the clock! So one cannot predict what will happen at the next one. But in general, I think the process is very useful, and I hope very much that it continues.</p>
<p><strong>Romesh</strong>: Final question, Olivier. I'd be interested in your reflections on the state of macroeconomic research and macroeconomic analysis. The profession has come in for a lot of flak following the crisis. Where do you think it now stands?</p>
<p><strong>Professor Blanchard</strong>: What I would say is, clearly, macroeconomics had understated, that's a fairly obvious statement, the importance of financial plumbing.</p>
<p>If I think about myself, I'm happy to criticize myself in that case. For me, finance was a set of arbitrage equations. The Fed would choose a policy rate, and then there would be some kind of term structure relation which would determine the long rate, and then there would be risk premia which basically would determine the other rates, and then some PDV equation which would determine the stock market, and then maybe bubbles. And the notion that there were banks involved and they had balance sheets and all that stuff, I thought, &quot;Look, I don't have time to waste. Let me just ignore.&quot; And I think what we've learned is the plumbing is terribly important. The notion of leverage, which I'd not thought about, is terribly important. We clearly missed the implications of finance for macro, and I think that it's true of me, but I suspect it's true of many people who had understood it, who are more on the margin or outside macro. I think some of the people in corporate finance had understood it. They had not always drawn the macro implications, but they have made much progress.</p>
<p>Beyond this, should we start from scratch in macro? No. Basically, I find that I now have a much better understanding of plumbing. And I find that what I would call that elaborate version of the Mundell Fleming model really helps me enormously when I go around the world. Now, does this mean that I'll only use pre 1975 macro? It's not true. I think there are many phenomena which I understand better as a result of recent theoretical developments. All the stuff about precautionary saving, precautionary behavior, option value of waiting, all these things were absolutely central in the crisis.</p>
<p>So, I don't think macro is in terrible shape. I think we just have to extend it. We could have done better. We'll do better.</p>
<p><strong>Romesh</strong>: Olivier Blanchard, thank you very much.</p>
<p><strong>Professor Blanchard</strong>: Good. It was a pleasure.</p>

Topics:  Global crisis Global economy

Tags:  fiscal consolidation, financial reform, Currency wars

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