introduction

It is a great pleasure for me to appear in front of you today to deliver the 2010 Per Jacobsson Foundation Lecture. At the outset, please allow me to express my deep appreciation to the Board of Directors of the Foundation. Thank you very much for this great honor, for allowing me to reconnect with friends and acquaintances here in Washington, D.C., and for deepening a personal tradition that started for me in 1982 when I attended my first Per Jacobsson Lecture.

As someone who has had the privilege to learn and operate in many different cultures and countries, I feel particularly honored to be invited by a Foundation whose purpose is “to foster and stimulate discussion of international monetary problems, to support basic research in this field, and to disseminate the results of these activities.” At the same time, however, I must admit to you that my delight comes with a certain degree of anxiety.

It is intimidating to follow the outstanding people who delivered past lectures and who truly meet the Foundation’s description of “persons of the highest international qualification and eminent experience in the world of international finance and monetary cooperation.” Indeed, I have had the honor over the years to interact with many who have spoken on this special occasion. Having also worked directly with some of them—including Abdelatif Al-Hamad, Michel Camdessus, Andrew Crockett, Jacques de Larosiere, Stan Fischer, Alan Greenspan, Guillermo Ortiz, Raghu Rajan, and Larry Summers—I can tell you with a high degree of confidence that I am a negative outlier: the left tail of the distribution if you like! (And you will hear me talk a lot today about distributions and their tails.)

Given this reality, what could I possibly contribute to such a prestigious gathering?

My hope is to share with you an analysis of the global economy based on a rather eclectic approach that combines academic and policy dimensions with the daily realities of working at an investment management firm that is deeply involved in global financial markets. My presentation will be based on three (hopefully familiar) contextual hypotheses:

• First, the international monetary system suffered a “sudden stop” two years ago¹—a cardiac arrest if you like—the adverse impact of which is still being felt today by millions, if not billions, of people around the world.

• Second, the causes of the crisis were many years in the making and included balance sheet excesses, risk management failures at virtually every level of society, antiquated infrastructures, and outmoded governance and incentive systems in both the public and private sectors.

• Third, the dynamics coming out of the crisis management phase— particularly the combination of deleveraging, reregulation, debt overhangs, and structural challenges in key industrial countries—are interacting with an accelerating secular realignment of the global economy to create what U.S. Federal Reserve Chairman Ben Bernanke correctly called an “unusually uncertain outlook.”²

In this context, my presentation will ask a simple, yet critical, question about the disappointing effectiveness of postcrisis responses by both the private and public sectors in industrial countries: Why have outcomes consistently fallen short of expectations, and what are the implications?

In responding, I will refer to three specific examples which shed light on the ongoing dynamics complicating both policy and company responses.

They are consequential for more than just what is being considered when it comes to appropriate reactions; they also matter for the how and why.

They speak to challenges that were inadvertently misdiagnosed while others were placed in the wrong context or subjected to excessive operational restrictions. They also shed light on the view that the world has been ill served by the understandable, yet regrettable, temptation of using short-term mean reversion as shorthand for thinking about economic and financial dislocations.

The result is simple yet disturbing. While industrial countries did well in the crisis management phase (think in terms of “winning the war”), they have not done as well in the postcrisis phase (and, thus, are not succeeding in “securing the peace”). Consequently, too many industrial countries find themselves in a rather unsettling situation in which expectations involve an unusually broad range of potential outcomes and equally unusually high risks.³ Increasingly, comforting images of normally distributed (bell curve) expectations—characterized by a dominant mean and thin tails—have given way to much flatter distributions with much fatter tails.

I will argue that this change is insufficiently recognized, even though it is a direct outcome of the three generally accepted hypotheses just cited. Indeed, an unusual aggregation problem persists today: Multiple visible structural changes on the ground are not being sufficiently aggregated into an acknowledgment of the ongoing paradigm shift and in the formulation of appropriate responses—particularly, though not exclusively, in industrial countries.

Recognition is the first part of meaningful course correction—thus the objective of this lecture. And there is much at stake for the global economy.

The longer the recognition problems persist, the greater the risk of continued “active inertia” and disappointing outcomes. The possibility of policy mistakes and business accidents will increase further, it will become harder for industrial country governments to convince their citizenry (as well as decision makers in emerging economies) to participate fully in the formulation and implementation of the required solutions, and multilateral institutions will not be able to fill the growing void at the core of the international system.

the anatomy of a global financial crisis

postcrisis realities

Crisis management is hard, very hard. Leaders must act urgently, and with only partial information. Policy imagination and boldness are needed to overcome malfunctioning transmission mechanisms. There is often little time to create the broad social consensus that is required for strong support of the legitimacy of the policy response, let alone time to make the midcourse corrections which are inevitably required.

In the postcrisis phase, societies must also deal with the unintended consequences of the crisis management period. Inevitably, policy responses are second-guessed. Fairness issues feature more prominently. And the initial policy convergence formed in the midst of the crisis gives way to fragmentation and excessive political brinksmanship. Indeed, governments are often replaced by an electorate that is seeking greater accountability for the crisis.

Much of this has come as a surprise to industrial country societies. Indeed, the whole transformation of unthinkables/improbables into facts on the ground has been unsettling.

Ironically, little of this would constitute news for emerging economies that have faced several financial crises of their own. Yet it has come as a surprise to too many in industrial countries. Indeed, there has been a distinct resistance among many policymakers to apply “emerging markets lessons” to some of the challenges their countries are facing— despite the important insights that such an approach can, and has, provided.

The recent global financial crisis has also left an important balance sheet legacy. In particular, many industrial countries did not have sufficiently sound initial conditions to accommodate the massive use of public sector balance sheets.

Related concerns about debt and deficits have added industrial country sovereign risk to an already substantial list of systemic concerns—a list that includes (still) overly leveraged balance sheets elsewhere (albeit not to the same extent as before), unacceptably high and persistent unemployment, regulatory uncertainty, and political complications (namely, a situation in which the economically desirable is not politically feasible, and the politically feasible is not economically desirable).

Fragilities are also evident at the global level. As countries’ circumstances evolve differently postcrisis, the delegation of national authority upward to multilateral institutions and groups has become difficult once again, especially as strong and credible global governance mechanisms are still lacking.

Sustaining a high degree of global coordination (or, if you are less charitable, maintaining a high level of “correlated actions”) beyond the immediacy of a crisis is inherently hard—a reality that adds to the complexity of postcrisis periods. Indeed, the narratives at this weekend’s Annual Meetings—particularly on “currency wars” and IMF Board representation—are a vivid reminder.

Sadly, a once-promising global response has now been replaced by inadequately coordinated national economic policies and growing frictions among countries. Moreover, with an oversimplification of the debates (e.g., “austerity now” versus “growth now”), obsession with corner solutions has tended to obfuscate the critical policy nuances in play.

It is not surprising that the impressive degree of global coordination highlighted by the April 2009 G-20 meeting did not last long. It only took a few months for that moment of extraordinary collaboration to give way to solely domestic agendas.⁷ Indeed, and ironically, it is precisely the success of globally coordinated policies which has allowed countries the luxury of returning so quickly to the pursuit of overly narrow national agendas. In the process, the world has lost both consensus and common analysis.

the situation today

In the course of the second and third quarters of 2010, it became clear to many that both policymakers and markets had wrongly extrapolated a cyclical bounce in industrial countries, erroneously concluding that the apparent recovery had developed secular and structural roots. Today, policymakers in industrial countries—and especially in the United Kingdom and United States, where a large bet was made on finance—find themselves facing an important set of challenges on the “bumpy journey to a new normal.”

We coined the term “new normal” at PIMCO in early 2009 in the context of cautioning against the prevailing (and dominant) market and policy view that postcrisis industrial economies would revert to their most recent means.⁸ Instead, our research suggested that economic (as opposed to financial) normalization would be much more complex and uncertain—thus the two-part analogy of an uneven journey and a new destination.

Our use of the term was an attempt to move the discussion beyond the notion that the crisis was a mere flesh wound, easily healed with time. Instead, the crisis cut to the bone. It was the inevitable result of an extraordinary, multiyear period which was anything but normal.

Also importantly, the new-normal concept was not an attempt to capture what should happen. Instead, the concept spoke to what was likely to happen given the prevailing configuration of national and global factors— some of which were inherited, and others that were the consequences of the choices being made. Put another way, the new normal postulated the world that would evolve absent a significant change in policy and business approaches.

It is a world of muted growth in industrial countries and stubbornly high unemployment—one where the private sector continues to deleverage, public finances become more of a concern, and reregulation replaces deregulation. And all this takes place in the context of an accelerated migration of growth and wealth dynamics from industrial to emerging economies.

Little did we know that, after almost a year of acute skepticism from markets and policy circles, the new-normal concept would catch on so widely. (And, in doing so, it now means many different things to many different people!)

Researchers—particularly Carmen Reinhart and Ken Rogoff—have produced admirable and comprehensive empirical work that supports the view of a protracted and complex recovery process.⁹ Others, like Warren Buffett, have found elegantly simple yet powerful ways to convey this reality. Two weeks ago he noted that the United States “had a huge, huge wound. . . . It takes time for wounds to heal, regardless of how good the care is.”¹⁰

The new-normal challenges faced by industrial countries are the outcome of two interrelated phenomena: first, a multiyear process of massively going structurally out of balance, as illustrated by excessive consumption in industrial countries, leverage-fueled asset bubbles, inadequate risk management and incentive structures, and disruptive accelerators in the form of ill-understood financial innovations; and second, the aftermath of large balance sheet destruction, part of which remains obfuscated even today by accounting issues. Their interactions were accentuated by ongoing global realignments.

The symptoms of these challenges include muted economic growth in industrial countries, persistently high unemployment which is increasingly structural in nature, continuous private sector deleveraging, large public sector deficits and debt, regulatory uncertainty, and a much greater influence of politics on economics. They also show up in the accelerated migration of growth and wealth dynamics to the emerging world.

The resulting dynamics are both unusual and unsettling for industrial societies.¹¹ As such, they also affect the way in which society thinks about the future. Indeed, we are increasingly coming across some noteworthy changes both in the pattern of expectation formation and in behavior.

When it comes to expectation formation, the predominance of regularshaped (bell) distributions is giving way to flatter distributions with much fatter tails. These flatter and fatter distributions are a reflection of the “unusually uncertain outlook” that is part of a paradigm shift. In some cases, they are even inverted. (As an example, witness the inflationary expectations chart included in a recent Bank of England Inflation Report)¹²

We are also witnessing interesting changes in expectations about the well-being of children and grandchildren. It is no longer unusual to come across surveys in industrial countries that speak to concerns that future generations may struggle to attain the standards of living of the current generations. Meanwhile, the opposite trend is increasingly evident in systemically important emerging economies. There, a growing number of people now believe that their children and grandchildren will have better lives than themselves.

Behavior is also changing, with companies and households in industrial countries embarking on a greater degree of “self-insurance”—again a phenomenon that is familiar to emerging economies but much less so to rich societies where the pooling of insurance dominates. For example, witness the unusual amount of cash that U.S. companies are hoarding on their balance sheets, and note the extent to which U.S. households are derisking their portfolios by continuously selling equities to go into cash and bonds.

All this is happening in a society in which cash has usually burnt holes in the pockets of companies and individuals. It is also taking place in the context of almost confiscatory interest rates and massive attempts by public sector agencies to entice the private sector into taking more risk.

The possibility of a world of persistently low nominal returns, including through unusually low interest rates, has its own complications. Think of the range of promises that have been made on the assumption of higher nominal interest rates and return. These are particularly visible in the pension and insurance industry. And while most are supersecular in nature, their impact could start to be priced in much earlier.¹³

We will come back to the implications of all this—and they are important. In the meantime, it is imperative to better understand why this situation has occurred. To this end, it is worth thinking about three previous unthinkables and/or improbables for industrial countries: the importance of debt overhangs, the degree of structural change, and the extent to which financial normalization can complicate (and not just facilitate) economic normalization.

These three factors shed tremendous light on the challenges that industrial countries face. They also explain why policy has been so frustratingly ineffective. And they illustrate the growing tension between economics and politics. Indeed, think of them as pointing to blind spots in policies and markets that can and should be addressed, especially as their adverse consequences can be with us for several years.

looking forward

The analysis suggests that the global economy is again at a critical juncture.

Having averted a crisis-induced depression, industrial countries are now losing the recovery momentum. If they are not careful, they risk slipping into a lost decade of low growth, high unemployment, and welfare destruction. In addition to its direct adverse effects on global growth and trade, such a slippage would complicate the challenge that key emerging economies face internally in managing their development breakout phase.

To minimize these risks, industrial country societies must go beyond thinking of what to do; they must also consider the how and why. Absent such a shift, active inertia will continue to dominate, instrument innovation will become even more elusive, and the private sector will continue to respond through higher self-insurance and greater deleveraging.

Income distribution issues (and other compositional aspects) will also require more urgent attention—within current generations, as well as between current and future generations. And the political system will find it even more difficult to coalesce around a holistic response, aggravating polarization and prompting additional piecemeal and reactive policy measures.

The onus is on national governments to minimize these risks. They can, and they should.

Industrial countries face the hardest challenges, requiring bold steps by policymakers, companies, and households.²⁴ Systemically important emerging economies are also part of the solution to what ails the global economy. Structural reforms are key to sustaining higher consumption by an emerging middle class that, in several cases, saves a remarkably high fraction of its income to offset deficiencies elsewhere.

Yes, most of the heavy lifting must be done at the national level. Having said that, multilateral institutions can (and should) play a much more important role. This aspect is the focus of the final part of this lecture.

Those interested in a better global outlook should look to credible and well-functioning institutions to play a greater role in informing and influencing the design and implementation of globally consistent and reinforcing national policies.

My thinking in this regard is educated by the 15 years I spent here in Washington at the IMF and the time I have closely followed the institution since then.

The average quality of the staff is remarkable. The institution is capable of producing path-breaking analytical insights—and not just in regular publications (such as the World Economic Outlook and the Global Financial Stability Report), but also through single-topic research (such as the recent analysis of the influence of debt and deficits on interest rate formation in industrial countries).

The IMF is still the best place for centralizing country experiences, exchanging best practices, and providing a safe forum for policy exchanges.

The institution’s virtually universal membership gives it unmatched access to countries, including under members’ Article IV obligations (which translate into periodic—usually annual—checkups by IMF staff, management, and the Board).

Simply put, the IMF is uniquely placed to be the trusted advisor.²⁵ It is also among those best placed to put together the pieces of the new normal and derive action plans that can be discussed, implemented, and monitored. Yet the institution continues to fall short in sufficiently facilitating the required level of international coordination of policies and in hard-wiring a meaningful peer review process that is viewed as credible, fair, and effective.

Some progress has been made in recent years to address the longstanding deficiencies. Witness the retooling of staff to ensure that the traditional focus on economic issues is supplemented by a better understanding of financial markets; attempts to enhance, albeit at the margin, emerging economies’ voice and representation; the large increase in the Fund’s financial resources; and efforts to improve governance and develop a more robust internal income model.

This progress is important. Yet unfortunately, the IMF is still not where we need it to be to fill the growing vacuum at the center of the international system. The longer this gap persists, the greater the risks for the global economy.

Then there is the even more complex issue—the nature of the IMF’s political mandate. This issue will likely involve discussion on the G-20, whether in its present form or reformed, and it will require a degree of trust and interaction between the two that is not yet visible to outsiders.

concluding remarks

Two years ago, policymakers from around the world gathered here in Washington, D.C., and recognized that the world was on the verge of an economic meltdown. Together they initiated an impressive set of measures, showing a commonality of purpose, narratives, interests, and actions. The private sector also responded as companies and households took steps to navigate the sudden stop in global financial flows. The war against a global depression was won.

History books will report with admiration on the crisis management phase. Unfortunately, they will be a lot less generous when it comes to the postcrisis period.

Having won the war, industrial country societies are failing to secure the peace. Indeed, absent some important midcourse corrections, industrial countries confront the prospects of low growth; high unemployment that is increasingly structural in nature; welfare losses, including a growing number of citizens falling through the large gaps created by overly stretched safety nets; and a rising risk of protectionism.

This dichotomy between winning the war and securing the peace is an important one. It points to shortfalls in diagnosis, inappropriate operational constraints, and the fact that structural and balance sheet imbalances that were years in the making cannot be overcome immediately. It is about what is likely to happen, rather than what should happen, and it speaks to the urgent need for a more common analysis and recognition of the unpleasant yet inevitable political trade-offs that have to be made in the policy world of second and third best.

It also reflects an excessive intellectual reliance on shortcuts, including short-term mean reversion. An important part of the disappointing postcrisis outcomes is due to the high degree of active inertia that dominates industrial countries, including difficulties in shifting from a cyclical mind-set to one that also acknowledges issues pertaining to national and global paradigm shifts and debt overhangs.

It is increasingly urgent for industrial societies to move beyond cyclical responses by also taking a longer, more secular view. Multilateral institutions can and should play a more important role in helping to navigate this critical transition. But to translate the possible into the probable, these institutions must step up their efforts to deal with long-standing, well-known problems—and do so by going well beyond the current measured pace.

In closing, we should not forget the insight of the philosopher Lawrence Peter Berra. Mr. Berra, a legendary baseball player and manager—and better known by his nickname “Yogi Berra”—once said, “The future ain’t what it used to be.”²⁶ Let us all hope that the global economy responds to this reality with the required degree of courage, imagination, purpose, and steadfastness that it displayed in dealing with the global financial crisis.

Thank you for your attention, and for the wonderful opportunity to be with you today.