Chapter

Chapter 10. A Roadmap for Collective Action

Author(s):
Hamid Faruqee, and Krishna Srinivasan
Published Date:
August 2013
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Author(s)
Krishna Srinivasan, Hamid Faruqee and Emil Stavrev1 

The sources of external imbalances in the run-up to the financial crisis vary widely across the seven systemic economies studied here, largely reflecting factors that have led domestic saving behavior to differ significantly. The case studies indicate that global imbalances have been driven primarily by saving imbalances—generally too low in advanced deficit economies and too high in emerging surplus economies—owing to a combination of equilibrium factors (demographic patterns), structural weaknesses, and domestic distortions. This implies that corrective steps at the national level as discussed in each country chapter—as part of collaborative action to address structural impediments and underlying distortions—will be needed to better support G20 growth objectives.

Understanding Imbalances

In a nutshell, as shown in Figure 10.1, current account deficits before the crisis reflected low public and private saving (United Kingdom and United States) or low public saving, which was partly offset by high private saving (France and India). Surpluses, on the other hand, reflected high national saving, owing in particular to exceptionally high private saving that exceeded high private investment (China) or to positive private saving–investment balances owing to high saving and low investment that has offset high or modest public dissaving (Japan and Germany).

Figure 10.1Elements of Imbalances

Source: IMF staff estimates.

Note: Countries circled denote those with current account deficits.

Abstracting from the financial crisis—which adversely affected budget balances in all countries—a variety of structural and equilibrium factors reflecting country circumstances have driven public saving behavior. These will need to be addressed to reduce external imbalances and bolster public finances. In particular, factors underpinning fiscal deficits include:

  • Persistently low growth (making it difficult to balance the budget), reflecting a decline in productivity, a shrinking labor force, and low investment, as well as the needs of a rapidly aging population (Japan);

  • Structural imbalances between tax revenues and spending commitments prior to the crisis, underfunded entitlement obligations, the lack of agreement on fiscal adjustment priorities, and the lack of fiscal rules and strict enforcement mechanisms to impose sufficient budgetary discipline (France, United Kingdom, and United States).

  • Political economy considerations exerting strong pressure on spending and resistance to raising taxes (India, Japan, and United States), a weak revenue system, and financial repression (India).

At the same time, domestic policy distortions (defined broadly as factors that impede a market from equilibrating) have also played an important role in driving imbalances. Distortions, for example, have helped fuel public dissaving in some emerging deficit economies. In India, tight financial restrictions have allowed the perpetuation of large fiscal deficits.

Distortions in financial systems have fueled low private saving and large current account deficits. Weak private saving–investment imbalances before the crisis, reflecting underlying problems in financial sectors, have played a role in fueling current account deficits in major advanced economies, notably the United States and United Kingdom. In particular, distortions in the financial system pertaining to regulatory and supervisory frameworks were partly responsible for a fundamental breakdown in market discipline and mispricing of risk (reflected in credit and housing booms) and contributed to a widening of external imbalances. In the United Kingdom, constraints on the supply of housing precluded a construction boom but further fueled a house price boom, which, in turn, contributed to low household saving and high private debt.

High national saving in China reflects significant underlying distortions. Policy distortions or gaps—reflecting inadequate social safety nets, restrictive financial conditions, an undervalued exchange rate, subsidized factor costs, limited dividends, and lack of competition in product markets—have underpinned exceptionally high national saving and, in turn, current account surpluses in China. Large current account and balance of payment surpluses have led to massive reserve accumulation in China (and elsewhere),2 contributing to the low-cost financing of U.S. current account deficits.

Weak investment in some advanced economies also reflects policy distortions. Modest external surpluses in Japan are a result in part of favorable private saving–investment balances (e.g., demographics), but distortions have also contributed, as private investment growth (particularly by small and medium-sized enterprises) has remained weak, while corporate saving has remained large. Similarly, for Germany, large external surpluses reflect, in part, favorable private saving–investment balances, but distortions in the financial sector may be a drag on domestic investment.

Policy Implications

Broadly speaking, saving imbalances—too low in major advanced economies and too high in key emerging surplus economies—imply that policymakers need to proceed with a greater sense of urgency to facilitate dual rebalancing acts: a hand-off from public-demand-led to private-demand-led growth in major advanced economies; and a shift from growth led by domestic demand toward external demand in major advanced deficit economies, and vice versa in major emerging surplus economies. Overall, external rebalancing has been modest, partly due to the global recession and insufficient policy effort. To facilitate better adjustment, efforts will be needed to tackle the underlying distortions that are the reason for high saving in some surplus members.

Actions on several fronts would facilitate greater rebalancing of global demand to support growth and enhance welfare. Specifically, as detailed in the case studies, policies tailored to individual country circumstances and aimed at addressing underlying distortions are needed to facilitate the dual rebalancing acts and to anchor countries’ growth objectives. On a broad level, two key actions, among others, are needed:

  • Appropriately timed and paced fiscal consolidation across major advanced economies, including France, Japan, the United Kingdom, and the United States, as well as in India, to reduce persistent deficits, create policy space, and anchor sustainability. This is currently in progress in many of these economies. Fiscal consolidation will, however, depress growth in the near term. Hence, closing the output gap will require complementary policies through greater G20 collaboration (see below).

  • To offset weaker demand in major advanced partner countries, increased internal demand elsewhere, notably China (and other surplus countries) to support domestic and global growth. This will require lower national saving in China, notably by reducing the distortions that have kept saving exceptionally high. To avoid overheating, China’s net exports will have to moderate, implying a lower current account surplus. There is also room to bolster domestic demand by reducing private saving–investment balances in Japan and Germany, particularly by lowering corporate saving and boosting investment by reducing distortions.

Collective Action

Against a backdrop of weaker global growth and heightened downside risks, there is an urgent need for stronger and more complementary policy action by the G20 membership to secure economic expansion. As highlighted by the country case studies, assessments of imbalances indicate the need for domestic policies and strengthened collaborative action to anchor growth over the medium term and to avoid damaging setbacks to the recovery. Thus, an “upside scenario” is developed that brings together these elements. While G20 baseline policies have strengthened over the past few years, further collective action on three key policy fronts—fiscal, structural, and other rebalancing policies—would be desirable. This collective effort would reduce problem imbalances and support growth, mitigating key risks while avoiding a “demand deficit” that could derail the global expansion.

Contours of Global Action

Strengthened collective policy action on key fronts will be needed to achieve the G20’s shared growth objectives and to reduce major imbalances. The overall assessment based on the country studies in this volume suggests three key policy areas for further action.

First, greater medium-term fiscal consolidation is needed in major advanced deficit countries to restore the sustainability of public finances. The review of policy commitments suggests that greater consolidation is necessary in the context of credible and realistic medium-term fiscal frameworks in order to anchor shared growth objectives. This assessment is supported by IMF staff’s analysis of G20 macroeconomic frameworks, which suggests that the anticipated improvement of public finances is partly predicated on optimistic growth projections by the authorities that may not fully materialize, according to IMF staff baseline growth projections. Finally, the country studies also suggest that additional fiscal adjustment will be needed to help reduce persistently moderate or large external imbalances in key deficit economies through higher national saving.

Second, further structural reform is needed to support growth, particularly in advanced surplus economies. In addition to near-term efforts to reduce high unemployment and financial sector repair and reform to support the private sector recovery, further action is needed to enhance growth potential. It is evident from the country studies that there are significant gaps between the alignment of structural reform plans in G20 economies and the strategic priorities for growth set by the Organization for Economic Cooperation and Development (OECD). The assessment of members’ macroeconomic frameworks also points to low potential growth in advanced surplus economies, highlighting the need for structural reform. Finally, the country studies indicate that reducing imbalances will necessitate structural reforms to also boost potential growth in major advanced economies.

Third, reform policies are needed to remove key distortions and narrow problem imbalances in emerging surplus economies. Limited progress has been made to date on rebalancing global demand and reducing external imbalances. The country studies indicate that policies aimed at reducing the distortions underpinning high national saving in China—including large gaps in the social safety net, financial restrictions, and undervalued exchange rates—will be needed to reduce imbalances, rebalance global demand, and anchor G20 growth objectives.

Upside Scenario

These three policy layers underpin a potential upside scenario. Policies are tailored for the G20 economies to reflect individual country circumstances. These are derived both from the case studies, as well as from IMF staff analysis in the context of the IMF’s regular surveillance activities.

Fiscal rebalancing is already advancing, but more will be needed in some deficit G20 members—preferably through “growth-friendly” measures including tax and entitlement reform.3 As highlighted in the country studies, budgetary consolidation is generally under way (i.e., part of the baseline), but members’ efforts will need to be sustained over time. According to policies assumed in IMF staff baseline projections, some members will also need to undertake more fiscal adjustment to meet their commitments, reestablish needed policy space, and ensure sustainable public finances in an upside scenario.4 In terms of timing, given the still-fragile nature of the recovery, some G20 members will also need to strike the right balance between supporting growth in the near term and more decisive action to consolidate growth over the medium term, especially if economies weaken further. Thus, where added fiscal effort is required, the upside considers the timing of adjustment that depends on country circumstances. Finally, budgetary actions that mitigate the dampening effects on short-run growth and further support external rebalancing and medium-term growth are preferable to help secure members’ shared objectives. Toward this end, several specific steps need to be taken in several areas, as outlined below.

  • Tax and entitlement reform are critical elements to underpin credible consolidation of sufficient scale. More credible adjustment, in turn, helps better anchor private sector expectations to advance gains over the medium term. Where possible, a shift toward greater reliance on indirect taxes (e.g., a value-added tax) rather than direct taxes on factor inputs would help limit tax distortions and improve incentives to save and invest. This could be budget-neutral (e.g., in Germany and France) or part of consolidation (e.g., the United States). This could help further reduce external imbalances, depending on the composition quality of fiscal adjustment, while better supporting growth over the medium term. Entitlement reform is a necessary ingredient of any credible fiscal consolidation plan in several G20 members given underfunded obligations and aging of the population. This includes added pension reform to advance the move toward actuarial balance (e.g., France).

  • Private sector rebalancing is at risk of stalling, and more targeted structural reform in key areas should be considered to support potential growth. To tackle still-high unemployment and weak private sector spending in some advanced G20 members, active labor market policies could be considered to facilitate reallocation and reemployment of displaced workers. Other demand-friendly policies—such as policies to encourage investment—could also be considered in some members. However, it will be important that the rebound in private saving in key deficit economies be maintained and that underlying distortions in the financial sector that gave rise to stability risks be effectively addressed. Over the medium term, structural factors behind low growth potential could be addressed more effectively as highlighted in the country studies. Besides reducing implementation risk, baseline structural reform policies could be strengthened through some reorientation toward problem areas. Specifically, more labor and product market reform in strategic priority areas would enhance growth potential. Based on OECD recommendations, lagging productivity in insular or restricted service sectors could be boosted in several G20 countries (e.g., Japan, France, Germany, China, and India) through competition policies to limit distortions and regulatory reform toward best practices. Product market reforms are also envisaged in other G20 economies (e.g., Australia, Canada, Indonesia, Italy, Korea, Mexico, Russia, and South Africa). On the labor market side, lowering hiring costs (e.g., France, India, Italy, Japan, Korea, and Turkey) and reforming disability insurance benefits (United Kingdom) would strengthen employment prospects. Measures to strengthen female participation rates in Japan and Germany could also support their medium-term growth.

  • Financial sector repair and reform are crucial to sustain the recovery. Against a backdrop of heightened financial stability risks, it is crucial that decisive near-term action be pursued to resolve the sovereign debt crisis in Europe. Moreover, many advanced economies appear to be mired in the repair-and-recovery phase of the credit cycle with incomplete balance sheet repair. More progress is needed to reduce sovereign spillovers and break the adverse feedback loop between the financial sector and real economy that could jeopardize the recovery. From a modeling perspective, technical limitations prevent an in-depth macroeconomic analysis of financial sector repair and reform in the upside scenario. Nonetheless, from an economic perspective, such policy measures are essential for securing the shared growth objectives and as part of a G20 action plan. Further action to reduce near-term financial sector risks would lay the critical foundations for the strengthened medium-term economic prospects examined in the upside scenario.

BOX 10.1Policy Assumptions for the G20 Upside Scenario

The upside scenario described in this chapter consists of three layers: (1) additional fiscal consolidation and budget-neutral tax reform; (2) structural reforms in labor and product markets (productivity effects are based on simulation results from the Organization for Economic Cooperation and Development), but have been scaled to take account of G20 members’ policies in IMF staff’s baseline projections); and (3) rebalancing reforms in China.

G20 members are assumed to fully implement country-specific policies that are identified by the country case studies and the IMF’s G20 Mutual Assessment Process reports. In particular, it is assumed that members will undertake the following:

  • Additional fiscal consolidation (relative to currently identified plans). A cumulative reduction of headline deficit by 2016 is assumed for Japan (3.75 percent of GDP), the United States (2.8 percent), the United Kingdom (2 percent), France (1.1 percent), India (2.3 percent), and other European Union countries (1 percent). The share of instruments used to achieve the consolidation is as follows: for Japan (0.2 percent transfers, 0.8 percent value-added tax [VAT]); the United States (0.25 percent government consumption, 0.5 percent transfers, 0.25 percent VAT); the United Kingdom (0.5 percent government consumption, 0.5 percent transfers); France (0.65 percent government consumption; 0.35 percent VAT); India (0.5 percent government consumption, 0.5 percent VAT); and other European Union countries (0.3 percent government consumption, 0.2 percent VAT, 0.5 percent transfers). Fiscal actions are assumed to be permanent in the year in which they occur.

  • Tax reform. A revenue-neutral tax reform is simulated for Germany and as part of consolidation for the United States. For Germany and the United States, the increase in indirect taxes (2 and 1.35 percentage points of GDP, respectively) is used to finance equal reductions in personal and corporate income taxes. For France, the higher revenue from indirect taxes (1.5 percentage points) is split 2 to 1 in favor of lowering labor income taxes (mainly social security contributions) versus corporate income taxes. For all three countries, the tax reform lowers distortions by shifting from direct to indirect taxes.

  • Structural reforms. Two types of structural reforms are considered—product market and labor market reforms. Which of the reforms applies to which countries is described in more detail below. Reforms that change the participation rate are assumed to be fully credible, while the credibility of those that raise the level of productivity is assumed to grow over time, becoming fully credible after five years. To mitigate deflation risk, reforms to enhance supply potential are phased in gradually and, where possible, “demand friendly” actions in labor markets (e.g., active labor market policies) are also considered in the near term. For the seven G20 countries selected for sustainability analysis in this volume, product market reforms are simulated for Japan, France, Germany, China, and India to boost productivity in the nontradable sector. In line with OECD recommendations, the product market reforms comprise an improvement of product market regulation toward best practices. Labor market reforms in the form of lower hiring costs are included for Japan, France, and India. In the United States, active labor market policies are considered to help reduce the high long-term unemployment rate, while in the United Kingdom, a reduction in the average replacement rate of disability benefits is assumed. Furthermore, in Japan and Germany, measures to increase female participation rates are considered, while for France, additional reform toward actuarially neutral pension is assumed. For the rest of the G20 membership, the simulations include product market reforms for Australia, Canada, Indonesia, Italy, Korea, Mexico, Russia, and South Africa; labor market reforms (lowering hiring costs) for Italy, Korea, and Turkey; active labor market policies in Brazil; lower average replacement rate of disability benefits in Canada; and pension reform in Turkey.

  • Reform in China. Finally, the upside scenario assumes reform in China to facilitate global rebalancing. With exchange rate flexibility, the following are considered:

    • ➢ Reform in education and safety nets. These reforms raise public consumption expenditure by 4 percent of GDP after 10 years and reduce private saving by 10 percent of GDP after 10 years.

    • ➢ Financial sector reform. These reforms raise the cost of capital to tradable sector firms by 100 basis points after five years and reduce the proportion of liquidity-constrained households by 5 percentage points after five years (10 percentage points after 10 years).

    • ➢ Nontradable sector reforms. These reforms encourage growth in the nontradable sector that raises both output and demand. The level of service sector productivity increases by 4 percent after 10 years, with the demand for services increasing sufficiently to prevent any exchange rate depreciation.

For the purposes of the upside scenario, further rebalancing policy efforts are also considered only in the systemic case of China based on its sustainability assessment, but they are relevant for other emerging surplus economies.5 Specifically, education reform and strengthened safety nets (through higher public expenditure) could help reduce high precautionary saving in China. Financial sector reform could help reduce distortions for firms and grant greater access to credit for liquidity-constrained households. This could help boost consumption and reduce inefficient investment. Finally, allowing greater market determination of the exchange rate and accepting greater currency appreciation would reinforce demand rebalancing at higher employment levels and facilitate the reallocation of resources across tradable to nontradable sectors.

Simulated Gains

An upside scenario that brings together all the central policy ingredients demonstrates the collective benefits through higher growth and lower imbalances. The effects of upside policies are shown with respect to (i.e., as deviations from) the IMF’s World Economic Outlook (WEO) baseline projections (Figure 10.2).6 The main findings associated with the collection of upside policies are described below.

Figure 10.2G20 Upside Scenario

(Percent deviation from baseline)

Sources: G20 authorities; and IMF staff estimates.

1Increase indicates appreciation.

Additional fiscal consolidation alone would be inimical to global growth at first (Figure 10.3). While critical for restoring soundness to public finances over time, further fiscal consolidation (beyond IMF staff’s baseline adjustment) in the major advanced economies will, in isolation, result in a decrease of world GDP by around ½ percent relative to the baseline at the time this withdrawal takes place. More front-loaded consolidation would further risk advancing and deepening these dampening effects on growth (especially given present constraints on monetary policy near the zero interest rate floor). Moreover, fiscal consolidation by itself would carry negative spillovers for partner countries. This underscores the need for well-timed fiscal plans to be as growth friendly as possible in G20 members requiring fiscal adjustment, as well as the need for supportive action by others to offset weaker demand in partner countries.

Figure 10.3Additional Fiscal Consolidation under the G20 Mutual Assessment Process Upside Scenario

(World real GDP; percent deviation from baseline)

Sources: G20 authorities; and IMF staff estimates.

Specifically, a complementary package of policy actions is required. If the necessary fiscal adjustment is combined with supporting policy measures, the picture progressively changes (Figure 10.4). First, consolidation when combined with budget-neutral tax reform—shifting the composition of revenue instruments away from distortionary taxes—produces adjustment that is more growth friendly. Also in this second layer, better-targeted structural reform in product and labor markets to boost potential growth would add to the growth benefits.7 Finally, rebalancing policies to reduce domestic distortions and boost internal demand in emerging surplus economies (i.e., China in the simulations) would further lift growth to help offset weaker domestic demand in partners.

Figure 10.4Additional Fiscal Consolidation, Structural Reforms, and Rebalancing Policies under the G20 Mutual Assessment Process Upside Scenario

(World real GDP; percent deviation from baseline)

Sources: G20 authorities; and IMF staff estimates.

Taken together, a cooperative policy action plan has appreciable upside potential for growth. The simulation results show that joint actions by the G20 members consistent with all three policy layers described above, if fully implemented, will result in an overall increase of world GDP by 1½ percent in 2016. This is equivalent to a global income gain of more than $750 billion. This sizable increase in income would add between 20 and 40 million new jobs. In cumulative terms, the upside gains will amount to nearly 3 percent higher global GDP over the medium term. Improved growth prospects across the G20 will be accompanied by significantly lower global imbalances. The simulation results suggest an appreciable reduction of global imbalances by about 3/4 percent of world GDP relative to the IMF staff’s baseline in 2016 (Figure 10.5). Overall, this improvement is driven by narrowing external imbalances in both deficit and surplus countries.

Figure 10.5Current Account Balances

(Percent of world GDP)

Source: IMF staff estimates.

Note: The period from 2000–10 is from the IMF’s World Economic Outlook (WEO) database; the period from 2011–16 reflects WEO projections plus the upside scenario rebalancing shock, except for total deficit and total surplus, which reflect the WEO baseline.

1Total for deficit countries in the case studies.

2Total for surplus countries in the case studies.

Conclusions

In the aftermath of the global financial crisis and the Great Recession, the world economy is still struggling to regain its footing. While the imbalances or “fault lines” associated with the crisis have moderated somewhat, they remain significant enough to warrant serious attention from policymakers around the world. Activity in the advanced economies remains sluggish, partly reflecting the scars left behind by the crisis. In Europe, in particular, the crisis is far from over due in part to large imbalances in the periphery and core and the need to rebuild a more resilient and vibrant monetary union. Meanwhile, in the absence of strong and concerted policy action in other major advanced economies—be it to address fiscal risks or undertake much-needed structural reforms—elevated vulnerabilities pose significant downside risks to growth, prompting worries that another deep downturn is in the offing. Emerging market economies have fared relatively better, but they are not immune to slower growth and risks on this front are increasing. This leaves us with an overall configuration of a slow and bumpy global recovery weighed down by low confidence and prone to setbacks.

Is there a solution to promote stronger, sustainable, and more balanced growth at the global level? This volume has argued that the answer is clearly yes—policymakers working collaboratively can collectively pursue actions to strengthen growth while reducing large imbalances. The challenge is essentially multilateral in nature and involves two rebalancing acts. The first is internal rebalancing. If growth is to be sustained, the countries hardest hit by the crisis need to rebalance away from public support and stimulus toward private demand. The second act is external rebalancing. If growth is to be more balanced, stronger reliance on external demand in major deficit economies needs to be matched by stronger reliance on internal demand in major surplus economies. More symmetric adjustment across deficit and surplus countries would support stronger growth. This would also help avoid a return to a configuration with large macrofinancial imbalances and their attendant risks that existed before the crisis.

Moreover, as shown by the case studies here, tackling many of these key imbalances is not only good for the global economy but also compatible with national interests. Much of the explanation for large imbalances in systemic members of the G20 originates in domestic factors, including distortions and structural issues, underpinning key differences in national saving—too low in major deficit economies and too high in major surplus economies. Efforts to address these underlying distortions or structural impediments can thus boost domestic welfare. Some actions—notably, necessary fiscal consolidation in deficit economies—will strengthen growth prospects only over time and may dampen activity in the near term. Complementary action in surplus economies, however, can make this adjustment less painful while supporting domestic growth in the process. Taken together, collective policy action among the G20 membership can thus provide the foundation for healthier global growth.

As a vehicle for raising awareness of prescient issues, bridging national interests to achieve a common goal, and building consensus aimed at policy coordination, the G20 Mutual Assessment Process (MAP) has a unique opportunity to galvanize such action. It has so far played a useful role in some of these areas, importantly in building a shared understanding of imbalances—including factors underlying them—that need to be addressed expeditiously. It has, however, failed to build consensus on the policy measures needed to reduce imbalances. In addition, the lack of a formal enforcement mechanism or stronger peer review in the process has limited the MAP’s traction with policymakers across the G20. Going forward, these shortcomings will need to be addressed if the MAP is to succeed in securing the growth objectives agreed upon by G20 leaders.

Krishna Srinivasan is an Assistant Director in the IMF European Department; Hamid Faruqee is a Division Chief and Emil Stavrev is a Deputy Chief in the IMF Research Department. This chapter was written with input from Derek Anderson, Michal Andrle, Mika Kortelainen, Dirk Muir, Susanna Mursula, and Stephen Snudden, and with the support of Eric Bang, David Reichsfeld, and Anne Lalramnghakhleli Moses.

One channel through which China’s reserve accumulation policy could affect reserve accumulation policies in other emerging market economies is through exchange rates, as they are competing in similar product markets.

See Box 10.1 for a more detailed description of the policy and technical assumptions underpinning the upside scenario using the IMF’s Global Integrated Monetary and Fiscal (GIMF) model.

For the upside scenario analysis, IMF staff estimates based on members’ budgetary plans envisage the need for an additional 1¼ percent of GDP reduction in the overall G20 fiscal deficit in 2016 (and a 3 percent cumulative reduction in fiscal deficits over the medium term, 2012–16).

An update of the IMF staff’s upside scenario—based on policy inputs for all G20 members—can be found in the 2012 Staff Reports for the G20 Mutual Assessment Process. See www.imf.org/external/np/g20/map2012.htm.

The simulations are based on the October 2011 WEO projections as the economic and policy baseline, available at the time of the analysis.

Work on the upside scenario analysis for this study was undertaken in close partnership with the OECD. The OECD contributed simulations of the effects of stylized and country-specific structural reforms for individual G20 members based on its past work and expertise.

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