FINANCE & DEVELOPMENT A QUARTERLY PUBLICATION OF
THE INTERNATIONAL MONETARY FUND
December 2010
•
Volume 47
•
Number 4
FEATURES
EMERGING MARKETS’ PLACE AT THE TABLE
6 Emerging Markets Come of Age
These vibrant middle-income countries
survived the global recession, but face bumps
as they seek to solidify their place in the
world economy
M. Ayhan Kose and Eswar S. Prasad
11 Gauging China’s Influence
China’s rapid integration and growth are
increasingly affecting the rest of the world
Vivek Arora and Athanasios Vamvakidis
ALSO IN THIS ISSUE
14 Stimulus Worked
Without the quick and massive policy response, the
Great Recession might still plague the United States
Alan S. Blinder and Mark Zandi
18 Getting Debt under Control
In dealing with the aftermath of the Great Recession,
policymakers must pay attention to the mix of
austerity policies
Emanuele Baldacci, Sanjeev Gupta, and Carlos
Mulas-Granados
22 The Tragedy of Unemployment
Governments can do more to alleviate joblessness
and its human costs
Mai Chi Dao and Prakash Loungani
28 Leveraging Inequality
Long periods of unequal incomes spur borrowing from
the rich, increasing the risk of major economic crises
Michael Kumhof and Romain Rancière
32 Faces of the Crisis Revisited
Real people, reacting to the crisis
Julian Ryall, Florencia Carbone, Niccole Braynen-
Kimani, Hyun-Sung Khang, and Jacqueline
Deslauriers
36 Bad News Spreads
When government debt is downgraded, the ill effects can be felt across
countries and financial markets
Rabah Arezki, Bertrand Candelon, and Amadou N.R. Sy
38 Risky Business
Global banks will adapt to the new international rules on capital and liquidity,
but at what cost to investors and the safety of the financial system?
˙
Inci Ötker-Robe and Ceyla Pazarbasioglu
41 Trusting the Government
Confidence in government is the key to financial development
Marc Quintyn and Geneviève Verdier
44 Good for Growth?
The spread of Islamic banking can spur development in countries with large
Muslim populations
Patrick Imam and Kangni Kpodar
FD
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EDITOR-IN-CHIEF
Jeremy Clift
MANAGING EDITOR
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ADVISORS TO THE EDITOR
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32
6
Thomas Helbling
Paul Hilbers
Paolo Mauro
Gian Maria Milesi-Ferretti
Paul Mills
Uma Ramakrishnan
Rodney Ramcharan
46 Put to the Test
Islamic banks were more resilient than conventional
banks during the global financial crisis
Maher Hasan and Jemma Dridi
50 Poorest Economies Can Export More
Advanced and emerging economies can make it
easier for the least developed countries to sell more
products abroad
Katrin Elborgh-Woytek and Robert Gregory
DEPARTMENTS
2 People in Economics
Fun & Games
Jeremy Clift profiles Avinash Dixit
26 Picture This
Youth for Hire
The global economic crisis has led to the highest
youth unemployment rates ever
Sara Elder
48 Back to Basics
What Are Externalities?
What happens when prices do not fully capture
costs
Thomas Helbling
Illustration: Cover, Chris McAllister; p. 18, John Labbe/The Image Bank;
p. 28, Kino Brod/Getty Images; p. 38, Images.com/Corbis.
Photography: p. 2, Nat Clymer Photography; p. 6, Frédéric Soltan/Corbis;
p. 11, Claro Cortes IV/Reuters/Corbis; p. 14, Axel Koester/Corbis; p. 22, Ralf-
Fin Hestoft/Corbis; p. 26, Najlah Feanny/Corbis; p. 27, Mast Irham/epa/
Corbis; p. 32, Alfie Goodrich; p. 33, Daniel Pessah, La Nación; p. 34, Michael
Spilotro/IMF and Tony Belizaire/AFP; p. 35, Michael Spilotro/IMF; p. 41, Steven
Puetzer/Getty Images; p. 44, staff/Reuters/Corbis; p. 46, Rafael Marchante/
Reuters/Corbis; p. 50, Stephen Jaffe/IMF; pp. 54–56, Michael Spilotro/IMF.
53 Data Spotlight
Trade Impact
The Great Recession seriously disrupted
international trade, but some regions and trading
partners were hit harder than others
Kim Zieschang
54 Book Reviews
The Globalization Paradox: Democracy and the
Future of the World Economy, Dani Rodrik
Exorbitant Privilege: The Decline of the Dollar and
the Future of the International Monetary System,
Barry Eichengreen
The Dragon’s Gift: The Real Story of China in
Africa, Deborah Brautigam
57 Index
M
AJOR emerging markets have exited from the
global economic crisis in the driver’s seat. They
are gaining in strength and prominence and
helping the world recover from the recession
that plagued advanced economies along with everyone else.
This issue of F&D looks at the growing role of the emerg-
ing markets. Analysis by the IMF’s Ayhan Kose and Eswar
Prasad, professor of trade policy at Cornell University, argues
that their economic ascendance will enable emerging mar-
kets, such as Brazil, China, India, and Russia, to play a more
significant part in global economic governance and take on
more responsibility for economic and financial stability. And
Vivek Arora and Athanasios Vamvakidis measure how China’s
economy is increasingly affecting the rest of the world.
Emerging markets are already highly influential in the
Group of Twenty (G-20) leading economies and their added
weight is being reflected at the International Monetary Fund,
where the Executive Board has approved a set of measures
to give them more influence in running the 187-member
organization.
In addition, this issue of F&D examines a variety of topics
as the world struggles to shake off the crisis. Alan Blinder
and Mark Zandi look at the positive effects of stimulus in
the United States. Without it, they say, the United States
would still be in recession. IMF researchers look at how
countries can get debt under control. Other articles exam-
ine the human costs of unemployment, how inequality can
lead over time to financial crisis, and what changes in the
way banks do business could mean for the financial system.
Two articles examine Islamic banking, which was put to
the test during the global crisis and proved its mettle, while
in our section on Faces of the Crisis Revisited, we continue to
track how the recession affected several individuals around
the world.
Finally, our profile of Princeton economic theorist Avinash
Dixit contains some good advice—be prudent in good times.
“The lesson that really should be learned, and I’m afraid will
never be learned, is that the time for fiscal prudence is when
times are good. That’s when governments should be running
substantial surpluses, so that when crises or a recession hit,
they’re able to spend freely without worrying so much about
debt.”
Jeremy Cli
Editor-in-Chief
Finance & Development December 2010 1
Emerging markets driving the recovery
FROM THE EDITOR
Read online at www.imf.org/fandd
2 Finance & Development December 2010
“Victory awaits him who has everything in order—luck,
people call it. Defeat is certain for him who has neglected
to take the necessary precautions in time; this is called
bad luck.”
—from The South Pole, by Roald Amundsen
I
T may seem strange that Avinash Dixit, who grew up
in the tropical heat of India, has a shelf in his living
room of neatly arranged books on icebound Antarctic
expeditions. But the owlish Princeton University profes-
sor has a simple explanation: “ey’re ideal for illustrating
game theory strategies. Almost always an expedition had a
fatal aw that guaranteed defeat compared with the rival that
succeeded.
“The Brits, for example, thought they knew it all, and had
nothing to learn from anyone else,” he said, while slicing
sandwiches for lunch in his sparsely equipped kitchen. “Scott
of the Antarctic, for example, thought that the hierarchi-
cal structure of the British Navy was the right way to orga-
nize his team, when a more open participatory organization
would have been better for his small group’s fateful attempt to
reach the South Pole.”
Dixit, who compares academic research to rock climbing—
it’s “the breathtaking view from the top” that makes it
all worthwhile—is a passionate advocate of game theory
and argues it has become part of the basic framework of
economics.
He was drawn to it when he discovered The Strategy of
Conflict by Thomas Schelling, one of the pioneers of the
study of bargaining. “That, to me, made game theory come
alive,” said Dixit, in an interview at his Princeton, New Jersey,
townhouse. “As Schelling says, ‘When two trucks carrying
dynamite meet on a single-lane road, who backs up?’”
Making learning fun
Teaching game theory, he insists, must be fun—he has won
awards for his teaching prowess—and he tries to illustrate
key concepts with tales from films, books, and real life.
Dani Rodrik, professor of international political economy
at Harvard, says Dixit was the best classroom teacher he ever
had—he never treated anything as silly or obvious. “No mat-
ter how stupid a question seemed, he would stop, raise his
hand to his chin, narrow his eyes,and think a long time about
it, while the rest of us in the classroom would roll our eyesat
the stupidity of thequestioner,” said Rodrik. “Then he would
say, “Ah, I see what you have in mind . . . ,” and he would roll
out an answer to a deep and interesting question the student
had no idea he had asked.”
“What makes him special,” says former student Kala Krishna,
now an economics professor at Penn State, “is that more than
anyone else I know, he sees economics as an inescapable part of
life: from books, movies, negotiating with a taxi driver—every-
thing has economic content. He truly loves economics, and you
can see how much he is enjoying himself doing it.”
Others praise his wit. “Avinash Dixit is one of my favorite
economists, in part because he has a trait that is extremely
rare among economists: a good sense of humor,” said Steven
PEOPLE IN ECONOMICS
Fun &
Jeremy Clift profiles economic theorist Avinash Dixit
D. Levitt, coauthor of the best-selling book
Freakonomics.
Dixit, who received his doctorate from
the Massachusetts Institute of Technology
(MIT), taught in Princeton’s econom-
ics department from 1981 to 2010. He
attained recognition early on for his work
with Joseph Stiglitz on imperfect markets
and what is referred to by economists as
monopolistic competition. This concept
offers an intermediate theoretical ground
between pure monopoly, in which one
firm controls the market, and perfect com-
petition, in which there are so many com-
petitors none has any market power.
He is also famous for his textbook on
trade with Norwegian economist Victor
Norman, The Theory of International
Trade, which was enormously influential,
and his work on oligopoly and industrial
organization.
Path-breaking model
What became known as the “Dixit-Stiglitz” model underpins
a huge body of economic theory on international trade, eco-
nomic growth, and economic geography—a model tapped by
Paul Krugman, who won the Nobel Prize in 2008.
The model, first published in 1977, became a building
block for others in the new fields of endogenous growth
theory and regional and urban economics—what journal-
ist David Warsh described as “one of those economical and
easy-to-use ‘Volkswagen’ models that were the hallmark of
MIT” (Warsh, 2006).
Monopolistic competition was pioneered by Joan Robinson
and Edward Chamberlin in the 1930s and was the stuff of
basic economics for years. But Stiglitz—who went on to win
a Nobel Prize in 2001 for his work with Michael Spence and
George Akerlof on the analysis of markets with asymmetric
information—and Dixit took it to a new level.
“The success of the Dixit-Stiglitz model of monopolistic
competition might have come as a surprise to students of
the history of economic thought, as it was by no means the
first attempt to deal with imperfect markets or monopolis-
tic competition,” said Steven Brakman and Ben Heijdra in a
book analyzing what they termed a revolution in the analysis
of imperfect competition.
“However, where the earlier attempts failed, the Dixit-
Stiglitz approach turned out to be very successful and has the
potential for ‘classic status.’ ”
Huge impact
The theory of monopolistic competition shook up modern
trade theory, which Oxford economist Peter Neary attributed
to “one factor above all others”: the development of the “ele-
gant and parsimonious” model by Dixit and Stiglitz.
The duo applied their innovation only to the classic ques-
tion in industrial organization of whether monopolistically
competitive industries would yield an optimal level of prod-
uct diversity. But within a few years, many were applying the
approach to international trade.
Dixit admitted to Warsh that he hadn’t foreseen the wide
applications of the model. “Joe and I knew that we were
doing something in building a tractable general equilibrium
model with imperfect competition, but we didn’t recognize
that it would have so many uses—obviously; otherwise we
would have written all those subsequent papers ourselves!”
Masahisa Fujita, Krugman, and Anthony Venables rave in
their book, The Spatial Economy, about the model’s adaptability
in the field of economic geography. “In short, Dixit-Stiglitz lets us
have our cake in discrete lumps while doing calculus on it, too.”
Wide-ranging work
By his own admission, Dixit is somewhat haphazard and
opportunistic about his research interests and focus. “I have
always worked on the next problem that grabbed my inter-
est, and tackled it using whatever approaches and techniques
seemed suitable, never giving a thought to how it might fit
into an overall world-view or methodology,” Dixit wrote in
Passion and Craft: Economists at Work, edited by Michael
Szenberg (see Box 1).
Barry Nalebuff, coauthor with Dixit of the popular book
on game theory Thinking Strategically, jokes that Dixit was
Finance & Development December 2010 3
Fun &
Games
Box 1
Being twenty-three
“Of all the lessons I have learnt during a quarter-century of
research,” writes Dixit, “the one I have found most valuable is
always to work as if one were still twenty-three. From such a
young perspective, I find it difficult to give advice to anyone.”
Dixit, who likes popular science and engineering books,
says he pretends to have a perpetually youthful mind so as
not to be confined by his field and the “distilled wisdom of a
middle-aged has-been.”
Research may seem frustrating and daunting to outsid-
ers, but he delights in it. “For me, it is the mental equivalent
of free-climbing a new rock face, using only hands and feet
for the ascent, or even free solo climbing, without any ropes,
pitons, or harnesses to protect one if one falls.”
the human prototype for Wikipedia, the online encyclopedia.
“Then and now, no matter what part of economics, he was
able to answer your question, and push it further.”
Dixit also wrote the introductory textbook Games of Strategy
with Susan Skeath, a former student and now professor at
Wellesley College. John Nash, the founder of modern game the-
ory and Nobel Prize–winner portrayed in the film A Beautiful
Mind, is a friend and occasional lunch or beer companion.
Apart from game theory and his eponymous model, Dixit
is known for seminal work on microeconomic theory, inter-
national trade and growth, and development. But his varied
interests have moved him to write extensively about gover-
nance, the role of institutions, law, and democracy in develop-
ment, and political polarization. He says his most cited work
is Investment under Uncertainty, written in 1994 with Robert
Pindyck of MIT, about how firms make investment choices.
That book points out the inherent irreversibility of most
business investment decisions. Dixit and Pindyck suggest a
way to deal with the risks posed by irreversibility: wait before
acting. Waiting is valuable because with time comes addi-
tional information whose value would be lost had the irre-
versible decision already been made.
Dixit has advocated the same approach in other fields, and
it is at the heart of a paper based on an episode of the popular
TV show Seinfeld, in which a young woman must make deci-
sions about using her finite supply of contraceptive sponges
(see Box 2).
Dixit, who was president of the Econometric Society in
2001 and the American Economic Association in 2008, has
taught at several U.S. and U.K. universities and had stints at
the International Monetary Fund and New York’s Russell Sage
Foundation, which is dedicated to research in the social sciences.
From mathematics to economics
Dixit didn’t start out in economics. His bachelor’s degree
from Bombay University is in mathematics and physics; he
earned another bachelor’s in mathematics from Cambridge
University. He credits a professor at his Cambridge college,
Corpus Christi, for setting him on his new path by suggesting
he read Paul Samuelson’s Foundations of Economic Analysis
and Gérard Debreu’s Theory of Value.
When he arrived at MIT in 1965, he was interested in
economics but formally a master’s student in the operations
research department. “They sent me to see Frank Fisher for
advice on what economics courses to take. He heard my story
and said, ‘Operations research is boring; it’s just all algo-
rithms. Come and join the economics Ph.D. program.’”
Although Dixit professes that his primary interest is in “the
ideas, not the people,” he goes out of his way to pay tribute
to the ideas and research of others, in particular fellow MIT
economist and New York Times columnist Krugman, and
Samuelson, the first U.S. economist to win a Nobel Prize, who
Dixit says taught him the unity of economics as a subject.
“From his own work and his teaching, I realized that all the
‘fields’ into which economics is conventionally divided are
intricately linked pieces of one big puzzle, with a common
framework of concepts and methods of analysis—choice,
equilibrium, and dynamics.”
Time of turmoil
Dixit calls himself a theorist, “albeit of a relatively applied kind.”
He started his research career in 1968, when the academic
world of Europe and the United States was in turmoil. Dixit
says the prevailing atmosphere was decidedly left-wing and
anti-establishment, and research almost had to be “relevant.”
In this climate, topics such as the problems of less-developed
countries, urban areas, and the environment reigned.
“Looking back on those years, much of the ‘relevant’
research in economics left little lasting mark on the subject.
Problems of less-developed countries and urban areas proved
so political that good economic advice would have achieved
nothing even if we had been able to give it,” Dixit said in “My
System of Work (Not!),” an article he wrote in 1994.
“No, the topics that proved to have lasting value in economics
were quite different—for example the theory of rational expec-
tations, the role of information and incentives, and later in
this period, game theory. In the early 1970s much of this work
seemed abstract and irrelevant and would have been called
politically incorrect had that phrase existed in those days.”
Dixit’s work with Victor Norman on international trade
changed how people think about factor price equalization
analysis—which looks at how free trade in commodities
affects factor prices such as wages and interest rates—and
most who studied international trade in the 1980s and 1990s
acknowledge its influence.
He also brought sophisticated ideas from game theory to
the study of industrial organization. His work on investment
and entry deterrence looked at incumbent firms’ strategic
buildup of excess capacity as a way to protect their monopoly
by scaring off new entrants to the market.
What drives development?
Dixit has spent the past decade watching what drives economic
development, including governance and institutions, and has
studied fragile states—poor countries recovering from conflict
or disasters. “Governance was neglected by economists for a
long time, perhaps because they expected the government to
4 Finance & Development December 2010
Box 2
The hidden model
In an episode of the television sitcom Seinfeld, Elaine Benes’s
favorite contraceptive sponge is taken off the market. She scours
pharmacies to stock up, but her supply is now finite, so she must
“reevaluate her whole screening process.” Every time she dates
a new man, she has to consider whether he is “spongeworthy.”
When Elaine uses a sponge, Dixit says, she is forfeiting
the option to have it available when an even better man
comes along. He developed a mathematical model to quan-
tify this concept of spongeworthiness many years ago, but
kept quiet because it seemed inappropriate at the time. “I
hope that my advanced age now exempts me from the con-
straints of political correctness,” Dixit wrote after retiring
from teaching earlier this year.
provide it efficiently. However, experience with less developed
and reforming economies, and observations from economic
history, have led economists to study non-governmental insti-
tutions of governance,” he says (Dixit, 2008).
To this he brings his habitual skepticism.
While Dixit acknowledges the importance of democracy,
property rights, contract enforcement, and the provision of
public infrastructure and services that support private eco-
nomic activity, he is scathing about attempts to draw up a menu
of items that underpin development in low-income countries.
“There’s a long, long tradition of people offering recipes
which don’t work out,” he says. He stirred things up with
a lecture at the World Bank in 2005 that he said he hoped
would be provocative and critical, but “evenhandedly so.”
In many cases, he argued in that lecture, the accumulated
research on the role of institutions in development stopped
short of giving useful or reliable policy prescriptions. “I
hope to give everyone some incentives to think further and
harder.”
In a subsequent talk at the Reserve Bank of India (Dixit,
2007), he said that in general “bottom-up and organically gen-
erated reforms will work better than imposed top-down ones.”
The World Bank’s Philip Keefer, who was Dixit’s respon-
dent at the 2005 lecture, said the Princeton professor was
right to be skeptical, but “big ideas” could help guide a coun-
try’s reform agenda.
To work effectively, Dixit said, change must be coordinated
and take place across several fronts. “The one recipe that
works is what I call ‘strategic complementarities.’ That is, if
15 things need to be done, doing 3 of them is not going to get
you 20 percent of the way there. It’s going to get you much
less. You’ll need to get all 15, or at least 13 or 12, right before
you start to see any big effect. So that’s one thing, strategic
complementarities, and the second is luck.
“Napoleon supposedly said that the quality he most
admired in his generals was luck, and the same goes for gov-
ernments and countries.”
Economics and the crisis
Dixit, recently retired from full-time teaching at Princeton,
rejects the agonizing of some chastened economists follow-
ing the global economic crisis. He says they are wrong to
blame the “dismal science.”
“Actually, I think that economic theory came out of this
rather better than policy practice did. . . . Economic theory
and economic analysis based on pretty standard theories told
everybody that the situation was unsustainable, that there
was going to be a house price bust sometime. The timing is
always unpredictable, but pretty much everybody knew that
things were going to go bad.
“But what we were not able to predict is the quantitative
magnitude of it—how far, for example, house prices would
fall. And secondly, we were not able to recognize how big an
effect the financial crisis would have on the real economy.”
In light of the crisis, how should economic research adapt?
“Going forward, I think some of the most fruitful research
will come from a better integration of financial theory and
macroeconomic theory. It may be supplemented by bet-
ter recognition of rare major events, something that already
exists in financial theory, but is less assimilated into financial
practice than it should be.
“But the real fault was not so much in economic theory as,
if you like, in the political and business world, where people
actually swallowed some of the simplistic views about the won-
der of markets too much without recognizing the hundreds of
qualifications that Adam Smith and a number of others have
told us about, and we should all have known about.”
Crises won’t go away
Dixit, now a visiting professor for part of the year at Hong
Kong’s Lingnan University, says the biggest message to take
on board is that crises are not going to go away.
“We shouldn’t think they have been abolished,” Dixit
said. “Thinking that we have abolished them is an illusion
and perhaps a dangerous illusion, because if you think you
have abolished crises, your policymakers, business people,
consumers, et cetera, will behave in more reckless ways and
thereby make crises more likely.”
He advises prudence in good times. “The lesson that really
should be learned, and I’m afraid will never be learned, is that
the time for fiscal prudence is when times are good. “That’s
when governments should be running substantial surpluses,
so that when crises or a recession hit, they can spend freely
without worrying about debt.
“Unfortunately, the reason the lesson will never be learned
is that good economic times are especially conducive to the
illusion that bad times will never return.”
■
Jeremy Cli is Editor-in-Chief of Finance & Development.
References:
Brakman, Steven, and Ben Heijdra, eds., 2004, e Monopolistic
Competition Revolution in Retrospect (Cambridge, United Kingdom:
Cambridge University Press).
Dixit, Avinash, 1994 “My System of Work (Not!),” e American
Economist, Spring.
———, 2005, DEC Lecture, World Bank, April 21.
———, 2007, Reserve Bank of India “P.R. Brahmananda Memorial
Lecture,” Mumbai, June 28.
———, 2008, “Economic Governance,” Intertic Lecture, University of
Milan, Bicocca, Italy, June 5.
———, and Victor Norman, 1980, e eory of International Trade:
a dual, general equilibrium approach (London: J. Nisbet).
———, and Joseph E. Stiglitz, 1977,“Monopolistic Competition and
Optimum Product Diversity,” American Economic Review, Vol. 67,
No. 3, pp. 297–308.
Fujita, Masahisa, Paul Krugman, and Anthony Venables, 1999, e
Spatial Economy: Cities, Regions, and International Trade (Cambridge,
Massachusetts: MIT Press).
Szenberg, Michael, ed., 1998, Passion and Cra: Economists at Work
(Ann Arbor, Michigan: University of Michigan).
Warsh, David, 2006, Knowledge and the Wealth of Nations (New
York: Norton).
Finance & Development December 2010 5
6 Finance & Development December 2010
Emerging
Finance & Development December 2010 7
These vibrant
middle-income
countries
survived
the global
recession, but
face bumps as
they seek to
solidify their
place in the
world economy
M. Ayhan Kose and Eswar S. Prasad
T
HE superlative performance of
emerging market economies, a
group of middle-income countries
that have become rapidly integrat-
ed into global markets since the mid-1980s,
has been the growth story of the past decade.
Aer being beset by various crises during the
1980s and 1990s, emerging markets came
into their own during the 2000s, recording
remarkable growth rates while keeping in-
ation and other potential problems largely
under control.
Before the global financial crisis of
2008–09, there was a growing sense among
investors and policymakers that emerging
economies, with their new economic might,
had become more resilient to shocks originat-
ing in advanced economies. Indeed, empiri-
cal evidence indicates that over the past two
decades there has been a convergence of busi-
ness cycles among emerging markets and a
convergence among advanced economies,
but a gradual divergence of cycles between
the two groups—referred to as decou-
pling. Fluctuations in financial markets have
become more correlated across these two sets
of countries, but that has not translated into
greater spillovers into the real economy, which
produces goods and services.
Yet the global financial crisis seemed to put
to rest such notions of decoupling. It cast a
shadow over the ability of emerging markets
to insulate themselves from developments in
advanced economies. Still, once the worst of
the crisis began to wear off, it became appar-
ent that as a group emerging economies had
weathered the global recession better than
advanced economies. In many emerging
markets, growth rates have bounced back
briskly during the past year, and as a group
these economies seem poised to record high
growth over the next few years (see Chart 1).
This is not to say that all emerging econo-
mies did equally well during the global reces-
sion. There is significant variation in the
degree of resilience they displayed during the
financial crisis. And therein lie some impor-
tant lessons regarding the future growth
paths of these economies and the issues they
might face.
As emerging markets grow, they will
continue to gain importance in the world
economy. That economic ascendance will
enable them to play a more significant role
in improving global economic governance,
so long as they employ good policies and
inten
sify reforms that contributed to their
resilience during the global recession. All
told, emerging markets are in control of their
own destiny.
Chart 1
Bouncing back
Emerging markets survived the Great Recession better and
recovered from it faster than advanced economies.
(GDP growth, annual percent change)
Kose, 11/11/10
Source: Authors’ calculations.
Note: Data for 2010 are based on forecasts in the IMF’s World Economic Outlook
(October 2010). Growth calculations use real GDP growth rates for each country and are
weighted by purchasing power parity.
2007 08 09 10
World
Advanced economies
Emerging market
economies
–4
–2
0
2
4
6
8
10
Come of Age
Markets
Changing drivers of global growth
The past five decades have witnessed substantial changes
in the distribution of world gross domestic product (GDP)
across different groups of economies. During 1960–85,
advanced economies on average accounted for about three-
quarters of global GDP measured in current dollars adjusted
for differences in purchasing power parity across countries.
This share has declined gradually over time—by 2008–09, it
was down to 57 percent. In contrast, emerging markets’ share
has risen steadily from just about 17 percent in the 1960s to
an average of 31 percent during the period of rapid global
trade and financial integration that started in the mid-1980s.
By 2008–09, it was close to 40 percent (see Chart 2).
The rising importance of emerging markets becomes even
more apparent when their contribution to world output
growth is considered.
During 1973–85, advanced economies accounted for about
60 percent of the 3.4 percent annual world GDP growth.
Emerging markets contributed a third (the remainder is
accounted for by other developing economies). Growth of
world GDP averaged 3.7 percent a year during the period of
globalization—1986–2007—and the contribution of emerg-
ing markets grew to about 47 percent. Advanced economies’
share fell to about 49 percent.
During the two years of the financial crisis there was a
stunning shift in these relative contributions. Emerging
markets became the lone engine of world GDP growth dur-
ing 2008–09, while advanced economies experienced a deep
contraction. The direct contribution of emerging markets to
global growth has continued to increase over time and was
further accentuated during the financial crisis, while the
reverse has been true for advanced economies.
Diverging performance
Although emerging economies as a group performed well
during the global recession of 2009, there were sharp dif-
ferences among them and across regions. The economies of
emerging Asia had the most favorable outcomes, surviving
the ravages of the global crisis with relatively modest declines
in growth rates. China and India, the two largest economies
in emerging Asia, maintained strong growth during the crisis
and played an important role in the region’s overall record.
When India and China are excluded, emerging Asia’s overall
performance is less impressive (see table).
While emerging Asia did well, emerging Europe per-
formed poorly and had the sharpest fall in total output during
2009. Latin America was also hit hard. Both regions suffered
because of their ties to advanced economies. But many of the
emerging economies in Latin America bounced back rela-
tively strongly—in contrast to earlier episodes of global finan-
cial turbulence, during which Latin American economies
proved vulnerable to massive currency and debt crises.
The emerging economies of the Middle East and North
Africa (MENA) region as well as those of sub-Saharan Africa
weathered the crisis better than Latin America, with only
small declines in output. The reason for the relatively good
performance of sub-Saharan African and MENA countries
may be their modest exposure to trade and financial flows
from advanced economies—which limited the extent of spill-
overs of the global shock.
Why the resilience?
Many factors account for the relative resilience of emerg-
ing markets, as a group, during the global financial crisis.
Some relate to policy choices made by these countries, while
others are associated with underlying structural changes in
their economies. These factors also help explain differences
in degrees of resilience across different groups of emerging
market economies.
• Better macroeconomic policies in most emerging markets
succeeded over the past decade in bringing inflation under
control through a combination of more disciplined fiscal and
monetary policies. Indeed, many emerging markets have now
adopted some form of inflation targeting—either explicit or
implicit, soft or hard—along with flexible exchange rates,
which help absorb external shocks. Prudent fiscal policies
that resulted in low levels of fiscal deficit and public debt
created room for emerging market economies to respond
8 Finance & Development December 2010
Chart 2
Growing in importance
Emerging market economies’ share of world GDP has been
growing steadily over the past ve decades.
(percent of global GDP)
Kose, 11/11/10
Source: Authors’ calculations.
Note: The values correspond to period averages as a share of world GDP computed using
purchasing-power-parity exchange rates. The sum does not equal 100 percent because not
all economies are counted—only advanced and emerging.
1960–72 1973–85 1986–2009 2008–09
Advanced economies
Emerging market economies
0
10
20
30
40
50
60
70
80
90
Differing performance
Emerging Asia experienced a mild growth slowdown during the
crisis, while emerging Europe had a steep decline.
(GDP growth, percent change from one year earlier)
2007 2008 2009
Projected
2010
Emerging Asia 10.6 6.8 5.8 9.3
Emerging Asia except China, India, and
Hong Kong SAR 5.9 3.0 0.6 7.1
Emerging Europe 7.6 4.7 –6.3 3.1
Emerging Latin America 5.7 4.2 –2.0 6.0
Emerging Middle East and North Africa 6.0 4.8 1.9 4.1
Emerging sub-Saharan Africa 7.1 5.6 2.7 4.9
Source: Authors’ calculations. Data for 2010 are based on forecasts in the IMF’s World Economic
Outlook (October 2010).
Note: Group growth is computed using real GDP growth rates for individual countries weighted by
purchasing power parity.
aggressively with countercyclical fiscal policies to offset the
contractionary effects of the crisis. In addition, emerging
economies with low inflation were able to employ expansion-
ary monetary policies to stimulate domestic demand.
• Less dependence on foreign finance and changes in the
composition of external debt reduced their vulnerability to
swings in capital flows. As a group, emerging economies were
net exporters of capital during the past decade. Asian emerg-
ing markets, especially China, have run significant current
account surpluses in recent years. There are, of course, other
emerging economies—especially those in Europe—that were
running large current account deficits before the crisis. This
latter group proved most vulnerable to the crisis because
credit booms in these countries were financed largely through
foreign capital rather than domestic savings (see “A Tale of
Two Regions,” in the March 2010 issue of F&D). However,
shifts in the nature of capital flows to emerging markets have
reduced their overall vulnerability to sudden stops of capital
inflows. During the past decade, disciplined macroeconomic
policies have facilitated a shift toward more stable forms of
capital inflows to a number of emerging markets, away from
debt and toward foreign direct investment (FDI) and equity
investment. FDI, in particular, tends to be less risky for the
recipient country.
• Large buffers of foreign exchange reserves also insured
against sudden reversals in investor sentiment. Following the
Asian financial crisis of 1997–98, emerging markets around
the world built large levels of foreign exchange reserves, partly
as a result of export-oriented growth strategies and partly as
a form of self-insurance against crises associated with sud-
den stops or reversals of capital inflows. Emerging economies
have accumulated $5.5 trillion in foreign exchange reserves,
nearly half of which is accounted for by China. These reserves
came in handy during the crisis but, as we discuss later, their
benefits have to be weighed against the costs of accumulating
such reserves.
• Emerging markets have become more diversified in their
production and export patterns, although this has been largely
offset by vertical specialization—with some countries supply-
ing parts and other intermediate products to the country that
is the ultimate exporter. This specialization has led, particu-
larly in Asia, to regional supply chains. Diversification offers
only limited protection against large global shocks but, as
long as the macro effects of shocks are not the same across the
export markets of emerging economies, it can help them deal
with the disruptions that occur over the normal business cycle.
• Greater trade and financial linkages among the emerg-
ing economies have increased their resilience as a group
(see Chart 3). Strong growth in the emerging markets has
shielded commodity-exporting countries from slowdowns
in the advanced economies. China’s continued rapid growth
during the crisis, fueled by a surge in investment, has boosted
the demand for commodities from emerging markets, such
as Brazil and Chile, and has increased the demand for raw
materials and intermediate inputs from other Asian emerg-
ing markets. The increase in trade flows among emerging
economies has been accompanied by a rise in financial flows
within this group.
• Broader divergence of emerging market business cycles
from those of the advanced economies has also increased
resilience. The rising intragroup trade and financial linkages
discussed above have strengthened this trend. In addition,
regional initiatives have encouraged financial integration and
financial development among some Asian countries, although
the scope and scale of these initiatives remain limited.
• Rising per capita income levels and a burgeoning middle
class have increased the size of domestic markets, making
emerging markets potentially less reliant on foreign trade to
benefit from economies of scale in their production struc-
tures and less susceptible to export collapses. Still, private
consumption may not always be able to take up the slack if
there are adverse shocks to export growth.
The good and the ugly
These factors are brought into sharper relief when we examine
more closely the experiences of two sets of emerging markets
between which there is a clear contrast in terms of resilience
to the global financial crisis. Before the crisis, average per
capita GDP growth was highest in emerging markets in Asia
and Europe. But since then these two groups’ fortunes have
diverged. While Asian emerging markets, particularly China
and India, were among the most resilient during the crisis,
some economies of emerging Europe were the hardest hit.
Emerging Asia was relatively insulated from the effects of
the financial crisis, possibly for the following reasons:
• Financial markets are relatively limited in their depen-
dence on foreign bank financing, which narrowed the chan-
nels for financial contagion and also kept trade finance from
collapsing.
• High and rising saving rates have more than kept pace
with rising investment rates, leading to current account
surpluses and growing stocks of foreign exchange reserves,
thereby insulating the region as a whole from the effects of a
sudden stop in capital flows from advanced economies.
• Prudent macroeconomic policies practiced by a number
of these countries allowed for the fiscal flexibility to respond
aggressively to the spillover effects of the crisis.
Finance & Development December 2010 9
Chart 3
Trading among themselves
Emerging economies are trading increasingly with one another
rather than with advanced economies.
(destination of emerging economy trade, percent of total)
Kose, 11/11/10
Source: Authors’ calculations.
Note: Trade ows are calculated by aggregating the bilateral export and import data of
emerging economies. The sum does not equal 100 percent because not all economies
are counted—only emerging and advanced.
1960s 1980s 2000–08
Advanced economies
Emerging market economies
0
10
20
30
40
50
60
70
80
90
Emerging economies are becoming
more important players in setting
global priorities.
By contrast, emerging Europe was particularly vulner-
able to the aftershocks of the crisis. It had a high level of
dependence on external finance, as reflected in large current
account deficits; significant exposure to foreign banks, which
had many benefits but also served as a transmission channel
for the crisis; and rapid credit expansion in the years before
the crisis, which was difficult to sustain after foreign bank
financing dried up.
Lessons
Our analysis points to some important lessons as well as a
few instances where it may be tempting for policymakers to
draw the wrong conclusions.
First, during good times, policymakers should work to cre-
ate more room for macroeconomic policy responses to adverse
shocks. Emerging economies that had lower levels of public
debt (relative to GDP) were better able to conduct aggressive
countercyclical fiscal policy responses to the global financial
crisis and less concern about worsening their debt service
obligations.
Second, a growth strategy that is well balanced between
domestic and external demand can lead to more stable outcomes.
Third—and this is hardly new—emerging economies can
derive significant indirect benefits from openness to foreign
capital but should be cautious about dependence on certain
forms of capital, particularly short-term external debt.
Fourth, a deep and well-regulated financial system can help
absorb capital inflows more effectively and reduce vulnerability
to volatile capital inflows. It can also enhance the transmis-
sion of monetary policy and add to its potency as a counter-
cyclical tool. This means that financial market development
and reforms are an important priority in most emerging
economies. Although some emerging economies were not hit
hard by the crisis precisely because they had underdeveloped
financial markets, this has potentially adverse long-term
implications for growth as well as the distribution of the ben-
efits of growth (see “Trusting the Government,” in this issue
of F&D).
Moreover, although large buffers of foreign exchange
reserves can mitigate vulnerabilities stemming from the cri-
sis, there are also significant costs associated with massive
stocks of reserves. One cost is the interest payments on gov-
ernment bonds that are used to soak up the liquidity created
by these inflows (when they are converted to domestic cur-
rency). Without such sterilization there would be risks of spi-
raling domestic inflation. Subtler but equally important costs
are the constraints on domestic policies used to buttress fixed
exchange rates; such constraints often include state owner-
ship of banks, heavy restrictions on capital flows, and gov-
ernment control of interest rates.
Confronting new issues
In the aftermath of the crisis, there is a striking dichotomy
between advanced and emerging economies in the short-
term risks and policy issues they face. Among advanced
economies, the major concern is weak growth and deflation
pressures. Conventional monetary policy has reached its lim-
its, and debt has risen to such high levels that it constrains
the scope of fiscal policy. In many emerging economies, by
contrast, growth has rebounded sharply, and some of these
economies face rising inflation, surges of capital inflows and
the accompanying risk of bubbles in asset and credit markets,
and the threat of rapid currency appreciation.
Along with an increase in their economic heft, emerging
economies are becoming more important players in setting
global priorities. The unofficial anointment of the Group of
20 large economies as the major body determining the global
economic agenda has given emerging markets a prominent
seat at the table. The same is true in international institutions
such as the new Financial Stability Board and the 65-year-old
International Monetary Fund, where emerging economies
are getting a much larger say than before.
Although emerging markets have attained a good level of
maturity in many dimensions, they still face major domestic
policy issues that could limit their growth potential. Financial
market development is essential to channel domestic and for-
eign savings more efficiently into productive investment. In
tandem with well-designed social safety nets, this is impor-
tant for distributing the fruits of growth more evenly. The
emphasis should be on more balanced growth rather than a
narrow focus on boosting bottom-line GDP without regard
for distributional and environmental consequences.
The global financial crisis presents a unique opportunity
for emerging markets to mature in another dimension—
taking on more responsibility for global economic and
financial stability. While emerging markets, such as China
and India, remain relatively poor in per capita terms, their
sheer overall size makes it important for them to consider the
regional and global spillovers of their policy choices. This will
require them to play an active role in guiding international
debate on key policy issues, including strengthening global
economic governance. It is in their own long-term interest
to take the lead on global challenges, from dismantling trade
barriers to tackling climate change, rather than focusing nar-
rowly on their own perceived short-term interests.
■
M. Ayhan Kose is an Assistant to the Director in the IMF’s
Research Department. Eswar S. Prasad is the Tolani Senior
Professor of Trade Policy at Cornell University, Senior Fellow
and New Century Chair in International Economics at the
Brookings Institution, and a Research Associate at the Na-
tional Bureau of Economic Research.
is article is based on Emerging Markets: Resilience and Growth Amid
Global Turmoil, by Kose and Prasad, published in November 2010 by the
Brookings Institution Press.
10 Finance & Development December 2010
China’s rapid
integration
and growth are
increasingly
affecting the
rest of the
world
Finance & Development December 2010 11
Photo above: Salesperson in
textile shop in Beijing, China.
C
HINA’S economy has grown dra-
matically and rapidly since 1978,
when it launched its “reform and
opening-up” strategy. It is now the
world’s second-largest economy, its biggest ex-
porter, and an increasingly important investor.
And to fuel its export engine, it imports sig-
nicant quantities of raw materials and semi-
nished products from around the globe.
But there is little empirical analysis of
how much China’s growth has affected other
countries—whether nearby Asian nations,
commodity-producing countries in Africa
and Latin America, or major consumers of
Chinese products.
To help remedy this, we have quantified
the implications of China’s growth for the
rest of the world and conclude that China’s
expansion has had a positive impact on
global growth that has increased over time
in both size and reach. A few decades ago,
China’s expansion influenced growth only in
neighboring countries; it now affects growth
all over the world. These findings confirm,
or at least provide a quantitative basis for, a
hunch that economists have had for years.
Unprecedented growth
The ramifications of China’s opening-up pol-
icy are well documented. Even so, the facts
are astonishing. From relatively poor begin-
nings three decades ago, China’s economy is
now second in size only to the United States.
Real gross domestic product (GDP) has
grown by about 10 percent annually, imply-
ing a doubling every seven to eight years. The
resulting 16-fold increase in a major econo-
my’s national income during a single genera-
tion is unprecedented.
That these improvements involve one-fifth
of the world’s population highlights the vast
human scale of the achievement. Several hun-
dred million people have been lifted out of
poverty, and living conditions have improved
for many more people in a shorter period of
time than ever before.
Tighter global linkages
China’s opening up has meant increas-
ing linkages with the rest of the world, as
reflected in its rising share in world trade,
global markets for selected goods, and capi-
tal flows. China’s stronger linkages with the
Vivek Arora and Athanasios Vamvakidis
Gauging
China’s Influence
12 Finance & Development December 2010
global economy have also led to a growing use of its cur-
rency abroad, as well as closer correlation of market senti-
ment in China and the rest of Asia and, more recently, the
world. China’s share in world trade has increased nearly ten-
fold over the past three decades, to about 9 percent, while its
share in world GDP has risen to 13 percent from less than
3 percent (purchasing-power-parity basis; see Chart 1).
Although China’s role in the world economy has increased
significantly, it remains small relative to that of the United
States. China’s GDP at current exchange rates is only one-
third of U.S. GDP, and its private consumption is only about
one-fifth. China cannot, therefore, replace the United States
as a global consumer anytime soon. But it continues to be an
important trading partner for many countries, and its rapid
expansion can affect growth in other countries in various ways.
The increase in China’s share of world trade is particu-
larly striking in the markets for certain products. China
now accounts for nearly one-tenth of global demand for
commodities and more than one-tenth of world exports of
medium- and high-technology manufactured goods. China
has become a major exporter of electronics and information
technology products and is the largest supplier to the United
States of consumer electronics products such as DVD play-
ers, notebook computers, and mobile phones.
China’s rising share in world trade over the past three
decades is underpinned by a rise in its share in the external
trade of every major region (see Chart 2). China’s share is,
perhaps unsurprisingly, largest in the trade of other emerg-
ing Asian economies (13 percent), and this share has seen a
striking increase over time. But its share of African trade is
almost as large, and its share in trade with the Middle East,
the Western Hemisphere, and Europe has increased several-
fold in recent decades.
China’s growing integration with the rest of the world
extends beyond trade. Developments in China appear to
have an increasing influence on business and consumer sen-
timent in other countries. And other countries’ capital flows
to and from China are growing steadily. Inflows of foreign
direct investment (FDI) to China, for example, accounted for
7 percent of gross world FDI inflows in 2009, compared with
just 1 percent in 1980. FDI outflows from China are a more
recent phenomenon, rising from a negligible share of gross
global outflows as recently as 2004 to 4 percent in 2009.
Impact on others
Flows of trade and capital between China and the rest of the
world are affecting growth in other countries through sev-
eral channels. China’s imports of commodities, inputs, and,
increasingly, final products directly raise partner countries’
exports and GDP. In turn, China’s exports have a negative
direct effect on partner countries’ net exports. The indi-
rect effects on welfare and GDP, however, could be positive
because relatively low-cost products from China raise con-
sumption and production possibilities in partner countries.
China’s role in processing trade also has implications
for other Asian countries in the Asian supply chain, where
Chinese final goods exported to the West require, for their
production, substantial inputs from the rest of Asia. This
supply chain allows other Asian countries, especially smaller
ones, greater access to global markets. Capital flows to and
from China can also affect the global demand and supply of
capital. Developments in China seem to have spillover effects
on market confidence in other countries. And the list goes on.
Measuring the impact
To quantify the effects of China’s growth on the rest of the
world, we conducted an empirical analysis using data from
the past few decades. In light of the multiple channels through
which China’s growth can influence growth elsewhere, and
the difficulty of identifying—let alone quantifying—each
channel, our analysis focuses on quantifying only the aggre-
gate impact. We leave for future research the task of assessing
the relative importance of various channels of impact.
Chart 2
Surging trade
China is an increasingly important trading partner with all
regions.
(percent of regions’ total trade)
Arora, 11/5/10
Source: IMF, Direction of Trade Statistics.
European Africa Emerging Middle East Western
Union Asia (excluding Hemisphere
China)
1980
2009
0
2
4
6
8
10
12
14
China’s imports of commodities,
inputs, and, increasingly, nal
products directly raise partner
countries’ exports and GDP.
Chart 1
Rising share
China’s share of world GDP and trade is rising rapidly.
(percent)
Arora, 11/5/10
Source: IMF, World Economic Outlook, and Direction of Trade Statistics.
Note: PPP = purchasing power parity, which takes into account national cost of living.
GDP ($) GDP (PPP)
Trade
1980
2000
2009
0
3
6
9
12
15
Finance & Development December 2010 13
Our empirical results suggest that the role of China’s
growth in explaining output fluctuations in other countries
is sizable and has increased substantially in recent decades.
The results include effects both during the one- to five-year
period typically associated with business cycles and over the
longer term.
In the short and medium term, our results suggest that
a 1 percentage point shock to China’s GDP growth is fol-
lowed by a cumulative response in other countries’ growth
of 0.2 percentage point after three years and 0.4 percent-
age point after five years (see Chart 3). What accounts for
this impact? Our analysis suggests that initially almost all
of the impact is felt through trade channels. But, over time,
the impact of nontrade channels increases. Over a full five
years, about 60percent of the impact of China’s growth on
other countries seems to be transmitted through trade chan-
nels and the remaining 40 percent through other channels.
Examples of these other channels include capital flows, tour-
ism (which is particularly important for some of China’s
neighbors) and business travel, and consumer and business
confidence.
Shifting to the longer term, we estimated the impact on the
rest of the world of long-term changes in Chinese growth,
smoothing over the short-term fluctuations associated with
the typical business cycle and focusing on longer-term fluc-
tuations. We looked at variables that are known to have a sig-
nificant impact on GDP growth, such as investment, trade,
initial income, age dependency (the ratio of non-working-
age to working-age people), government consumption, and
inflation. We found, as have previous studies, that domestic
growth is positively correlated with investment and trade
and negatively correlated with initial per capita GDP, age
dependency, government consumption, and inflation. We
conducted several tests to rule out the effects of such factors
as common global shocks, which could simultaneously influ-
ence growth in China and the rest of the world.
The results suggest that, over the long term, as in the short
and medium term, China’s expansion affects growth in other
countries. And, as noted, the size and scope of this effect
have increased in recent decades: initially China’s growth sig-
nificantly affected only neighboring Asian countries, but the
influence has spread over time to countries all over the world.
The size of the global impact of China’s growth, moreover,
has increased from negligible levels until about two decades
ago to a sizable impact more recently.
Our results, based on data for the past two decades, sug-
gest that a 1 percentage point change in China’s growth sus-
tained over five years is associated with a 0.4 percentage point
change in growth in the rest of the world (coincidentally the
same amount as for the short and medium term). Moreover,
analysis of a longer time period (1963–2007) suggests that
the spillover effect of China’s growth has increased over time.
Geographic distance seems to affect the strength of the spill-
over effects, with a stronger impact the closer a country is to
China. But the estimates also suggest that the role of distance
has diminished over time.
Just a first step
We have taken a first step in assessing the influence of China’s
growth on other countries, but we have quantified only the
aggregate impact. Future work will need to document and
quantify the various channels of transmission, which may
themselves change over time with changes in the structure of
the Chinese economy and the composition of its trade and
capital flows.
■
Vivek Arora is an Assistant Director in the IMF’s Asia and
Pacic Department, and Athanasios Vamvakidis is a Deputy
Division Chief in the IMF’s Strategy, Policy, and Review
Department.
is article is based on the authors’ IMF Working Paper 10/165, “China’s
Economic Growth: International Spillovers.”
Chart 3
Branching out
China’s growth affects other countries rst only in trade but
over time also through other channels.
(cumulative effects of a 1 percentage point rise in China’s growth on
growth in other countries, in percentage points)
Arora, 11/5/10
Source: Authors’ calculations, based on IMF, World Economic Outlook database.
Note: Estimates from an unrestricted panel vector autoregression with two lags, using
annual data for 172 economies for the rest of the world.
2 years 3 years 4 years 5 years
Impact on rest of world
Impact on rest of world
excluding trade impact
0
0.1
0.2
0.3
0.4
14 Finance & Development December 2010
Without the
quick and
massive policy
response,
the Great
Recession
might still
plague the
United States
T
HE U.S. economy has come a long
way since the dark days of the Great
Recession. Less than two years ago,
the global nancial system was on
the brink of collapse, and the United States
was suering its worst economic downturn
since the 1930s. At its worst, real gross do-
mestic product (GDP) appeared to be in
free fall, declining at nearly a 7 percent an-
nual rate, with job losses averaging close to
750,000 a month. Today, the nancial system
is operating much more normally, real GDP
has grown by more than 3 percent during the
past year, and job growth has resumed, al-
though at an insucient pace.
From the perspective, say, of early
2009, this rapid turnabout was a surprise.
Maybe the country and the world were just
lucky. But we take another view: the Great
Recession in the United States gave way to
recovery as quickly as it did largely because
of the unprecedented responses by monetary
and fiscal policymakers.
The Federal Reserve (Fed), the Bush
and Obama administrations, and the U.S.
Congress pursued the most aggressive and
multifaceted fiscal and monetary policy
responses in history. While the effectiveness
and/or wisdom of any individual element can
be debated, we estimate that if policymakers
had not reacted as aggressively or as quickly
as they did, the financial system might still be
unsettled, the economy might still be shrink-
ing, and the costs to U.S. taxpayers would
have been vastly greater.
That said, almost every policy response
remains controversial, with critics accus-
ing them of being misguided, ineffective,
or both. Resolution of this issue is crucial
because, with the durability of the economic
recovery still uncertain, there may be need
for further stimulus.
Policy responses
Broadly speaking, the U.S. government set
out to accomplish two goals: to stabilize the
sickly financial system and to mitigate the
burgeoning recession and restart economic
growth. The first task was necessitated by
the financial crisis, which struck in mid-
2007 and spiraled into a financial panic
in late 2008. After the bankruptcy of the
investment banking firm Lehman Brothers,
liquidity evaporated, credit spreads bal-
looned, stock prices fell sharply, and a string
of major financial institutions failed. The
second task was required because of the dev-
astating effects of the financial crisis on the
real economy, which began to contract at an
alarming rate after the Lehman collapse.
The Fed took a number of extraordinary
steps to quell the financial panic. In late
Alan S. Blinder and Mark Zandi
Worked
Finance & Development December 2010 15
2007, it established the first of what would eventually become
an alphabet soup of new credit facilities designed to pro-
vide liquidity to financial institutions and markets. The Fed
lowered interest rates aggressively during 2008, adopting a
near-zero interest rate policy by year’s end. It also engaged
in massive quantitative easing to bring down long-term
interest rates, purchasing treasury bonds and Fannie Mae
and Freddie Mac mortgage-backed securities in 2009 and
2010. The Federal Deposit Insurance Corporation increased
deposit insurance limits and guaranteed bank debt. Congress
established the Troubled Asset Relief Program (TARP) in
October 2008, part of which was used by the U.S. Treasury
to inject much-needed capital into the nation’s banks. The
Treasury and the Fed ordered 19 large financial institutions
to conduct comprehensive stress tests in early 2009 to deter-
mine whether they had sufficient capital—and to raise more
if necessary. The stress tests and subsequent capital raising
seemed to restore confidence in the banking system.
The fiscal (that is, taxing and spending) efforts to end the
recession and jump-start the recovery were built around a
series of stimulus measures. Income tax rebate checks were
mailed to households in early 2008; the American Recovery
and Reinvestment Act (ARRA) was passed in early 2009; and
several smaller stimulus measures became law in late 2009
and early 2010—such as the Cash-for-Clunkers tax incentive
for auto purchases, the extension and expansion of the hous-
ing tax credit through mid-2010, the passage of a new jobs
tax credit through year-end 2010, and several extensions of
emergency unemployment insurance benefits. In all, close to
$1 trillion, roughly 7 percent of GDP, will be spent on fis-
cal stimulus. We do not believe it was a coincidence that the
turnaround from recession to recovery occurred in mid-
2009, just as ARRA was providing its maximum impact.
The emergency measures included rescuing the nation’s
housing and auto industries. The housing bubble and bust set
off a vicious cycle of falling house prices and surging fore-
closures, which policymakers appear to have broken with
an array of efforts, including the Fed’s actions to bring down
mortgage rates, an increase in limits on the size of loans that
conformed to government standards, a dramatic expansion
of Federal Housing Administration lending, a series of tax
credits for home buyers, and the use of TARP funds to miti-
gate foreclosures. While automakers General Motors (GM)
and Chrysler eventually went through bankruptcies, TARP
funds made the process relatively orderly—and GM is a pub-
licly traded company again.
Withering criticism
The response to the crisis sounds like a success story to us.
Yet nearly all aspects of the government’s response have been
subjected to intense criticism. The Fed has been accused of
overstepping its mandate by conducting fiscal as well as mon-
etary policy. Critics have attacked efforts to stem the decline
in house prices as inappropriate, claimed that foreclosure
mitigation efforts were ineffective, and argued that the auto
bailout was both unnecessary and unfair. Particularly heavy
criticism has been aimed at the two biggest programs: TARP
and the Recovery Act.
The Troubled Asset Relief Program was controversial
from its inception. Both the program’s $700 billion headline
price tag and its goal of “bailing out” financial institutions—
including some of the institutions that had triggered the
panic—were hard for citizens and legislators to accept. To this
day, many believe TARP was a costly failure. In fact, however,
TARP has been a substantial success, helping restore stability
to the financial system and end the free fall in housing and
auto markets at an ultimate cost to taxpayers that will be a
small fraction of the headline $700 billion figure.
Criticism of ARRA has also been strident, focusing on the
high price tag, the slow delivery, and the fact that the unem-
ployment rate rose much higher than the Obama administra-
tion predicted in January 2009. While we would not defend
every aspect of the stimulus, we believe this criticism is
largely misplaced. The unusually large fiscal stimulus is con-
sistent with the extraordinarily severe downturn and the lim-
ited ability to use monetary policy once interest rates neared
zero. Regarding speed, spending surged from nothing at the
start of 2009 to over $100 billion (over $400 billion at an
annual rate) in the second quarter—which is a huge change
in a short period. (But soon the stimulus will end, with a
resulting drag on economic growth.)
Critics who argue that ARRA failed because it did not
keep unemployment below 8 percent ignore that unemploy-
ment was already above 8 percent when ARRA was passed
(which we learned only later because of lags in the data) and
that most private forecasters also misjudged how serious the
downturn would be. If anything, this forecasting error sug-
gests the stimulus package should have been even larger.
Quantifying the economic impacts
To quantify the economic impacts of the fiscal stimulus and
the financial market policies such as TARP and the Fed’s
quantitative easing, we simulated the Moody’s Analytics
model of the U.S. economy under four scenarios:
• No. 1, with all the policies pursued;
• No. 2, which includes the fiscal stimulus but excludes the
financial policies;
• No. 3, with the financial policies but without fiscal stim-
ulus; and
• No. 4, which excludes all the policy responses.
The differences between the baseline and what would
have happened with no policy response provide our central
results: estimates of the impacts of the entire menu of anti-
The turnaround from recession
to recovery occurred in mid-2009,
just as ARRA was providing its
maximum impact.
16 Finance & Development December 2010
recession policies. Scenarios 2 and 3 enable us to decompose
this overall impact into the components stemming from
the fiscal stimulus and financial initiatives. All simulations
begin in the first quarter of 2008, with the start of the Great
Recession, and end in the fourth quarter of 2012. The impact
on the U.S. economy of the substantial policy efforts imple-
mented in much of the rest of the world in response to the
global downturn was not explicitly considered.
Estimating the economic impact of the policies is a
counterfactual econometric exercise. Outcomes for GDP,
employment, and other variables are estimated using a statis-
tical representation of the U.S. economy based on historical
relationships—in particular, the Moody’s Analytics model,
which is used regularly for forecasting, scenario analysis, and
quantifying the impacts of fiscal and monetary policies.
The modeling techniques for simulating the fiscal poli-
cies were straightforward and have been used by countless
modelers over the years. While the scale of the fiscal stimulus
was massive, most of the instruments themselves (tax cuts,
spending) were conventional.
But modeling the vast array of financial policies, most of
which were unprecedented and unconventional, required
some creativity and forced us to make some major simplify-
ing assumptions. Our basic approach treated these policies
as ways to reduce credit spreads, particularly the three credit
spreads in the model: between the three-month London
interbank offered rate (LIBOR)—at which banks lend money
to each other—and three-month U.S. treasury bills; between
fixed-rate mortgages and 10-year U.S. treasury bonds; and
between below-investment-grade corporate bonds and U.S.
treasury bonds. All three of these spreads rose alarmingly
during the crisis, but then came tumbling down once the
financial medicine was applied (see Chart 1). The key ques-
tion for us was how much of the decline in credit spreads to
attribute to the policies, and here we tried several different
assumptions.
The simulation results
Under the baseline scenario, which includes all the finan-
cial and fiscal policies, the recovery that began over a year
ago is expected to remain intact. Real GDP, which declined
2.4 percent in 2009, expands 2.7 percent in 2010 and 3 per-
cent in 2011, with monthly job growth averaging near 75,000
in 2010 and 175,000 in 2011. Unemployment is still close to
10 percent at the end of 2010, but closer to 9.5 percent by the
end of 2011.
With no policy responses, the downturn is estimated to
continue into 2011. The decline in real GDP is stunning, fall-
ing peak-to-trough by close to 12 percent—compared with
an actual decline of about 4 percent. By the time employ-
ment hits bottom, some 16.6 million jobs are lost, about
twice as many as actually were lost. The unemployment rate
peaks at 16.5 percent. With outright deflation in prices and
wages during 2009–11, this dark scenario would constitute a
1930s-like depression.
The differences between the baseline scenario and the sce-
nario with no policy responses are huge (see Charts 2–4). By
Chart 1
Quelling the panic
After Lehman Brothers collapsed, the spread between rates
on U.S. treasury bills and on private credit (such as LIBOR)
rose dramatically, a sign of investor panic. After nancial
support programs were put in place, the spreads shrank.
(difference between yield on three-month LIBOR and U.S. treasury bills,
percentage points)
Blinder, 11/9/10 revised
Sources: U.S. Federal Reserve; and Moody’s Analytics.
Note: LIBOR is the London interbank offered rate, a rate at which banks lend to each other;
TARP is the Troubled Asset Relief Program; FDIC is the Federal Deposit Insurance Corporation;
TLGP is the Temporary Liquidity Guarantee Program.
TARP passes
TARP fails to
pass Congress
Bank funding
problems
Fannie/Freddie
takeover
Bank stress
tests
Lehman
failure
Bear
collapses
Bear Stearns
hedge funds
liquidate
FDIC TLGP
program adopted
Fed adopts zero
interest rate policy
2007 08 09 10
0
1
2
3
4
5
Blinder, 11/9/10 revised
Chart 2
Judging U.S. policy
The U.S. economy, as measured by GDP, is much better off
because of the policy responses to the Great Recession. Had
there been no response, the recession would continue today.
(U.S. real GDP, trillions of dollars)
Sources: U.S. Bureau of Economic Analysis; and Moody’s Analytics.
Note: The chart estimates GDP under four scenarios: baseline (which includes
both the stimulus and nancial support); no policy (in which the government took no
action); no nancial (in which only scal stimulus was provided); and no stimulus
(in which only nancial support was undertaken).
Baseline
No stimulus
No nancial
No policy
2008 09 10 11 12
11
12
13
14
15
Blinder, 11/9/10 revised
Chart 3
Unemployment would soar
Had U.S. authorities taken no action, unemployment would have
risen to nearly 17 percent and would be above 14 percent at
the end of 2012.
(unemployment rate, percent)
Sources: U.S. Bureau of Economic Analysis; and Moody’s Analytics.
Note: The chart estimates unemployment under four scenarios: baseline (which
includes both the stimulus and nancial support); no policy (in which the government
took no action); no nancial (in which only scal stimulus was provided); and no
stimulus (in which only nancial support was undertaken).
No policy
No nancial
No stimulus
Baseline
2008 09 10 11 12
4
6
8
10
12
14
16
18
Finance & Development December 2010 17
2011, real GDP is $1.8 trillion (15 percent) higher because of
the policies, there are almost 10 million more jobs, and the
unemployment rate is about 6½ percentage points lower. The
inflation rate is about 3 percentage points higher (roughly
2 percent instead of –1 percent). That’s what averting a
depression means.
How much of this gigantic effect was due to the govern-
ment’s efforts to stabilize the financial system and how much
was due to the fiscal stimulus? The other two scenarios are
designed to answer those questions.
We find that the financial policy responses were more
important than the fiscal policies. In the scenario without
them but including the fiscal stimulus, the recession would
only now be winding down, the peak-to-trough decline in
real GDP and employment would be about 6 percent and
12 million respectively, and the unemployment rate would
peak at about 13 percent.
The differences between the baseline and the scenario with
no financial policy responses represent our estimates of the
combined effects of the various policy efforts to stabilize the
financial system. They are very large. By 2011, real GDP is
almost $800 billion (6 percent) higher because of the poli-
cies, and the unemployment rate is almost 3 percentage points
lower. By the second quarter of 2011—when the effects are at
their largest—the financial rescue policies are credited with
saving almost 5 million jobs.
In the scenario that includes all the financial policies but
none of the fiscal stimulus, the recession ends in the fourth
quarter of 2009 and expands very slowly through mid-2010.
The peak-to-trough decline in real GDP is over 5 percent,
and employment declines by more than 10 million. The
economy finally gains some traction by early 2011, but by
then unemployment is peaking at nearly 12 percent.
The differences between the baseline and the scenario with
no fiscal stimulus represent our estimates of the effects of
all the fiscal stimulus efforts. Because of the fiscal stimulus,
real GDP is about $460 billion (more than 6 percent) higher
by 2010, when the impacts are at their maximum; there are
2.7 million more jobs; and the unemployment rate is almost
1.5 percentage points lower.
The combined effects of the financial and fiscal policies
exceed the sum of the financial policy effects and the fiscal
policy effects, each taken in isolation. This is because the
policies tend to reinforce one another. As one simple example
(there are many others), by holding interest rates constant,
the Fed increases the fiscal multiplier.
Laissez-faire: not an option
The financial panic and the ensuing Great Recession were
massive blows to the U.S. and world economies. Employment
in the United States is still some 7.5 million below where it
was at its prerecession peak, and the unemployment rate
remains over 9 percent. The hit to the nation’s fiscal health
has been equally disconcerting, with budget deficits in fiscal
years 2009 and 2010 of close to $1.4 trillion. These unprec-
edented deficits reflect both the recession itself and the costs
of the government’s multifaceted response to it.
It is understandable that the still-fragile economy and the
massive budget deficits have fueled criticism of the govern-
ment’s response. No one can know for sure what the world
would look like today if policymakers had not acted as they
did. Our estimates are just that: estimates. It is also not diffi-
cult to find fault with aspects of the policy response. Were the
bank and auto industry bailouts necessary? Was the hous-
ing tax credit a giveaway to buyers who would have bought
homes anyway? The questions go on and on.
Although these—and other—questions deserve careful con-
sideration, we believe that laissez-faire was not an option. Not
responding would have left both the economy and the govern-
ment’s fiscal situation in far graver condition. We conclude
that U.S. Federal Reserve Board Chairman Ben Bernanke was
probably right when he said, “We came very close in October
[2008] to Depression 2.0” (Wessel, 2009).
While TARP has not been a universal success, it was instru-
mental in stabilizing the financial system and ending the
recession. The fiscal stimulus also fell short in some respects,
but without it, the economy might still be in recession. When
all is said and done, the panoply of policy responses will have
cost taxpayers a substantial sum, but not nearly as much as
most had feared and not nearly as much as if policymakers
had not acted at all. If the comprehensive policy responses
saved the economy from another depression, as we estimate,
they were well worth their cost.
■
Alan S. Blinder is a Professor of Economics at Princeton Uni-
versity and Mark Zandi is Head of Moody’s Analytics.
is article is based on the authors’ paper “How the Great Recession Was
Brought to an End,” released July 28, 2010, and available at www.dismal.
com/mark-zandi/documents/End-of-Great-Recession.pdf
Reference:
Wessel, David, 2009, “Inside Dr. Bernanke’s E.R.,” e Wall Street
Journal, July 24.
Blinder, 11/9/10 revised
Chart 4
More on the job
Far more people are at work because of the nancial and
scal actions than would have found jobs had there been no
policy response.
(U.S. payroll employment, millions)
Sources: U.S. Bureau of Labor Statistics; and Moody’s Analytics.
Note: The chart estimates employment under four scenarios: baseline (which includes both
the stimulus and nancial support); no policy (in which the government took no action); no
nancial (in which only scal stimulus was provided); and no stimulus (in which only nancial
support was undertaken).
Baseline
No stimulus
No nancial
No policy
2008 09 10 11 12
120
122
124
126
128
130
132
134
136
138
18 Finance & Development December 2010
In dealing with
the aftermath
of the Great
Recession,
policymakers
must pay
attention
to the mix
of austerity
policies
T
HE severe nancial crisis that hit
the world economy in 2008 not
only caused a large decline in out-
put and brought about an uncer-
tain economic outlook, it also harmed many
countries’ public nances. Its legacy can be
seen in the massive buildup of public debt
around the world—more so in advanced than
in emerging market economies.
In the advanced economies, public debt
is projected to reach an average of 108 per-
cent of gross domestic product (GDP) at
end-2015. This is about 35 percentage points
more than at end-2007, before the onset of
the global crisis. That high a level of debt has
not been seen in these countries since just
after the end of World War II (see Cottarelli
and Schaechter, 2010) and reflects in large
part a permanent loss of revenue from the
bursting of the asset price bubble, lower
potential output, and countercyclical fiscal
stimulus. Public debt had started to pile up
before the crisis in these countries, mostly
because of rising spending, but the increase
in the aftermath of the global recession has
been rapid and large, as some countries bor-
rowed at wartime levels.
In the absence of policy changes, the fis-
cal position of advanced economies is pro-
jected to get even worse. Population aging
is likely to exert significant upward pressure
on health care and pension spending (IMF,
Emanuele Baldacci, Sanjeev Gupta, and Carlos Mulas-Granados
Getting Debt
under Control
Finance & Development December 2010 19
2010), creating a tide against which advanced economies will
be forced to swim, even as they seek to implement policies
aimed at reducing their debt burden (fiscal consolidation).
In emerging economies, the impact of the crisis has been
milder and underlying fiscal conditions stronger than in
advanced economies (with some exceptions, such as central
and eastern European economies). Nonetheless, emerging
economies have less tolerance for debt, because their abil-
ity to raise revenue is more limited—for example, their large
informal sectors escape taxation—and their tax bases are
more volatile than those in advanced economies. Emerging
economies remain exposed to spillover from debt problems
in advanced sovereigns and face possible problems refinanc-
ing existing debt as it comes due.
Crises spawn debt accumulation
High public debt levels in the wake of financial crises are not
new. Studies have shown that banking crises have large fiscal
consequences both in advanced and emerging market econo-
mies. For example, Rogoff and Reinhart (2009) found that
in a sample of historical episodes, government debt on aver-
age rose by 86 percent in the three years following a bank-
ing crisis; Laeven and Valencia (2008) report that the average
fiscal cost of banking crises was slightly less than 15 percent
of GDP in the past three decades. Furthermore, the average
increase in the ratio of public debt to GDP was about 40 per-
centage points during these episodes (see Baldacci, Gupta,
and Mulas-Granados, 2009).
What is unprecedented this time is that many countries—
those with the biggest slice of global output—have been pil-
ing up government liabilities in a fragile global economic
environment amid a high degree of uncertainty. This can be
problematic for four reasons.
First, high debt levels raise solvency risks and increase
the cost of borrowing for sovereigns. Second, high debt can
constrain the ability of a government to use fiscal policy
as a countercyclical tool, for example, when crisis strikes.
Third, high interest rates spawned by high debt can have an
adverse impact on output growth and productivity. Fourth,
the need for simultaneous fiscal tightening—in the absence
of exchange rate depreciation and with limited room for
expansionary monetary policy across a number of large
economies—risks harming global aggregate demand.
Restoring debt sustainability
How then should countries lower their debt-to-GDP ratio?
ey can either implement new revenue and/or expenditure
measures to reduce the scal decit or take steps to promote
growth—or do both. Improvements in the primary balance
(the scal balance without interest costs) can reduce new bor-
rowing and help lower the debt stock. Higher output growth
can help improve the overall scal position in two ways: in-
creased revenue and a lower ratio of spending to GDP.
However, reducing public debt after the recent financial
crisis will likely be particularly challenging. Adjustments suf-
ficient to reduce debt to prudent levels have been achieved
both in advanced and in emerging market economies in the
past two decades, but this time fiscal consolidation must take
place in an environment of higher global risk, more turbu-
lent financial markets, and weaker demand. In addition, the
scope for monetary policy to support growth, if countries
undertake fiscal consolidation, is limited by many advanced
economies’ low policy interest rates. Moreover, policymakers
will find it difficult to use exchange rate policies to support
competitiveness, because many large economies are in need
of fiscal consolidation at the same time.
What is a desirable debt level for these countries to ensure
fiscal sustainability? This is a difficult question to answer:
the target must take into account country-specific consider-
ations concerning sustainable debt in light of fiscal policies,
demographics, and unfunded entitlements, as well as long-
term interest rates and output growth rates. For example,
a return to the precrisis public debt level may not be suffi-
ciently ambitious for countries that had high ratios before the
crisis. A widely used approach is to define specific thresholds
of 60 percent of GDP for advanced economies and 40 percent
of GDP for emerging market economies—reflecting the per-
ceived higher risk for the latter. The 60 percent of GDP target
for advanced economies is roughly also the median debt-to-
GDP ratio of those economies before the crisis.
Previous banking crises
What factors explain the success of public debt consolida-
tion after banking crises, and why are some countries able to
reduce their public debt to a prudent level faster than others?
To answer these questions we looked at 100 banking crisis
episodes that occurred between 1980 and 2008 in advanced,
emerging market, and low-income economies (see Baldacci,
Gupta, and Mulas-Granados, 2010). The analysis focuses on
factors affecting the length of successful debt reduction epi-
sodes. These are defined as reductions in the ratio of govern-
ment debt to GDP to the 60/40 percent of GDP thresholds,
but we also use alternative thresholds to test the robustness
of the results.
To assess the factors underlying the probability of success-
ful debt reduction, we first determined the length of success-
ful debt consolidation cases. Such episodes are identified by
a decline in public debt to a level (in percent of GDP) that
is lower than the target threshold. The length of the success-
ful debt consolidation episode ranges between 1 and 24 years:
the mean length of successful adjustment is about 10 years.
We then sought to explain differences in the length of suc-
cessful debt reductions across episodes on the basis of three
sets of variables. First, we control for the fiscal cost of the cri-
sis by including the length of the banking crisis preceding the
Successful debt consolidation is
less likely when countries are hit
by longer-lasting (and thus more
severe) banking crises.
20 Finance & Development December 2010
adjustment episode and the size of the debt accumulated dur-
ing the crisis.
We also control for the quality of fiscal adjustment (defined
as how much of it stems from expenditure savings, because
studies suggest that expenditure-based adjustment is more
durable). Unlike other studies, we allow interaction between
the quality of fiscal adjustment and the size of that adjustment
because, for countries with large adjustment needs, spending
cuts alone may not generate the needed fiscal consolidation.
To achieve large fiscal consolidation through spending cuts
only, governments may need to rely on inefficient saving
methods (such as limiting funds for public investment that
could help support growth). This implies that the adjustment
in these countries may need to be a balanced combination
of spending cuts and revenue increases—a key hypothesis to
be tested in the context of difficult postcrisis debt reduction.
We also control accompanying policies by including the
share of private investment, interest rates on deposits, and bud-
get composition.
Our analysis shows that successful debt consolidation is
less likely when countries are hit by longer-lasting (and thus
more severe) banking crises. This reflects typically higher
uncertainty and permanent output losses that make fiscal
consolidation more difficult and, in some cases, large struc-
tural fiscal imbalances accumulated before the crisis that
must be reversed in a weaker economic environment.
Lowering public debt takes time. Countries typically need
six to eight years or more to reduce an amount of debt equal
to the increase in advanced economies during the recent
crisis (see Chart 1). This means that to retain creditor con-
fidence countries should adopt fiscal adjustment strategies
early on and start implementing them as soon as economic
conditions are suitable.
Evidence from previous postcrisis debt reductions shows
that only 12 percent of countries were able to reduce their
debt to precrisis levels. Only 17 percent of the countries
achieved a debt reduction of 40 percentage points of GDP or
more (see Chart 2). This highlights the difficulty of adjust-
Baldacci, 10/27/10
Chart 4
Cutting spending counts
Debt reduction policies are in general more successful when
they are based on cuts in current expenditures.
(cuts in current spending as a percent of total budget adjustment)
Source: Authors’ calculations.
Note: Total adjustment could also include long-term spending cuts and tax increases.
Debt reduction, percent of GDP
–100 –80 –60 –40 –20 0
0
10
20
30
40
50
60
70
80
90
Chart 1
It takes time
Countries typically need six to eight years to work off
government debt following an economic crisis, when the
required reduction is 40 percent or less of GDP.
(duration, years)
Baldacci, 10/27/10
Source: Authors’ calculations.
Note: On average, the crisis that triggered the buildup in debt lasted two years.
Debt reduction, percent of GDP
–100 –80 –60 –40 –20 0
0
2
4
6
8
10
12
14
16
Baldacci, 10/27/10
Chart 2
Hard to trim
Only 17 percent of the countries that faced a run-up in
debt were able to reduce it by 40 percent of GDP or more
after the crisis.
(percent of countries with postcrisis debt reduction)
Source: Authors’ calculations.
0
10
20
30
40
50
60
61–8041–6021–40
Debt reduction, percent of GDP
Up to 20
Baldacci, 10/27/10
Chart 3
When it’s bad to begin with
Larger debt reductions occurred mainly among countries
whose debt as a percent of GDP was substantial at the start of
a crisis.
(precrisis public debt, percent of GDP)
Source: Authors’ calculations.
Debt reduction, percent of GDP
–100 –80 –60 –40 –20 0
0
20
40
60
80
100
120
Finance & Development December 2010 21
ment in a postcrisis environment. Larger debt reduction was
associated with high initial levels of debt, as problems with
fiscal sustainability triggered forced budget consolidation
(see Chart 3).
Two lessons
Policymakers should be aware of two issues when devising
debt consolidation strategies:
• Cuts in low-priority expenditures facilitate fiscal adjust-
ment: debt consolidation is in general more likely to succeed
when based on cuts in current expenditures (see Chart 4).
This also holds true for countries in which the debt increase
is not related to a financial crisis. Why? Because curtailing
spending on transfers (such as pensions, subsidies, and other
entitlements) and wages reduces pressure on nondiscretion-
ary spending, which tends to rise over time, and may also
raise trend growth prospects. Curtailing this spending would
not only generate short-term savings for the budget, it would
also limit the momentum of public spending growth.
Constraining age-related spending, including on health
care and pensions, could be particularly important in light
of the demographic pressures that will accompany fiscal
consolidation in many countries. In this respect, entitlement
reforms that also have positive effects on growth should take
priority. For example, raising the retirement age can stimu-
late private consumption in the short term, contributing to
less-painful fiscal adjustment, while at the same time ensur-
ing the pension system’s medium-term financial viability.
Increasing the share of public investment raises the likeli-
hood of successful debt reduction by shifting the composi-
tion of the budget toward growth-friendly programs that
can boost medium-term productivity through enhanced
infrastructure.
• Raising additional tax revenues may also be needed:
cutting spending may, however, be insufficient in countries
with large adjustment needs. Unlike previous research on fis-
cal consolidation, our findings show that raising tax revenue
is key to successful debt reduction in countries with large
fiscal adjustment needs. This reflects the need to maintain
a balance between expenditure savings and revenue-raising
measures. The contribution of revenue to large consolidation
is not dependent on the initial tax-to-GDP ratio: revenue
reforms help achieve debt reduction even when the initial
tax-to-GDP ratio is not low.
Measures to increase taxation should, however, be
designed in a way that does not harm efficiency and mini-
mizes distortion, particularly where taxes as a percentage of
GDP are already high. Simplifying the tax system by reduc-
ing excessive tax rates and broadening the tax base could help
enhance revenue collection while shifting the burden of taxes
away from productive inputs. For example, financial sector
and carbon taxation may help the budget while at the same
time addressing efficiency concerns (see IMF, 2010).
Credible strategies
Our findings highlight the importance of credible fiscal
adjustment strategies that anchor market expectations about
fiscal sustainability. Fiscal policies that lack credibility can
hinder debt reduction and lead to potentially self-fulfilling
expectations about rising solvency risk. This is why measures
to strengthen the fiscal framework—such as adopting, when
needed, fiscal rules to guide budget policies and improving
fiscal transparency through independent fiscal agencies—
may benefit countries facing these challenges.
Other policies will strengthen fiscal efforts.
• When monetary policy establishes and maintains accom-
modative conditions and risk premiums are contained, debt
reduction is more likely—a key lesson for countries exiting the
crisis and preparing to unwind fiscal and monetary support.
• Pro-growth structural reforms (including product and
labor market liberalization) always matter, but are even more
essential during postcrisis fiscal consolidation: higher growth
makes debt reduction easier to achieve and sustain.
We show that getting the mix of expenditure and revenue
measures right can also help reduce credit risk premiums and
foster growth, in addition to allowing a sustained improve-
ment in the cyclically adjusted primary fiscal balance.
Policy implications
Successful debt consolidation is in general more likely when
based on cuts in current expenditures but, when adjustment
needs are large, raising taxes can result in more sustainable
debt reduction. This reflects the need to maintain a balance
between expenditure savings and revenue-raising measures in
such instances to avoid inefficiency and help support ambi-
tious consolidation plans. Higher taxation must, however, be
handled carefully to protect economic efficiency and mini-
mize distortions, particularly where taxes are already high.
■
Emanuele Baldacci is a Deputy Division Chief and Sanjeev
Gupta is a Deputy Director, both in the IMF’s Fiscal Aairs
Department. Carlos Mulas-Granados is a Professor of Eco-
nomics at Complutense University, Fellow of the ICEI Research
Institute, and Executive Director of the IDEAS Foundation in
Madrid.
References:
Baldacci, Emanuele, Sanjeev Gupta, and Carlos Mulas-Granados,
2009, “How Eective Is Fiscal Policy Response in Systemic Banking Crises,”
IMF Working Paper 09/160 (Washington: International Monetary Fund).
———, 2010, “Restoring Debt Sustainability aer Crises: Implications
for the Fiscal Mix,” IMF Working Paper 10/232 (Washington:
International Monetary Fund).
Cottarelli, Carlo, and Andrea Schaechter, 2010, “Long-Term Trends
in Public Finances in the G-7 Economies,” IMF Sta Position Note 10/13
(Washington: International Monetary Fund).
International Monetary Fund (IMF), 2010, “Fiscal Exit: From Strategy
to Implementation,” Fiscal Monitor (Washington, November).
Laeven, Luc, and Fabian Valencia, 2008, “Systemic Banking Crises: a
New Database,” IMF Working Paper 08/224 (Washington: International
Monetary Fund).
Rogo, Kenneth S., and Carmen M. Reinhart, 2009, “e Aermath
of Financial Crises,” NBER Working Paper 14656 (Cambridge,
Massachusetts: National Bureau of Economic Research).
22 Finance & Development December 2010
Governments
can do more
to alleviate
joblessness
and its human
costs
The Tragedy
of Unemployment
Measuring misery
The misery index—the sum of the inflation
and unemployment rates—gained popular-
ity as an indicator of economic distress dur-
ing the U.S. presidential election of 1980.
Since that time, the index has declined in
the United States and in advanced econo-
mies, in large part thanks to the taming of
inflation (see Chart 2). Unemployment,
however, has remained a problem, and its
contribution to the misery index increased
sharply during the Great Recession.
T
HE world faces an unemployment
crisis. Across the globe, an estimated
210 million people are unemployed,
an increase of more than 30 million
since 2007. ree-fourths of this increase has
occurred in the advanced economies. e
problem is particularly severe in the United
States—the epicenter of the Great Recession
and the country with the highest increase in
the number of unemployed people. ere are
7.5 million more people unemployed today
than in 2007. And while the U.S. recession has
been declared to have ended in June 2009, evi-
dence from the past couple of recoveries shows
that employment has taken quite a bit longer to
recover than incomes (see Chart 1).
The so-called misery index, the sum of the
inflation and unemployment rates, is now
almost totally dominated by joblessness (see
box). The human toll of the slow recovery in
jobs in the United States and elsewhere could
be very high. Studies have
demonstrated that the costs
to the unemployed include
a persistent loss in earnings
through career downgrad-
ing, reduced life expectancy,
and lower academic achieve-
ment and earnings for their
children. These costs are
greater for those who have
been unemployed longer.
There are many facets to
joblessness. This article will
look at
• the human cost of unemployment and
how governments’ policy responses during
the Great Recession kept it from being even
bigger;
• near-term policies to aid labor market
recovery; and
• the challenge posed by the high level of
long-term unemployment.
Human cost of unemployment
Research on the effects of past recessions
gives us a good idea of the often high and
persistent cost of unemployment for indi-
viduals and their families (see Dao and
Loungani, 2010, for a survey).
Layoffs are associated with loss of earn-
ings not just during the jobless episode but far
into the future (see Sullivan and von Wachter,
2009). The losses are higher if the unemploy-
ment occurs during a recession. Studies of
the United States and Europe show that even
15 to 20 years after a job loss during a reces-
sion, earnings of those who lost their jobs are
20 percent lower than those of comparable
workers who kept their jobs. The adverse
effects on lifetime earnings are most pro-
nounced for unemployment episodes experi-
enced by young people, especially following
college graduation. In a recession, young work-
ers tend to take worse jobs than they would
during better times. And as they settle into
family life and become less mobile, it is hard to
recover from this “cyclical downgrading.”
There is persistent and large loss of earn-
ings in other countries as well—Germany,
Mai Chi Dao and Prakash Loungani
Finance & Development December 2010 23
for example—and it is of similar magnitude. As the German
example shows, even in countries with more generous wel-
fare systems and lower earnings inequality than in the United
States, workers are not shielded from lifetime earnings losses
caused by job displacement.
The human toll is not limited to monetary losses: layoffs
may also be associated with loss of health and life, accord-
ing to recent studies. To rule out spurious associations—
unhealthy individuals may, for example, be less productive
and thus more likely to become unemployed—and other
confounding factors, the studies use data sets that allow
researchers to control for preexisting health, socioeconomic,
family, and other background characteristics as well as the
timing of health and job outcomes. Even after accounting
for these factors, layoffs are associated with a higher risk of
heart attack and other stress-related illnesses in the short
term. In the long term, the mortality rate of laid-off workers
is higher than that of comparable workers who do not lose
employment. For the United States, the increased mortality
rate due to joblessness is estimated to persist up to 20 years
after the job loss and lead to an average 1- to 1.5-year lower
life expectancy.
Job loss can reduce the academic achievement of children
of the unemployed: one study found that children whose par-
ents experienced job loss were 15 percent more likely than
other children to repeat a grade. In the long term, fathers’
income loss also reduces the earnings prospects of their chil-
dren. In Canada, for instance, children whose fathers were
displaced from their jobs were estimated to have annual
earnings nearly 10 percent lower than similar children whose
fathers remained employed. This relationship holds after
controlling for other individual and family characteristics
that might have an impact on earnings. In Sweden, lower
parental income has been correlated with children’s signifi-
cantly higher mortality later in life, even after controlling for
the children’s own income and education.
These costs are likely to be higher, the longer a person
is unemployed. Not only are the earnings losses greater,
but people who are out of a job for a long time lose self-
confidence and skills and become detached from the labor
force. This in turn affects how they are viewed by prospective
employers and reduces their chances of finding a job. Data
from the U.S. Census Bureau show that a person unemployed
for more than six months has only a 1-in-10 chance of find-
ing a job in the subsequent 30 days. By contrast, someone
unemployed less than a month has a 1-in-3 chance of finding
employment. Long-term unemployment thus means cycli-
cal unemployment can become entrenched as a structural
phenomenon.
Governments to the rescue
Most countries mounted a strong policy response without
which unemployment—and its attendant human costs—
would have been even higher. Broadly speaking, that
response had three parts:
• support for aggregate demand through monetary and
fiscal policy action;
• short-time work programs and unemployment insur-
ance benefits to ease the pain in labor markets; and
• hiring subsidies to limit layoffs and accelerate jobs
recovery.
Central banks moved quickly to stimulate aggregate demand
by lowering policy interest rates and then, as interest rates fell
to near-zero levels and could be lowered no further, through
quantitative easing—that is, direct purchase of long-term
government assets—and other interventions.
Fiscal policy turned accommodative, and governments
allowed recession-induced lower tax revenue to be reflected
in higher cyclical fiscal deficits, rather than trying to cut
spending to match the decline. In addition, many govern-
ments provided direct support to their financial sector—
fiscal stimulus and the so-called bank bailouts (see “Stimulus
Worked,” in this issue of F&D).
To ease the pain in labor markets, governments comple-
mented monetary and fiscal policy actions with active labor
market policies. One of the key policies was to provide gov-
ernment financial assistance for programs to encourage
Loungani, 10/28/10
Chart 1
Jobs lag during recoveries
Evidence from U.S. recoveries that began in 1991, 2001,
and 2009 shows that employment takes much longer to
revive than GDP.
(change, in percent, since end of recession)
Sources: U.S. Bureau of Economic Analysis; and U.S. Bureau of Labor Statistics.
Quarters following end of recession
1 2 3 4 5 6 7 8 9 10 11 12
Recession 2009, GDP
Recession 1991, GDP
Recession 2001,GDP
Recession 2009, employment
Recession 1991,
employment
–2
0
2
4
6
8
10
Recession 2001,
employment
Chart 2
Measuring economic distress
The misery index—the sum of ination and unemployment
rates—is now dominated by joblessness, as major
economies have tamed ination.
(percent)
Loungani, 10/28/10
Source: IMF, World Economic Outlook database.
1980 1990 2000 2010
Ination
Unemployment
Advanced economies
0
4
8
12
16
20
24 Finance & Development December 2010
companies to retain workers but reduce their working hours
and wages. Such short-time work programs can spread the
burden of the downturn more evenly across workers and
employers, reduce future hiring costs, and protect workers’
human capital until the labor market recovers. During the
Great Recession, such programs were extensively used in
Germany, Italy, and Japan. Although it is too early to under-
take a full assessment, these programs are credited with hav-
ing played a crucial role in stemming unemployment in many
countries. Governments also eased the pain of unemploy-
ment through provision of unemployment insurance benefits.
Many countries had already extended the duration of these
benefits; others extended it as the recession dragged on—in
the United States, for example, unemployment insurance ben-
efits were extended from 26 to 99 weeks. In recessions, the
potential adverse effect of benefits on a job search effort is
estimated to be very small (see Dao and Loungani, 2010).
The third part of the strategy was to use subsidies to
directly speed up job recovery. It is difficult to design hiring
subsidies that are effective: companies could end up with sub-
sidies for jobs they would have created anyway or for jobs that
should never have been created and should not be maintained
in the future. However, in the midst of a deep recession, the
costs of these inefficiencies were less severe than the costs of
high unemployment. And steps that countries took to target
subsidies toward those most adversely affected likely served
to reduce the inefficiency costs. Subsidies were targeted to
vulnerable groups such as the long-term unemployed and the
young (in, for example, Austria, Finland, Portugal, Sweden,
and Switzerland), hard-hit regions (as in Korea and Mexico),
or specific sectors (such as services in Japan).
What next?
Over the coming year, the three-part strategy adopted dur-
ing the crisis should remain in place. But the relative impor-
tance of the parts should shift over time as recovery takes
hold and should differ across countries depending on their
circumstances.
A recovery in aggregate demand is the single best cure for
unemployment, and fiscal and monetary policies should, to
the extent possible, remain supportive of such a recovery.
The deficit-reduction plans that advanced economies have
for 2011 imply an average decrease in the structural balance
equivalent to 1¼ percentage points of gross domestic product
(GDP). A more severe consolidation would stifle still-weak
domestic demand.
Clearly, however, the fiscal situation varies across coun-
tries. The current debt-to-GDP ratio varies widely (see
Chart 3). How much more fiscal space—that is, room to add
debt—do countries have? To answer this question, Ostry and
others (2010) define a “debt limit,” which is the debt-to-GDP
ratio beyond which a country’s normal fiscal response to ris-
ing debt becomes insufficient to maintain debt sustainability.
The normal response is estimated based on the country’s his-
torical taxing and spending record.
The difference between the debt limit and the projected
ratio in 2015 provides an estimate of the fiscal space avail-
able to the country. Because the normal fiscal response is
estimated with uncertainty, there is also uncertainty associ-
ated with the resulting estimates of fiscal space. In Chart 3,
countries whose probability of having fiscal space of 50 per-
cent of GDP or more is quite low are shown in red. Greece,
Iceland, Italy, and Japan fall into this category. Countries
whose probability of fiscal space of 50 percent of GDP or
more is moderate are shown in black. Ireland, Spain, the
United Kingdom, and the United States are in this category.
These calculations suggest that, in many advanced econo-
mies, what is needed is credible fiscal tightening over the
medium term, not a fiscal noose today.
Monetary policy remains an important policy lever to sup-
port aggregate demand. Inflation pressure is subdued—head-
line inflation in advanced economies is expected to remain
at about 1½ percent in 2011. As a result, accommodative
monetary policy can continue in most advanced econo-
mies. Moreover, if growth falters, monetary policy should be
the first line of defense in many advanced economies. With
policy interest rates already near zero in many economies,
central banks may again need to rely more strongly on quan-
titative easing. Although these demand-stimulating measures
seem necessary to ensure recovery in most advanced econo-
mies, their implications for international capital flows and
emerging market countries’ exchange rates and external bal-
ances must also be taken into account.
If the recovery takes hold, subsidies for short-time work and
the various types of hiring subsidies introduced during the
crisis could start to be phased out. Such subsidies put a strain
on public finances and can give firms an incentive to free ride
even when conditions improve. And if the fortunes of certain
firms and industries are permanently affected, subsidies can
Loungani, 10/28/10
Chart 3
Ability to respond
The capability of a country to add debt—that is, its scal
space—depends not only on its ratio of debt to GDP, but also
its history of spending and taxing. Countries in red are
constrained, those in black judged a little less so.
(public debt as a percent of GDP, 2010)
Sources: Authors’ calculations based on IMF, World Economic Outlook database; and
Ostry and others (2010).
Note: A red bar indicates a country’s scal space is probably less than 50 percent of
GDP; a black bar indicates a moderate possibility of scal space exceeding 50 percent of
GDP.
Japan
Greece
Iceland
Italy
Belgium
United States
Portugal
France
Canada
Ireland
United Kingdom
Israel
Germany
Austria
Spain
Netherlands
Norway
Denmark
Finland
Sweden
Korea
New Zealand
Australia
0
50
100
150
200
250
Finance & Development December 2010 25
obstruct reallocation of resources to other industries. The pro-
vision of unemployment insurance benefits should be tied to
compulsory job training and community service, so that those
who are unemployed remain attached to the labor force.
The challenge of long-term unemployment
The proportion of the long-term unemployed—those out of
work for 27 weeks or more—has increased in most advanced
economies since the start of the Great Recession. In the few
cases where it did not—such as in France, Germany, Italy,
and Japan—long-term unemployment had been persistently
very high even before the crisis. In the United States, the
numbers of workers unemployed for 27 weeks or more (as a
share of the total number of the unemployed) has risen dur-
ing every recession since 1980, but the increase during the
Great Recession was alarming: nearly half of all unemployed
people have been out of work 27 weeks or more.
Much of the increase in long-term unemployment dur-
ing the Great Recession may be a result of structural factors.
This is because recessions can have very different impacts
across industries. Some industries suffer and recover along
with the overall economy. Others, such as some service
industries—for example, health care—shrug off the effects
of the recession. And some industries suffer a perma-
nent decline. In many cases, these are industries that—in
hindsight—had expanded too much before the recession.
Examples of these are the high-tech industry prior to the
2000 dot-com bust and the construction sector ahead of the
Great Recession.
Chart 4 shows an index of structural change in the United
States using data on stock returns in various industries.
The greater the dispersion of stock returns across indus-
tries—indicating the extent to which the industries’ fortunes
are expected to diverge—the higher the value of the index.
Historically, the more intense the structural change that pre-
cedes or accompanies a recession, the higher the incidence
of long-term unemployment. During the Great Recession,
the index rose sharply and was matched by a steep rise in
long-term unemployment. There is a similar increase in the
intensity of structural change and the incidence of long-term
unemployment in many other advanced economies (see
Chen and others, forthcoming).
A recovery in aggregate demand, using monetary and fis-
cal policy, will lead to a decline in long-term unemployment.
But there is evidence that recovery in aggregate demand
takes too long to lift the boats of the long-term unemployed,
and even then does not give them much of a lift. For instance,
in the United States, movement in the federal funds rate, the
traditional instrument of monetary policy, has more of an
impact on short-term than on longer-term unemployment
(see Chart 5, right panel). In contrast, the index of structural
change is more strongly associated with long-term than with
short-term unemployment (see Chart 5, left panel).
This suggests that tackling long-term unemployment will
require that aggregate demand policies be supplemented with
more targeted labor market policies, such as retraining, to
put the long-term unemployed back to work.
■
Mai Chi Dao is an Economist and Prakash Loungani is an
Advisor, both in the IMF’s Research Department.
References:
Chen, J., P. Kannan, P. Loungani, and B. Trehan, forthcoming, “Stock
Market Dispersion and U.S. Long-Term Unemployment,” IMF Working
Paper (Washington: International Monetary Fund).
Dao, Mai Chi, and Prakash Loungani, 2010, “e Human Cost of
Recessions: Assessing It and Reducing It,” background discussion paper
for the Joint International Labor Organization–IMF conference on the
Challenges of Growth, Employment, and Social Cohesion, September
(Oslo).
Ostry, Jonathan D., Atish R. Ghosh, Jun I. Kim, and Mahvash S.
Qureshi, 2010, “Fiscal Space,” IMF Sta Position Note 10/11 (Washington:
International Monetary Fund).
Sullivan, Daniel, and Till von Wachter, 2009, “Job Displacement and
Mortality: An Analysis Using Administrative Data,” Quarterly Journal of
Economics, Vol. 124, No. 3, pp. 1265–1306.
Loungani, 10/28/10
Chart 5
Intransigent unemployment
Changes in the federal funds rate, the traditional tool of
Federal Reserve monetary policy, have more impact on
short-term joblessness than on long-term unemployment.
Sources: U.S. Bureau of Labor Statistics; and authors’ calculations.
up to 5 6–14 15–26 27+
Weeks unemployed
Percent of unemployment
explained by structural changes
Percent of unemployment
explained by federal funds rate
up to 5 6–14 15–26 27+
Weeks unemployed
0
5
10
15
20
25
30
35
40
0
12
24
36
48
60
Loungani, 10/28/10
Chart 4
Declines in fortune
Much of the long-term unemployment in the United States is
the result of permanent reversals in some industries.
Sources: U.S. Bureau of Labor Statistics; and DataStream.
Notes: Long-term unemployment is 27 weeks or more. The structural change index uses
stock returns in various industries. The greater the dispersion in stock returns across
industries, which indicates the degree to which the relative fortunes of industries are
expected to diverge, the higher the index value (between 0 and 1).
1973 78 83 88 93 98 2003 08
Unemployment rate 27 weeks and more,
percent (left scale)
Index of structural change (right scale)
0
1
2
3
4
5
0.05
0.08
0.11
0.14
0.17
0.20
0.23
26 Finance & Development December 2010
Rutgers University students apply for work, New Brunswick, New Jersey, United States.
PICTURE THIS
Youth for Hire
Y
OUNG PEOPLE have been particularly vulnera-
ble to unemployment during the global recession
and the accompanying shrinking job market. In
2009, an estimated 81 million young people ages
15 to 24 were unemployed around the world—a record—
and the number is expected to continue to increase in 2010,
according to the International Labor Organization (ILO).
The youth unemployment rate increased from 12.1 percent
in 2008 to 13.0 percent in 2009—the largest-ever annual
increase in the global rate. In 2009 alone, 6.7 million youths
joined the ranks of the unemployed. This compares with an
average annual increase of 191,000 in the 10 years before
the crisis (1997 to 2007).
The 2008–09 economic crisis reversed the precrisis
improvements in global youth unemployment.
(millions) (percent)
Picture This, 11/3/10
2000 01 02 03 04 05 06 07 08 09 10 11
Projection
68
70
72
74
76
78
80
82
11.0
11.5
12.0
12.5
13.0
13.5
Youth unemployment rate
(right scale)
Youth unemployment
(left scale)
Advanced and emerging economies also saw record
increases in youth unemployment rates in 2009.
(youth unemployment rate, percent)
Picture This, 11/3/10
2007 08 09 10 11
Projection
10
12
14
16
18
20
22
Advanced economies and European Union
Non-EU emerging Europe
and Commonwealth of
Independent States
+4.6
+3.5
{
}
The global economic crisis
has led to the highest youth
unemployment rates ever
Youths in advanced regions most vulnerable
In advanced and some emerging economies—where the
youth unemployment rates are much higher than the global
rate—the crisis affects young people mainly in terms of rising
unemployment and the social hazards associated with long-
term job searches, discouragement, and prolonged inactivity.
Many young people are taking any part-time employment
they can find or feel trapped in a less than satisfactory job
they fear leaving lest they fail to find another. Alternatively,
some go back to school for another degree and hope for bet-
ter economic times when they try to reenter the labor mar-
ket. Governments in these regions are struggling to prevent a
situation in which young people, having lost all hope of being
able to work for a decent living, give up and settle for long-
term dependence on state income support.
Young people have long been disadvantaged when it
comes to finding work, for many reasons: they have less
work experience; they have less knowledge about how and
where to look for work; and they have fewer job-search
contacts. The result is a global youth unemployment rate
nearly three times higher than the adult unemployment
rate—a ratio that has not changed significantly over time.
Job seekers line up during a job fair in Jakarta, Indonesia.
Finance & Development December 2010 27
Prepared by Sara Elder, an Economist at the Interna-
tional Labor Organization. Text and charts are based
on Global Employment Trends for Youth (August),
published by the ILO in 2010, and underlying data
from the ILO’s Trends Econometric Models (April
2010). e main report is available at www.ilo.org/
youth, and the underlying data at www.ilo.org/trends
Employment ratios for young men—while declining
worldwide—are higher in lower-income regions, where
working poverty is pervasive.
(male youth employment-to-population ratio)
1991 93 95 97 99 2001 03 05 07 09
55
60
65
70
75
80
85
Advanced economies
and European Union
Central and southeastern
Europe (non-EU) and
Commonwealth of
Independent States
Young women’s share in employment is slowly
increasing in most regions, thus narrowing the
gender gap.
(female youth employment-to-population ratio)
1991 93 95 97 99 2001 03 05 07 09
10
20
30
40
50
60
70
80
Latin America and
the Caribbean
Middle East
North Africa
Sub-Saharan Africa
East Asia
Southeast Asia
and the Pacic
South Asia
Working but still poor in developing regions
In contrast, in developing economies—where 90 percent of the
world’s young people live and where social protection frame-
works do not provide unemployment benefits that support job
search—the unemployment statistics seem less dire because most
youths have no choice but to work. The lowest-income regions—
specifically sub-Saharan Africa, southeast Asia and the Pacific,
and south Asia—continue to show the highest employment-to-
population ratios, a reflection of the need to contribute to house-
hold income. Young men and women (in countries where the
social norms accommodate women’s participation in the job mar-
ket) typically work in the informal economy, often in self-employed
or occasional wage activities, such as seasonal farm work.
These are the young people trapped in what the ILO calls
“decent work deficits”—those who work long hours, often under
very difficult conditions, but still live in poverty. The ILO esti-
mates that 152 million young people were living on less than $1.25
a day in 2008. This number is down from 234 million in 1998 but
still represents a remarkable 28 percent of all young workers in the
world. The majority of the young working poor lack even a pri-
mary-level education and are employed in the agricultural sector.
Better education needed
There is no one-size-fits-all solution to raising youth employ-
ment prospects. Continuing efforts are clearly needed in improved
access to and quality of education to boost young people’s chance
for decent employment. Enrollment in education is increasing
around the world and is reflected in part in the declining employ-
ment ratios of young men. Young women too are making gains
in education, but with a lag. At the same time, there are some
improvements in the gender gap as attitudes against the economic
participation of young women slowly begin to change. More gen-
erally, additional means of improving decent work prospects for
all young citizens include policies and national programs that
encourage businesses to hire young people, promote youth entre-
preneurship, and facilitate access to financial services.
■
T
HE United States experienced two
major economic crises over the past
100 years—the Great Depression
of 1929 and the Great Recession of
2007. Income inequality may have played a
role in the origins of both. We say this because
there are two remarkable similarities between
the eras preceding these crises: a sharp in-
crease in income inequality and a sharp in-
crease in household debt–to-income ratios.
Are these two facts connected? Empirical
evidence and a consistent theoretical model
(Kumhof and Rancière, 2010) suggest they
are. When—as appears to have happened in
the long run-up to both crises—the rich lend
a large part of their added income to the poor
and middle class, and when income inequal-
ity grows for several decades, debt-to-income
ratios increase sufficiently to raise the risk of
a major crisis.
Shifting wealth
We looked at the evolution of the share of
total income controlled by the top 5 per-
cent of U.S. households (ranked by income)
compared with ratios of household debt to
income in the periods preceding 1929 and
2007 (see Chart 1). The income share of the
top 5 percent increased from 24 percent in
1920 to 34 percent in 1928 and from 22 per-
cent in 1983 to 34 percent in 2007 (we used
fewer years before 1929 than before 2007
because the earlier data were highly distorted
by World War I). During the same two peri-
ods, the ratio of household debt to income
increased dramatically. It almost doubled
between 1920 and 1932, and also between
1983 and 2007, reaching much higher levels
(139 percent) in the second period.
Long periods of unequal incomes spur borrowing from
the rich, increasing the risk of major economic crises
Michael Kumhof and Romain Rancière
Leveraging
Inequality
28 Finance & Development December 2010
Finance & Development December 2010 29
In the more recent period (1983–2007), the difference
between the consumption of the rich and that of the poor
and middle class did not widen as much as the differences
in incomes of these two groups. The only way to sustain high
levels of consumption in the face of stagnant incomes was for
poor and middle-class households to borrow (see Chart 2).
In other words, the increase in the ratios of debt to income
shown in Chart 1 was concentrated among poor and middle-
class households. In 1983, the debt-to-income ratio of the top
5 percent of households was 80 percent; for the bottom 95
percent the ratio was 60 percent. Twenty-five years later, in
a striking reversal, the ratio was 65 percent for the top 5 per-
cent and 140 percent for the bottom 95 percent.
The poor and the middle class seem to have resisted
the erosion of their relative income position by borrow-
ing to maintain a higher standard of living; meanwhile,
the rich accumulated more and more assets and invested
in assets backed by loans to the poor and the middle class.
Consumption inequality that is lower than income inequality
has led to much higher wealth inequality.
The higher indebtedness of the bottom income group
has implications both for the size of the U.S. financial
industry and its vulnerability to financial crises. The bot-
tom group’s greater reliance on debt—and the top group’s
increase in wealth—generated a higher demand for financial
intermediation.
Between 1981 and 2007, the U.S. financial sector grew
rapidly—the ratio of private credit to gross domestic prod-
uct (GDP) more than doubled, from 90 to 210 percent. The
financial industry’s share in GDP doubled, from 4 to 8 per-
cent. With increased debt, the economy became more vul-
nerable to financial crisis. When a crisis eventually hit in
2007–08, it brought with it a generalized wave of defaults; 10
percent of mortgage loans became delinquent, and output
contracted sharply.
There are of course other possible explanations for the
origins of the 2007 crisis, and many have stressed the roles
of overly loose monetary policy, excessive financial liberal-
ization, and asset price bubbles. Typically these factors are
found to have been important in the years just preceding the
crisis, when debt-to-income ratios increased more steeply
than before. But it can also be argued, as in Rajan (2010),
that much of this was simply a manifestation of an under-
lying and longer-term dynamic driven by income inequality.
Rajan’s argument is that growing income inequality created
political pressure—not to reverse that inequality, but instead
to encourage easy credit to keep demand and job creation
robust despite stagnating incomes.
Modeling the facts
An economic model can clearly illustrate these links among
income inequality, leverage, and crises. Our model has sev-
eral novel features that reflect the empirical facts described
above. First, households are divided into one income group
at the top 5 percent of the income distribution (call them
“capital owners”) that derives all its income from returns on
the economy’s capital stock and from interest on loans and a
second group composed of the remaining 95 percent (“work-
ers”), who earn income in the form of wages. Second, wages
are determined by a bargaining process between capital
owners and workers. Third, all households care how much
The only way to sustain high levels
of consumption in the face of
stagnant incomes was for poor and
middle-class households to borrow.
Kumhof, 11/8/10
Chart 1
Lending disposable income
As income inequality increases, the rich lend to workers,
whose leverage increases.
(percent) (percent)
Sources: U.S. Department of Commerce, Statistical Abstract of the United States (top
panel); Picketty and Saez, 2003 (income shares, bottom panel); and Federal Reserve
Board, Flows of Funds database (debt to GDP).
Note: Income excludes capital gains.
1920 22 24 26 28 30
Private noncorporate + trade debt to GNP (left scale)
Share of top 5 percent in income distribution (right scale)
(percent) (percent)
60
55
50
45
40
35
30
25
35
33
31
29
27
25
23
1983 86 89 92 95 98 2001 04 07
Household debt to GDP (left scale)
Share of top 5 percent in income distribution
(right scale)
150
140
130
120
110
100
90
80
70
36
34
32
30
28
26
24
22
20
Kumhof, 11/8/10
Chart 2
Increasingly indebted
Workers have been borrowing more as capital owners lend
from their rising disposable income.
(debt-to-income ratio)
1983 87 92 95 98 2001 04 07
Bottom 95 percent of the wealth distribution; “workers”
Top 5 percent of the wealth distribution; “capital owners”
Source: Authors’ calculations based on model simulations.
0.3
0.5
0.7
0.9
1.1
1.3
1.5
30 Finance & Development December 2010
they consume, but capital owners also care about how much
capital—physical capital and financial assets—they own. This
implies that when capital owners’ income increases at the
expense of workers, they will allocate it to a combination of
higher consumption, higher physical investment, and higher
financial investment. The latter consists of increased loans to
workers—whose consumption originally accounts for a very
high 71 percent of GDP—giving them the means to consume
enough to support the economy’s production.
Our model can be used to show what happens after the
economy experiences a lengthy shock to the distribution of
incomes in favor of capital owners. Workers adjust through
a combination of lowering their consumption and borrow-
ing to limit the drop in their consumption (see Chart 3). This
gradually raises workers’ debt-to-income ratio, which follows
the pattern and magnitude documented in Chart 2. Workers’
higher debt is made possible by the lending of capital owners’
increased disposable income.
More saving at the top and more borrowing at the bottom
mean consumption inequality increases significantly less
than income inequality. Saving and borrowing patterns of
both groups spur a need for financial services and interme-
diation. As a result, the size of the financial sector roughly
doubles. The rise of poor and middle-class household indebt-
edness begets financial fragility and a higher probability of
financial crises. With workers’ bargaining power, and there-
fore their ability to service and repay loans, recovering only
very gradually, loans continue to increase and the risk of a
crisis persists. When the crisis does occur—assumed here to
materialize after 30 years—there are large-scale household
debt defaults on 10 percent of the existing loan stock, accom-
panied by an abrupt output contraction, as occurred during
the 2007–08 U.S. financial crisis.
The model points to a number of ways the increase in
debt-to-income ratios in the precrisis period could be more
pronounced than shown in Chart 3. First, if capital owners
allocate most of their additional income to consumption
and financial investment rather than to productive invest-
ment, debt-to-income ratios increase much more. The rea-
son is that capital owners are willing to lend at lower interest
rates, thereby increasing debt, and the capital stock is lower,
thereby reducing output and workers’ incomes. Second, if
the rate at which workers’ bargaining power recovers over
time is close to zero, even a financial crisis with substantial
defaults provides little relief: debt-to-income ratios continue
to increase for decades after the crisis, and a series of finan-
cial crises becomes very likely.
Policy options
There are two ways to reduce ratios of household debt to
income.
The first is orderly debt reduction. What we have in mind
here is a situation in which a crisis and large-scale defaults
have become unavoidable, but policy is used to limit the
collateral damage to the real economy, thereby leading to a
smaller contraction in real economic activity. Because this
implies a much smaller reduction in incomes for any given
default on loans, it reduces debt-to-income ratios much more
powerfully than a disorderly default. Still, a long-lasting
trend toward higher debt-to-income ratios resumes immedi-
ately after the debt reduction, because workers continue to
have a reduced share of the economy’s income.
The second possibility, illustrated in Chart 4, is a restora-
tion of workers’ earnings—for example, by strengthening col-
Chart 4
Averting a crisis
If workers’ earnings are restored, they can pay off their
debts.
(real wage of workers)
Kumhof, 11/8/10
Years
(debt-to-income ratio)
Years
Source: Authors’ calculations based on model simulations.
0 10 20 30 40 50
0 10 20 30 40 50
−6
−4
−2
0
2
4
60
90
120
150
Chart 3
Borrowing from Peter to pay Paul
When workers’ wages drop, they borrow more to maintain
their consumption.
(real wage of workers)
Kumhof, 11/8/10
Source: Authors’ calculations based on model simulations.
0 10 20 30 40 50
0 10 20 30 40 50
−6
−5
−4
−3
−2
−1
0
1
2
60
90
120
150
Years
Years
(debt-to-income ratio)
lective bargaining rights—which allows them to work their
way out of debt over time. This is assumed to head off a crisis
event. In this case, debt-to-income ratios drop immediately
because of higher incomes rather than less debt. More impor-
tant, the risk of leverage and ensuing crisis immediately starts
to decrease.
Any success in reducing income inequality could there-
fore be very useful in reducing the likelihood of future cri-
ses. But prospective policies to achieve this are fraught with
difficulties. For example, downward pressure on wages is
driven by powerful international forces such as competition
from China, and a switch from labor to capital income taxes
might drive investment to other jurisdictions. But a switch
from labor income taxes to taxes on economic rents, includ-
ing on land, natural resources, and financial sector rents, is
not subject to the same problem. As for strengthening the
bargaining power of workers, the difficulties of doing so
must be weighed against the potentially disastrous conse-
quences of further deep financial and real crises if current
trends continue.
Restoring equality by redistributing income from the rich
to the poor would not only please the Robin Hoods of the
world, but could also help save the global economy from
another major crisis.
■
Michael Kumhof is a Deputy Unit Chief and Romain Rancière
is an Economist, both in the IMF’s Research Department.
References:
Carroll, Christopher D., 2000, “Why Do the Rich Save So Much?” in
Does Atlas Shrug? e Economic Consequences of Taxing the Rich, ed.
by Joel B. Slemrod (Cambridge, Massachusetts: Harvard University Press).
Dynan, Karen, Jonathan Skinner, and Stephen Zeldes, 2004, “Do the Rich
Save More?” Journal of Political Economy, Vol. 112, No. 2, pp. 397–444.
Kumhof, Michael, and Romain Rancière, 2010, “Inequality, Leverage,
and Crises,” IMF Working Paper 10/268 (Washington: International
Monetary Fund).
Piketty, omas, 2010, “On the Long-Run Evolution of Inheritance:
France 1820–2050,” PSE Working Paper 2010-12 (Paris: Paris School of
Economics).
———, and Emmanuel Saez, 2003, “Income Inequality in the United
States, 1913–1998,” e Quarterly Journal of Economics, Vol. 118, No. 1,
pp. 1–39.
Rajan, Raghuram, 2010, Fault Lines: How Hidden Fractures Still
reaten the World Economy (Princeton, New Jersey: Princeton
University Press).
Reich, Robert, 2010, Aershock: e Next Economy and America’s
Future (New York: Random House).
Reiter, Michael, 2004, “Do the Rich Save Too Much? How to Explain
the Top Tail of the Wealth Distribution,” Universitat Pompeu Fabra
Working Paper (Barcelona).
Schneider, Martin, and Aaron Tornell, 2004, “Balance Sheet Eects,
Bailout Guarantees and Financial Crises,” Review of Economic Studies,
Vol. 71, No. 3, pp. 883–913.
Finance & Development December 2010 31
32 Finance & Development December 2010
L
AST year, F&D profiled six people from different countries, hit
by the global economic crisis in different ways. As the reces-
sion recedes, we returned to find out how they have coped
with the turmoil of the past year.
Changes wrought by the crisis have turned some lives upside
down. In Japan, former auto worker Yoshinori Sato survives on wel-
fare, while in Spain, where real estate agent Santiago Baena had
once been doing so well, the housing sector is now saddled with
billions of euros worth of foreclosed property. But even a financial
crisis is of little concern if your country is slammed by the more
immediate problems of natural disaster and epidemic, as in Haiti.
For others, adversity presented an opportunity for a fresh start.
In Argentina, where the economy has since picked up, dockworker
Gustavo Ramírez has become a trade union official. In Côte
d’Ivoire, cocoa farmer Ignace Koffi Kassi was campaigning before
the national elections and was too busy to speak with us. And in
New York, Shital Patel has found a job—studying the job market.
We share some of their stories with you.
Faces
of the
Crisis
J
UST over a year ago, Yoshinori Sato did not believe his
life could get worse. It did. When F&D profiled 51-year-
old Sato in September 2009, he had recently lost his job
as a temporary worker at Isuzu Motors Co. in Yokohama,
Japan. The factory worker had been forced to vacate his
company-owned apartment and was subsisting on welfare
payments living apart from his family, who remain in his
native Hokkaido.
Since then, Sato’s situation has deteriorated. “It has been
hard,” Sato admits. He has faced health problems and has
not seen his family since December—and his lawyers are
pessimistic about the outcome of his suit against his former
employer to regain his job. After rent, utilities, and transpor-
tation, Sato says he is left with about ¥30,000 ($367) a month
for food and other expenses. He divorced his wife so that she
too could claim state benefits, and the prospects for reuniting
with his family look bleak. Sato is calm as he speaks, but it is
clear that he is angry about his situation.
“We want to be together, but this legal battle is going to
take a long time—probably more than a decade,” he says.
Temporary workers have long been critical to the vehicle
manufacturing industry. At the peak, an estimated 3.8 million
workers fell into this category, with the government claiming
the use of temporary staffers benefited both employers and
workers, who gained greater job mobility. It quickly became
clear that the greater advantage lay with companies, which
were able to lay off employees more easily.
The economic crisis triggered by the collapse of investment
banking firm Lehman Brothers in September 2008 has com-
pounded the plight of temporary workers in the Japanese auto
industry, which has suffered a sharp drop in demand. Sato says
it is the workers who have borne the brunt of the downturn.
“Large corporations here had large savings and resources,
so they were able to survive quitecomfortably, but smaller
enterprises and subcontractors were in a much more difficult
situation,” he points out, adding that even regular employees
Revisited
Yoshinori Sato lives on state support in Yokohama, Japan.
Japan
From Bad to Worse
Finance & Development December 2010 33
G
USTAVO Ramírez today acts like someone other
than the dockworker whose living standard declined
at the height of the world trade collapse in 2009.
Last year Ramírez, along with most of his coworkers at
the Port of Buenos Aires, found himself working a reduced
schedule when the Great Recession hit the docks of the
Argentine capital.
Even then, although his income was lower and things were
tighter for his wife and four daughters, Ramírez took a philo-
sophical approach to the harder times. He said in an inter-
view with F&D last year that he was able to use the newly
free time to do volunteer work for the dockworkers union, an
activity he found quite satisfying.
Today world trade has picked up markedly and Argentine
shipping is again bustling. As a result, most of Ramírez’s
coworkers have experienced a big pickup in hours—and a big
pickup in pay.
Things are looking better for dockworkers at the Port of
Buenos Aires—and for Ramírez too. But Ramírez no longer
works on the docks. He became a union official.
After three years of working on contract at the port, the
days he spent volunteering during his forced free time per-
suaded him to run for union office late last year and work
full time on union issues. He won the election and today is
in charge of communications for the Single Argentine Port
Workers Union.
He says he has found his place in the world. “I’ve always
liked politics. I’d been searching for opportunities for activ-
ism.” He said he found that opportunity when he began
working at the port.
Like most emerging market countries, Argentina with-
stood the global crisis better than the advanced economies
and is now showing signs of recovery. Exports grew by
18 percent in the first six months of 2010, for example.
Ramírez, 38, says the pay in his new job is not very different
from what he earned when he started working at the port—
but higher than it was last year, when Ramírez’s work schedule
was cut from about 24 days a month to 14 or 15 days. Many
of his 1,500-odd former colleagues almost certainly earn more
than he does today. The sharp boost in their take-home pay is
a result of the recovery that began in late 2009.
“Working hours at the port have increased over the past year.
Today the average net [monthly] wage for a contract worker is
about 6,000 pesos [about $1,500], compared with half that last
year,” reflecting mainly an increase in hours worked and not
the 30 percent pay hike the union won this year, he said.
Even though Ramírez has not enjoyed the pay increase his
former coworkers received, things are better than a year ago.
His family has been able to rent a larger apartment and can
now go to the movies or eat at a restaurant “every so often,”
he said.
But income is not the driving force in Ramírez’s life. “I
used to be a total skeptic, but then it dawned on me that I had
a choice: either go out and combat reality in a positive way
and find my place in the world or close myself in at home
and leave the world to tear itself apart. When I set out to face
the world, I did so from a different perspective. When you’re
young you believe in the utopia of revolution, but as you
grow up you start to understand the processes the country is
going through. This year I regained hope,” he said.
■
By Florencia Carbone, a journalist with La Nación in Buenos
Aires.
are now struggling.
“Some have been forced to retire early, others have had
their wages cut, and some have even been laid off,” he
said.“Large corporations are still earning a profit, but work-
ers’ salaries are being reduced, and large Japanese compa-
niesare finding that they can’t earn so much by producing
here, so they are setting up their production facilities abroad.”
“I have tried to get part-time jobs, but if I get a full-time
job, then it might weaken my position in my legal case,” says
Sato, who instead occupies himself with union activities. He
volunteers with the All Japan Metal and Machinery Workers’
Union, speaking at meetings and offering advice to others
who find themselves jobless.
Of the 12 people who filed the suit against Isuzu, some
have found new jobs or are training for new positions but
continue to seek compensation. Some, like Sato, get by on
welfare payments. Sato, however, is the only one seeking
reinstatement.
Sato says he is committed to his lawsuit against Isuzu and
the government, and that means he will probably have to
finally give up on his marriage.
“I have told my wife that if she wants to have a fresh start,
if she finds a good partner and wants to remarry, then that
would be OK with me,” he said. “I would be happy for her.”
■
By Julian Ryall, a freelance journalist working in Tokyo.
Argentina
A New Vocation
Gustavo Ramírez became a union official in Buenos Aires, Argentina.
34 Finance & Development December 2010
H
AITI is oen said to be one of the most unfortunate
places on earth. is year’s events in the small Carib-
bean nation seem to bear that out. Hard on the heels of
the global nancial crisis that threatened the remittances Hai-
tians rely on, the new year socked the poorest country in the
Western Hemisphere with a devastating earthquake in January.
Francette Picard, a Haitian single mother of two featured
last year in F&D, was one of thousands of victims caught up
in the disaster’s maelstrom. Now Haiti faces another catas-
trophe: a cholera epidemic. F&D has been unable to locate
either Picard or her daughters.
Even before the earthquake, like scores of other Haitians,
Picard, 58, was struggling to make ends meet—aided by
occasional remittances of $30 to $60 from her cousin Claude
Bruno, a 60-something-year-old dishwasher at a rehabilita-
tion facility in New Jersey.
Bruno last spoke to his cousin some five months ago and
knows she survived the earthquake. Whether for financial
reasons or because of the earthquake, Picard moved out of
her home and, the last Bruno heard, was living in one of
the tent cities set up around the country to house the newly
homeless.
The relocation of the 1.5 million people the earthquake left
homeless remains the most pressing humanitarian challenge,
according to Jacques Bouhga-Hagbe, the IMF’s resident rep-
resentative in Haiti. “The initial response to the emergency
situation [following the earthquake] was good, but the transi-
tion to a reconstruction phase has been slow,” he said.
To the surprise of many—and unlike remittances to other
parts of the world—money sent home by Haiti’s sizable dias-
pora held up well in the wake of the global financial crisis,
showing “remarkable resilience,” according to IMF econo-
mist Aurelie Martin.
Haitians abroad—mostly in the United States—send home
22 percent of the country’s gross domestic product (GDP), or
about $1.5 billion every year, according to IMF data. “Before
the earthquake, remittances were the single largest source of
foreign currency for the country,” says Martin. But they have
been bumped to No. 2 by earthquake relief.
Remittances to Haiti jumped in the aftermath of the earth-
quake and then leveled off. The IMF says they were up by
7 percent as of September 2010, compared with the preced-
ing year.
And that money is now needed more than ever.
The world responded to the earthquake—which caused
damage of about 120 percent of Haiti’s GDP—with an out-
pouring of funds and humanitarian support. For example,
the IMF has provided $114 million in emergency financing
and forgiven Haiti’s $268 million in outstanding loans for
reconstruction.
But even with donor help, the country is grappling with
the scale of the catastrophe, and the need to provide food,
housing, clean water, and sanitation to its 8 million people
is straining the country’s limited resources. Even before the
disaster, 80 percent of the population lived on $2 or less a day,
according to the United Nations.
The lack of clean drinking water and adequate sanita-
tion contributed to a cholera outbreak. At F&D press time,
the Haitian authorities were struggling to contain a looming
epidemic, which has already claimed more than 1,000 lives
and sparked violence against UN peacekeepers, whom many
Haitians blame for the outbreak.
Meanwhile 2,000 miles away, Claude Bruno watches events
unfold back home. He continues to work at the nursing home
in New Jersey, saving money from his earnings to send back
to his relatives and hoping that Haiti can find a way out of the
maze of its successive misfortunes. Those misfortunes have
also exacted a heavy personal price on Bruno: he lost five
family members in the January earthquake, including one of
his children.
■
By Niccole Braynen-Kimani, an Editorial Assistant, and
Hyun-Sung Khang, a Senior Editor, both on the sta of
Finance & Development.
Haiti
No Respite
Claude Bruno had been sending remittances from New Jersey, United States, to his cousin, Francette Picard, in Haiti.
Finance & Development December 2010 35
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S
HITAL Patel was until recently a New York City unem-
ployment statistic. Now it’s her job to study them.
Patel has become an economist in the research depart-
ment of the New York State Department of Labor, where she
is part of a team that monitors the ups and downs of the New
York City job market. She spent more than a year unemployed
after investment bank Morgan Stanley let her go in May 2008.
So when anxious job hunters sit before Patel in a room at
the Labor Department’s Manhattan headquarters to listen to
her brief them on the city’s employment and economic pros-
pects, she knows whereof she speaks.
“I’ve been through it, so I just tell them, ‘I’ve been in your
shoes, and it all works out; you just have to remain positive
because there are jobs out there,’” said Patel.
What a difference a year makes.
In a rags-to-not-quite-riches story that could have come
straight out of Hollywood, Patel was “discovered” by her new
employer when she walked through their doors to apply for
her unemployment benefits.
Part of the application included handing over a copy of
her résumé and attending a presentation by the staff of the
Department—the very one Patel now gives to the ranks of the
newly unemployed in the city.
Patel’s qualifications and skills came up in a search of
the Department’s database after officials began looking for
someone with a background in economics and financial
experience, said Jim Brown, a labor market analyst with the
Department and now Patel’s new boss.
Patel applied for the job and was selected above a number
of applicants.
“We talk to a wide variety of audiences, so we were looking for
someone with both analytical and presentation skills who was
comfortable discussing data in less technical ways,” said Brown.
One of Patel’s responsibilities is talking to people at com-
panies that are planning layoffs and giving them the outlook
for jobs in their industry across New York state.
According to the state Department of Labor, the city’s unem-
ployment rate for September this year was 9.3 percent, just
below the then-prevailing national rate of 9.6 percent. The rate
varies across New York City’s five boroughs, reaching a citywide
high of 12.5 percent in the Bronx.
The human cost of the global economic crisis is staggering,
and worldwide unemployment hovers around 210 million
people, according to the International Labor Organization’s
latest estimate.
Patel, 33, reflects on the big changes over the past two
years, from the shock and grief experienced after she lost her
job, to the new meaning she has found in helping people who
are going through a similar ordeal.
Her commute is a 15-minute walk to work from her apart-
ment in Greenwich Village to her office in Tribeca, and Patel
arrives at a job where she feels appreciated by her colleagues
as well as by the job seekers she helps. Best of all, Patel has job
security, something she never had in her Wall Street career.
“I am so much more relaxed and healthier—I am out of the
office at 6 p.m. and no longer tied to a BlackBerry,” said Patel.
The one downside Patel freely admits is financial; she
is paid much less than she made when she worked for an
investment bank.
There is also pressure from some of her friends, who
expect the ambitious and talented Patel to return to the bank-
ing world. She has to explain she enjoys her new life, and feels
fortunate to be working again.
“My mother always says that I’m lucky, and she’s right,”
said Patel.
■
By Jacqueline Deslauriers, an Assistant Editor on the sta of
Finance & Development.
United States
Life’s Labors
Shital Patel found a new job as an economist in New York, United States.
36 Finance & Development December 2010
When
government
debt is
downgraded,
the ill effects
can be
felt across
countries
and financial
markets
T
HE recent European sovereign
debt crisis was concentrated in a
few countries, but its eects were
felt in nancial markets through-
out the euro area. Following downgrades of
credit ratings for countries such as Greece,
Ireland, Portugal, and Spain, sovereign bond
spreads widened, the costs of insuring sov-
ereign debt (as measured by credit default
swap—CDS—spreads) rose, and stock mar-
kets well beyond the aected countries felt
the pressure (see chart).
The resulting debate over the role of credit
rating agencies during crises and the inter-
dependence of different financial markets
has focused on changes in sovereign debt
ratings. These measure the likelihood that
a government will fail to meet its financial
obligations and whether these changes have
spillover effects across countries and markets
in a highly integrated environ-
ment, such as the euro area, which
includes 16 European economies.
The financial intertwining of
European economies over the past
decade has created unique condi-
tions for the study of the effects
of rating news on financial mar-
kets, but the issue is not unique to
Europe. The current debate sur-
rounding the agencies that assign
credit ratings echoes discussions
during the Asian financial crisis
of 1997–98, when sovereign debt
problems hopscotched from econ-
omy to economy.
Unfortunately, there has been
little research on the spillover
effects of rating news. Gande and
Parsley (2005), using data on bond
spreads for emerging markets from 1991 to
2000, found that when one country’s rating
is downgraded it has a significant negative
effect on the sovereign bond spreads of other
countries. In more integrated financial mar-
kets, however, the shock of a rating down-
grade is likely to have effects beyond bond
markets. Indeed, more recent studies (for
example, Ehrmann, Fratzscher, and Rigobon,
2010) analyze the transmission of shocks
across markets and countries and find evi-
dence of substantial international spillovers,
both within and across asset classes, affect-
ing, for example, money, bond, and equity
markets as well as exchange rates.
Kaminsky and Schmukler (2002) provide
some evidence that changes in sovereign debt
ratings and outlooks affect financial mar-
kets in emerging economies. They find that
Bad News
Fear spreads
When Greece’s credit rating was downgraded in early
2010, not only did the cost of insuring Greek debt soar, so
did the cost of insuring debt from other countries that were
not downgraded.
(spread on credit default swaps, basis points)
Arezki, 10/27/10
Source: DataStream.
Note: A credit default swap (CDS) is a contract in which the buyer pays what is the
equivalent of an insurance premium (called the spread) to the seller, which guarantees a
specic debt will be paid in the event the borrower defaults. Although a CDS is often
purchased by the holder of the debt, neither party to a CDS transaction need be involved
in the underlying transaction. A basis point is 1/100th of a percentage point.
2008 09 10
0
100
200
300
400
500
600
700
Greece
Ireland
Portugal
Spain
Austria
Rabah Arezki, Bertrand Candelon, and Amadou N.R. Sy
Spreads
Finance & Development December 2010 37
sovereign ratings affect not only the instrument being rated
(bonds) but also stocks.
We examine the impact of rating news on CDS mar-
kets, but also consider systematically the potential spillover
effects within the structure of different asset market classes
(Arezki, Candelon, and Sy, 2010). We compiled a database
that includes daily European sovereign CDS spreads and
stock market indexes—including subindexes for banking and
insurance equities—during 2007–10.
Our approach is designed to capture the effects of credit
rating agencies’ news while taking into account the structural
interdependence of financial markets. It allows us to identify
which markets and countries are affected by any given sover-
eign rating downgrade. In addition, we are able to isolate the
spillover effect of rating news on different asset classes across
countries after controlling for the tendency for large fluctua-
tions to be followed by similar ones.
The main finding is that a sovereign rating downgrade
influences financial markets not only in the country affected,
but also in other euro area countries. The direction and mag-
nitude of the effect of the rating news depend on where the
credit rating news originates. For instance, downgrades of
Greek sovereign debt systematically affected all euro area
countries, resulting in higher costs for insuring sovereign
debt (measured by CDS spreads) and pressure on stock
markets, even if the credit rating of the other countries was
unchanged. In contrast, downgrades of eastern European
economies affected only euro area countries to which they
were financially linked.
The nature of the interdependence of stock market per-
formance and the cost of insurance against sovereign default
(CDS spreads) varies from country to country. This suggests
that sovereign rating news affects economies through a vari-
ety of channels, and the point of entry in one may be different
than in another. For example, in Spain, an increase in CDS
spreads on sovereign debt led to a decline in the stock mar-
ket index—including the insurance and banking subindexes.
But a change in the stock market index did not significantly
affect CDS spreads in Spain. In contrast, in the Netherlands,
an improvement in the stock market led to a reduction in
CDS sovereign spreads. But in Italy, the effect went in both
directions: better stock market performance led to a reduc-
tion in CDS spreads, and a higher CDS sovereign spread
hurt stocks. Differences in market interdependence within
countries can be explained by differences in the economy’s
structure, including differences in public sector involvement
in the economy.
The type of rating news also matters. Credit rating agen-
cies typically signal their intention to consider rating
changes. For example, the three major credit rating agen-
cies—Fitch, Moody’s, and Standard & Poor’s (S&P)—all use
a negative “outlook” notification to indicate the potential for
a downgrade within the next two years (one year in the case
of speculative-grade credit ratings). We find that the average
effect of downgrades on CDS spreads is larger than the effect
of revisions of the outlook (when a rating is not changed but
a possible change is signaled).
Financial markets may be myopic because they focus nar-
rowly on downgrades. The downgrade of one country may
convey new information about other countries (such as on
financial linkages). It could also prompt market participants to
reassess the fundamentals of countries with similar character-
istics (such as fiscal deficits and indebtedness) or trigger herd
behavior. The less-uniform response to outlook revisions could
be related to the rating agency itself: either the market does not
understand what the agency is trying to communicate when it
ventures an opinion on the future, or the market doesn’t react
because it places little store in the agency’s opinion.
Of course, the explanation could be simpler. In rules-based
investing, holders of sovereign debt might be forced to sell
if there is a downgrade, but not in the event of a revised
outlook. Similarly, rating-based regulation constrains the
European Central Bank—which must reject downgraded
debt as collateral for a loan to a financial institution, but
could accept it in the case of an outlook revision.
Moreover, which credit rating agency issues the rating
news trumps the news itself. S&P outlook revisions are more
likely to spill across countries than those of the other two
major agencies. In contrast, rating downgrades that emanate
from Moody’s and Fitch tend to spill across countries more
than S&P downgrades. Financial markets are indeed selective
in the way they react to the rating news from different rating
agencies, perhaps because of differences in the credibility of
credit rating agencies. Other differences related to the com-
munication strategy of rating agencies can also explain the
difference in market reactions.
This evidence of spillover effects indicates that bad news
does spread, but the transmission process is complex. The
news can move rapidly from country to country and mar-
ket to market, with varying effects both across countries and
markets. The complexity of transmission complicates the
design of regulation and the conduct of surveillance, so it is
important that regulators understand how bad news spreads
and what happens when it does.
■
Rabah Arezki is an Economist and Amadou N.R. Sy is a
Deputy Division Chief, both in the IMF Institute. Bertrand
Candelon is Professor of International Monetary Economics at
Maastricht University.
References:
Arezki, Rabah, Bertrand Candelon, and Amadou Sy, 2010, “Sovereign
Ratings News and Financial Markets Spillover” (unpublished;
Maastricht, Netherlands: Maastricht University) and forthcoming IMF
Working Paper.
Ehrmann, Michael, Marcel Fratzscher, and Roberto Rigobon, 2010,
“Stocks, Bonds, Money Markets and Exchange Rates: Measuring
International Financial Transmission,” Journal of Applied
Econometrics, doi: 10.1002/jae 1173.
Gande, Amar, and David Parsley, 2005, “News Spillovers in the Sovereign
Debt Market,” Journal of Financial Economics, Vol. 75, No. 3, pp. 691–734.
Kaminsky, Graciela, and Sergio Schmukler, 2002, “Emerging Markets
Instability: Do Sovereign Ratings Aect Country Risk and Stock
Returns?” World Bank Economic Review, Vol. 16, No. 2, pp. 171–95.
Spreads
38 Finance & Development December 2010
Global banks will adapt to the
new international rules on capital
and liquidity, but at what cost to
investors and the safety of the
financial system?
T
HE recent crisis revealed the sig-
nicant risks posed by large, com-
plex, and interconnected banks of
all types and the fault lines in their
regulation and oversight. Over the past two
decades, nancial institutions in advanced
economies expanded signicantly and in-
creased their global outreach. Many moved
away from the traditional banking model—
taking deposits and lending at the local level—
to become large and complex nancial insti-
tutions (LCFIs). ese global nancial titans
underwrite bonds and stocks, write and sell
credit and other derivatives contracts, and en-
gage in securitization and proprietary trading
within and across borders. When they fail, as
did the Lehman Brothers investment bank in
2008, their downfall can lead to plummeting
asset prices and turmoil in nancial markets
and threaten the whole nancial system.
International banking reforms, under what
is commonly known as Basel III, will require
banks to hold more and better-quality capital
and liquid assets. The effect of these reforms
will vary across regions and bank business
models: banks with significant investment
activities will face larger increases in capi-
tal requirements, and traditional commer-
cial banks will be relatively less affected.
The Basel III regulations will likely have the
strongest impact on banks in Europe and
North America.
Risky
Business
˙
Inci Ötker-Robe and Ceyla Pazarbasioglu
These more stringent rules will affect
LCFIs’ balance sheets and profitability. Banks
will in turn adjust their business strategies,
as they attempt to meet the tighter require-
ments and mitigate the effects of the regu-
latory reforms on their profitability. A key
issue for policymakers is to ensure that the
changes in banks’ business strategies do not
result in a further buildup of systemic risk in
the shadows of less-regulated or unregulated
sectors (such as hedge funds, money market
funds, special purpose vehicles) or in loca-
tions with less-onerous regulatory standards.
Tighter capital and liquidity rules
The new rules, approved by the leaders of
the Group of Twenty advanced and emerg-
ing economies in November 2010, require,
among other things
• higher and better-quality bank capital—
mainly common equity—that can absorb
greater losses during a crisis;
• better recognition of banks’ market and
counterparty risks;
• a leverage ratio to limit excessive
buildup of debt alongside the capital require-
ment;
• tighter liquidity standards, including
through a liquid asset buffer for short-term
liquidity stresses and better matching of asset
and liability maturities; and
• buffers for conservation of capital.
Our analysis of a sample of 62 LCFIs from
20 countries and covering three business mod-
els—commercial, universal, and investment
banks—suggests that banks with significant
investment banking activities, which derive
earnings primarily from trading, advisory, and asset manage-
ment income, will experience larger declines in regulatory
capital ratios, mostly because of higher market risk weights for
trading and securitization activities (see Chart 1).
Banks’ derivatives, trading, and securitization activities
will be subject to tighter capital requirements as of end-2011
and, as a result, will be more costly. The goal is for tighter
liquidity and capital requirements to ensure better coverage
of the risk associated with those activities.
Universal banks, whose activities range from lending to
investment banking, insurance, and other services, will also
be affected by a combination of increased risk weights associ-
ated with their trading business and deductions from their
capital as a result of their insurance business and minority
interests related to third-party shareholdings in consolidated
subsidiaries within a banking group.
Traditional commercial banks whose principal source
of income is lending activity (see Chart 2) will be the least
affected, thanks to their simpler business focus and the grad-
ual phase-in period.
Across regions, the regulations will have a greater effect
on European and North American banks, reflecting the large
concentration of universal banks in Europe and the impact of
higher risk weights on trading and securitization activities.
Shaping banks’ business
Investment banking activities will also face regulatory
reform initiatives beyond the Basel requirements that will
raise their need for capital. The securitization business is
subject to the U.S. Financial Accounting Standards Board’s
new accounting rules, which require originators to consoli-
date some securitized transactions onto bank balance sheets.
Moreover, the 5 percent risk-retention rule for all securitiza-
tion tranches aims (for example, under the Dodd-Frank Act
recently signed into law in the United States) will compel
their originators to keep some skin in the game. Combined
with higher Basel risk weights, these reforms are expected
to limit the desirability and profitability of the securitization
business.
Similarly, the derivatives business will be affected by the
global proposals made by the Financial Stability Board—an
Finance & Development December 2010 39
Chart 1
The cost of risk
The reduction in core capital ratios will hit investment
banks hardest.
(percent)
Pazarbasioglu, 11/12/10 corrected
Sources: Company reports; Fitch database; and authors’ estimates based on data
for sample large and complex nancial institutions.
Core Tier 1 ratio, 2009
Basel III core ratio, 2012
Commercial banks Universal banks Investment banks
0
2
4
6
8
10
Chart 2
Making money
Net interest income is the main component of all banks’
revenues, especially those of commercial banks.
(end-2009, percent)
Pazarbasioglu, 11/12/10
Sources: Company reports; Fitch database; and authors’ estimates based on data
for sample large and complex nancial institutions.
Net interest income
Trading account prot
Net commissions
Investment banks Commercial banks Universal banks
0
10
20
30
40
50
60
70
international group of central bankers and regulators—on
exchange trading and central counterparty clearing of over-
the-counter (OTC) derivatives. Moreover, national initiatives,
such as the U.S. requirement to move some banks’ deriva-
tives business to separately capitalized nonbank subsidiaries,
will have an impact. These regulations will affect investment
banks and universal banks that are most active in derivatives
business, while attempting to limit, through various exemp-
tions, adverse effects on legitimate transactions, such as
hedging.
The cost and profitability of the trading business, which
boosted investment bank revenue in 2009, are also affected
by higher Basel risk weights for the trading book and vari-
ous global and national proposals (including the Volcker rule
in the United States, which limits proprietary trading and
investment in, or sponsorship of, private equity and hedge
funds) and market infrastructure reforms that regulate OTC
derivatives trading.
Basel III also affects banks with a universal banking focus.
Banking groups undertaking a combination of commercial
and investment banking activities will be affected by reform
measures that target investment activities or systemically
important institutions, including reforms that propose to
break up banks or prohibit certain activities. While limiting
these activities may not be costly from an economic perspec-
tive, the reduced ability to benefit from diversification and
compensate low-margin activities with investment income
could reduce banks’ ability to generate retained earnings,
which add to a bank’s capital requirements and its resilience
to adverse economic shocks.
Rules galore
Groups that carry out insurance and banking business under
one roof, such as under the European bancassurance model,
will feel the combined impact of the new Basel rules and
Solvency II, an updated set of rules for European Union
insurance firms set to take effect in late 2012. These will likely
lower the capital benefits associated with this model—an
intended consequence of the Basel reform measures. Partial
recognition of insurance participation in common equity
may help smooth out the real-sector implications for banking
systems that rely heavily on the bancassurance model.
Globalized banks with a diversified set of business lines may
also be affected by national-level structural reform propos-
als, including stand-alone subsidiarization (SAS) and living
wills (that is, recovery and resolution plans for large banks
that map out how to safely wind down institutions in case of
failure). These reforms, by encouraging simpler and more
streamlined corporate structures, may limit the diversifica-
tion benefits of groups with different business lines. The key
objective of the two proposed reforms is easier and less-costly
resolution of large banking groups as a result of compartmen-
talized risk and individual group parts that are more resilient
to shocks. By establishing effective firewalls between various
parts of a banking group, SAS may affect the group’s ability to
manage liquidity and capital and may hurt its ability to sus-
tain a diversified corporate structure. This may have a greater
impact on global banks with a centralized business model
than on those with a decentralized or retail orientation.
Surviving by adapting
The combined effect of the various reform measures will
therefore depend on how financial institutions react to the
additional costs imposed on them—whether by shrinking
their assets, repositioning across business lines, transfer-
ring the costs to customers through changes in margins and
spreads, or restructuring their cost base and lowering divi-
dends paid to shareholders.
Ultimately, the impact of the reforms on LCFIs will depend
on the flexibility of their business model and how they adjust
to the changes. Banks with a major investment banking
focus could restructure their activities to reduce the effects
of the regulatory reforms. With their flexible balance sheet
structures, they can capture the most profitable segments to
generate robust cash flows and earnings, buy or sell assets
with relative ease, shift their operations rapidly, and manage
capital by shrinking assets and repositioning their portfolios
away from the most capital-intensive assets.
Such adjustments in business strategies could, however,
have unintended consequences that increase systemic risk.
As risky activities become more costly (for example, deriva-
tives and trading activities, some types of securitization, and
lending to high-risk borrowers), this business may shift to
the less-regulated shadow banking sector. The risk to the
financial system, however, may remain, given the funding
and ownership linkages between banks and nonbanks.
Although supervision could help contain this vulnerabil-
ity, its ability to do so may be limited without a widening
of the scope of regulation. Moreover, absent careful global
coordination of the implementation of tighter rules, some
businesses may be prompted to move to locations with
weaker regulatory frameworks to minimize regulatory
costs. This may affect the capacity to monitor and manage
systemic risk.
Safeguards are needed to mitigate the new rules’ unin-
tended consequences and minimize the danger to banks’
ability to support economic recovery. Most important, super-
visors must understand banks’ business models and have
increased oversight in order to monitor and limit excessive
risk taking. Stronger market infrastructure and risk man-
agement by financial institutions should accompany these
efforts. Policies and their implementation need to be coordi-
nated among national authorities and standard setters, given
the global reach of many of these institutions.
■
İnci Ötker-Robe is a Division Chief and Ceyla Pazarbasioglu is
an Assistant Director, both in the IMF’s Monetary and Capital
Markets Department.
is article is based on IMF Sta Position Note 10/16, “Impact of
Regulatory Reforms on Large and Complex Financial Institutions,” by
˙
Inci
Ötker-Robe and Ceyla Pazarbasioglu with Alberto Bua di Perrero, Silvia
Iorgova, Turgut KıŞınbay, Vanessa Le Leslé, Fabiana Melo, Jiri Podpiera,
Noel Sacasa, and André Santos.
40 Finance & Development December 2010
Confidence in
government
is the key
to financial
development
Finance & Development December 2010 41
T
HE epicenter of the recent nan-
cial crisis was in countries with the
most developed nancial systems,
raising questions about the advan-
tages of such systems. But there is still broad
consensus that nancial development—the
creation of a financial system that ensures ef-
fective intermediation between saving and
investment via banking, insurance, and stock
and bond markets—contributes
to economic growth and a better
standard of living.
To reap the benefits of deep
and well-functioning financial
markets, many countries liber-
alized their financial systems in
the hope of jump-starting finan-
cial development. Industrialized
countries led the reform efforts
in the 1970s, followed by many
middle- and low-income coun-
tries. However, efforts to stimu-
late the financial sector have had
uneven results: liberalization
has fostered financial develop-
ment in a number of countries,
but financial systems in a major-
ity of countries have remained small and
underdeveloped by most standards. In some
cases, short-term surges in financial develop-
ment even led to severe financial crises fol-
lowing liberalization. These varied outcomes
(see chart) prompted a decades-long search
for policies and institutional features condu-
cive to financial development.
Trusting
the
Government
Deepening nancial markets
The degree of nancial development, as measured by the amount of credit available in an economy,
varies widely across countries.
(cross-country disparities in the ratio of private sector credit to GDP, 2005)
Quintyn, 11/2/10
Source: Authors’ calculations based on World Bank, World Development Indicators.
Note: Bars reect a representative sample of countries; red bars represent countries that have experienced an acceleration episode lasting
10 years or more.
0
0.5
1.0
1.5
2.0
Marc Quintyn and Geneviève Verdier
42 Finance & Development December 2010
We have found that financial liberalization is a necessary but
not sufficient condition for financial development (Quintyn
and Verdier, 2010). Our research concludes that financial
development depends not only on the prevailing macroeco-
nomic environment, policy design, and principles such as
property rights and contract enforcement, but especially on
the quality of the political systems that uphold these principles.
Political institutions that keep politicians’ actions in check
reassure savers, investors, and borrowers that their property
rights will be protected.
From repression to liberalization
Post–World War II attempts to use the financial system as
an engine for economic growth were characterized by direct
state intervention to channel funds to sectors designated as
crucial for development. This strategy was popular in low-
and middle-income countries and was employed to some
degree even in several advanced economies. In its extreme
form, such government-led strategy relied on state-owned
banks and a host of administrative controls on financial
institutions (including interest rate controls, credit ceilings,
directed credit, and strict limits on entry into the sector). Far
from yielding the expected economic growth and develop-
ment outcomes, it had perverse effects, including suboptimal
allocation of capital and widespread corruption, and it dis-
couraged saving.
This strategy, baptized “financial repression” by authors
such as McKinnon (1973) and Shaw (1973), was gradually
abandoned by the early 1970s. It was replaced by financial
liberalization: elimination of administrative controls on finan-
cial institutions (including on interest rates); privatization of
state-owned banks and authorization of more private banks;
entrance of foreign banks into the domestic sector; and (later
in the process) capital account openness. The ultimate goal of
these measures was a competitive financial system that could
allocate financial resources to the economy based on risk and
return. Financial liberalization required a new approach to
prudential supervision, to ensure that the financial institu-
tions’ risk management was on a sound footing.
Many countries have since embarked on this type of lib-
eralization, with mixed results. In fact, if anything, the gap
between countries with developed financial systems—as
measured by bank credit to the private sector as a share of
gross domestic product (GDP), a common yardstick of finan-
cial development—and “laggards” has been growing since
the 1990s. For a better indication of banks’ role as interme-
diaries of financial resources, we prefer to use private sector
credit as a measure rather than other criteria, such as bank
deposits to GDP. Admittedly, private sector credit does not
take into account other features of financial sector develop-
ment, such as the quality of financial services or stock mar-
ket development. However, since most financial systems are
dominated by banks, and private sector credit data are read-
ily available for a wide range of countries, we opted for this
variable, which, we believe, captures broad developments in
most of the world.
Keeping a promise
Faced with these disappointing outcomes, one strand of
research points to the prevailing legal system among institu-
tional factors crucial to financial development. For example,
common law supports financial development, because it pro-
tects individuals from the state more than other legal tradi-
tions do (La Porta and others, 1998).
Other researchers have looked at the degree to which
countries effectively protect property rights (Acemoglu and
Johnson, 2005). Inherent in each financial transaction is
the promise of future repayment. Economic agents willingly
engage in financial transactions if this promise is backed by
a credible enforcement mechanism—that is, if their property
rights are effectively protected. Hence, the argument goes,
sustained financial development will take place only if all
parties involved believe that promises will be honored.
This finding, however important, raises the question of the
ultimate source of effective protection of property rights. A
number of authors argue that political institutions are cru-
cial: essentially, only governments can ensure that protection
is not simply written into law, but is carried out effectively.
Economic agents must trust that the political system will
give those in power the incentive to enforce property rights.
Financial development may be best served if governments
are strong enough to effectively protect property rights and
willing to keep their own power in check to prevent abuse
(Haber, North, and Weingast, 2008; and Keefer, 2008). This
delicate equilibrium rests on political actors’ willingness to
submit to a system of checks and balances. Trust in govern-
ment will result in increased financial activity. According to
this view, the quality of a country’s political institutions is the
ultimate determinant of financial development. We found
that most long-lasting episodes of financial deepening have
indeed occurred in countries with high-quality and stable
political institutions.
Accelerating financial development
To test the hypothesis, we analyzed developments in the
ratio of private sector credit to GDP. We looked at a sample
of 160 high-, middle-, and low-income countries during
1960–2005 and identified 209 periods of accelerated financial
development—defined as annual growth in the ratio of pri-
vate sector credit to GDP of more than 2 percent for at least
five years. We applied a centered three-year moving aver-
age that allowed us to avoid “accidents” or random one-year
changes.
Political institutions that keep
politicians’ actions in check
reassure savers, investors, and
borrowers that their property rights
will be protected.
The episodes of financial acceleration ranged in length
from 5 years (the imposed minimum) to as long as 22 years.
Based on criteria established in the literature, we divided the
acceleration periods into short ones (lasting between 5 and
10 years) and long, sustained ones (longer than 10 years). Of
the 209 episodes, only 48—just over one-fifth—were long.
Most countries that now have highly developed financial
systems experienced a sustained acceleration at some point
during the past 50 years. But that by itself is no guarantee of
success; reversals occurred in a number of countries.
To test our political institutions hypothesis, we compared
the prevailing economic and institutional conditions at the
start of short-term accelerations and sustained accelerations.
We examined whether, and how, a given set of factors—
macroeconomic variables, financial liberalization, and types
of political institutions—affect acceleration. Macroeconomic
variables include GDP growth and inflation. Financial liberal-
ization is captured by an index. The quality of political institu-
tions is reflected in a polity index (Polity IV Project)that ranges
from –10 (autocratic regimes) to +10 (democratic regimes).
We found that the determinants of financial acceleration
vary between short and long episodes. Favorable macroeco-
nomic conditions increase the likelihood of all types of accel-
eration. The same is true for financial liberalization. When
a country takes measures to liberalize its financial system,
it has a significant and large impact on the probability of all
types of acceleration.
The big difference is in the impact of the political insti-
tutions variable. Our results strongly support the view that
political institutions matter, suggesting that countries with
checks and balances in their political system—that is, more
democratic regimes—are more likely to experience sustained
financial development. In contrast, we find that the polity
variable has a significant and negative effect on the probabil-
ity of a short acceleration period. This suggests that countries
with political systems with high democratic content are also
less likely to experience short-lived financial development.
To further investigate the impact of political stability
on financial development, we also considered the effect of
the durability (length in years) of the political regime. The
results show that the durability of a democratic regime—
a combination of stability and high-quality political
institutions—greatly increases the probability of a sustained
period of financial development.
Fertile ground
We found that countries with weaker political institutions
are more likely to experience temporary surges in financial
development. In contrast, countries with political institu-
tions that include checks and balances are more likely to
experience genuine long-lasting financial deepening follow-
ing financial liberalization. Durable democratic regimes—
those that offer a combination of stability and high-quality
political institutions with players subject to checks and bal-
ances—offer the most fertile ground for financial deepening.
Financial liberalization is a strong impetus for financial
acceleration, but it is not enough for sustained deepening of the
financial sector. This requires financial liberalization measures
supported by a political environment that instills trust—trust
that financial promises will be enforced and that the govern-
ment will not overrule property rights. Such trust stems from
the quality of the political institutions and their durability.
■
Marc Quintyn is a Division Chief in the IMF Institute, and
Geneviève Verdier is an Economist in the IMF’s African
Department.
References:
Acemoglu, Daron, and Simon Johnson, 2005, “Unbundling Institutions,”
Journal of Political Economy, Vol. 113, No. 5, pp. 949–95.
Haber, Stephen, Douglass North, and Barry Weingast, 2008, “Political
Institutions and Financial Development,” in Political Institutions and
Financial Development, ed. by Stephen Haber, Douglass North, and
Barry Weingast (Stanford, California: Stanford University Press), pp. 1–9.
Keefer, Philip, 2008, “Beyond Legal Origin and Checks and Balances:
Political Credibility, Citizen Information, and Financial Sector
Development,” in Political Institutions and Financial Development,
ed. by Stephen Haber, Douglass North, and Barry Weingast (Stanford,
California: Stanford University Press), pp. 125–55.
La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert
Vishny, 1998, “Law and Finance,” Journal of Political Economy, Vol.
106, No. 6, pp. 1113–55.
McKinnon, Ronald I., 1973, Money and Capital in Economic
Development (Washington: Brookings Institution).
Polity IV Project, available at www.systemicpeace.org/polity/polity4.htm
Quintyn, Marc, and Geneviève Verdier, 2010, “‘Mother, Can I Trust the
Government?’ Sustained Financial Deepening—A Political Institutions View,”
IMF Working Paper 10/210 (Washington: International Monetary Fund).
Shaw, Edward S., 1973, Financial Deepening in Economic Development
(New York: Oxford University Press).
Finance & Development December 2010 43
Pushing the pedal
The drivers of short accelerations and longer accelerations vary.
Accelerations lasting
5 to 10 years
Accelerations lasting
more than 10 years
Macroeconomic
Real economic growth + +
Financial
Financial liberalization + +
Bank supervision – +
Political institutions
Polity – +
Durability, democracy – +
Durability, autocracy + –
Other
Credit/GDP ratio – –
GDP per capita + +
Source: Authors’ calculations.
Note: Plus (minus) sign indicates positive (negative) correlation between the variable and financial
acceleration.
Durable democratic regimes . . .
offer the most fertile ground for
nancial deepening.
I
N Islamic countries, many of them poor and not highly
developed, large segments of the Muslim population do
not have access to adequate banking services—oen be-
cause devout Muslims are unwilling to put their savings
into a traditional nancial system that runs counter to their
religious principles (see box). Islamic banks seek to provide -
nancial services in a way that is compatible with Islamic teach-
ing, and if Islamic banks can tap that potential Muslim clientele,
that could hasten economic development in these countries.
There is evidence of close correlation between financial sec-
tor development and growth. Countries whose financial systems
offer a variety of services—including banking and insurance—
tend to grow faster. Banks, whether Islamic or traditional, play
a fundamental economic role as financial intermediaries and
as facilitators of payments (King and Levine, 1993). They also
help stimulate saving and allocate resources efficiently.
Globally, the assets of Islamic banks have been expanding
at double-digit rates for a decade, and Islamic
banking is an increasingly visible alternative to
conventional banks in Islamic countries and
countries with many Muslims. Our study iden-
tifies the sources of Islamic banking’s expan-
sion and ways to stimulate its continued growth.
Knowing what drives the development of Islamic
banking will help developing countries in Africa,
Asia, and the Middle East catch up.
The rise of Islamic banking
Four decades ago, Islamic banking emerged on a
modest scale to fill a gap in a banking system not
attuned to the needs of the devout. Two events were
crucial to its development. First, the early 1960s
appearance in rural Egyptian villages of micro-
lending institutions following Islamic banking
principles demonstrated the feasibility of Islamic
banking. These experiments thrived and spread to
Indonesia, Malaysia, and sub-Saharan Africa.
Second, top-down support following the 1975
es tablishment of the Islamic Development Bank
in Jeddah, Saudi Arabia, further spurred diffusion
of Islamic banking by centralizing expertise. In its
infancy, Islamic banking required much interpre-
tation of Shariah law by Islamic scholars. In the
first few years, basic implementation tools—such as legislation
allowing such banks to be set up and the training of staff—were
key ingredients for the spread of Islamic banking. And the past
few years have seen rapid innovation, most recently improved
regulation of liquidity management and accounting.
Similarly, the development of sukuk (Islamic bonds) has
revolutionized Islamic finance in recent years: Islam pro-
hibits conventional fixed income interest-bearing bonds.
Harnessing sophisticated financial engineering techniques,
sukuk are now a multibillion-dollar industry.
Rising oil prices since 2000 were also a catalyst, leading to a
massive transfer of resources toward the large oil-producing
countries, which have been more inclined to adopt Islamic
banking. During the past decade, Islamic banking industry
assets grew at an average 15 percent annually, and more than
300 Islamic institutions claim total assets of several hun-
dred billion dollars. Two-thirds of Islamic banks are in the
Good for
Growth?
The spread of Islamic banking can spur
development in countries with large
Muslim populations
Patrick Imam and Kangni Kpodar
44 Finance & Development December 2010
Customers at the Dubai Islamic Bank in Dubai, United Arab Emirates.
Features of Islamic banking
Islamic banks serve Muslim customers, but are not religious institutions.
They are profit-maximizing intermediaries between savers and investors and
offer custodial and other traditional banking services. The constraints they
face are, however, different and are based on Shariah law. Four features are
unique to Islamic banking:
• Prohibition against interest (riba) is the major difference between
Islamic and traditional banking. Islam prohibits riba on the grounds that
interest is a form of exploitation, inconsistent with the notion of fairness. This
implies that fixing in advance a positive return on a loan as a reward for the
use of one’s money is not allowed.
• Prohibition against games of chance (maysir) and chance (gharar):
Islamic banking bars speculation—increasing wealth by chance rather than
productive effort. Maysir refers to avoidable uncertainty; for example, gam-
bling at a casino. An example of gharar is undertaking a business venture with-
out sufficient information.
• Prohibition against forbidden (haram) activities: Islamic banks may
finance only permissible (halal) activities. Banks are not supposed to lend to
companies or individuals involved in activities deemed to harm society (for
example, gambling) or prohibited under Islamic law (for example, financing
construction of a plant to make alcoholic beverages).
• Payment of some of a bank’s profits to benefit society (zakat): Muslims
believe in justice and equality in opportunity (not outcome). One way to do this
is to redistribute income to provide a minimum standard of living for the poor.
Zakat is one of the five tenets of Islam. Where zakat is not collected by the state,
Islamic banks donate directly to Islamic religious institutions.
Middle East and North Africa, with the rest mainly in south-
east Asia and sub-Saharan Africa. But even in countries with
many Islamic banks, they are overshadowed by conventional
banks. In the Gulf region, Islamic banks—in terms of their
assets—account for one-quarter of the industry (see chart).
Elsewhere, their share is in the single digits.
Islamic banking and development
The rise of Islamic banking has contributed to economic
development in two main ways. One key benefit is increased
financial intermediation. In Islamic countries and regions,
large segments of the population do not use banks. The Islamic
world, as a whole, has a lower level of financial development
than other regions—in part because conventional banks do
not satisfy the needs of devout Muslims. This “underbanking”
means savings are not used as efficiently as they could be.
Moreover, because Islamic banking requires borrowers
and lenders to share the risk of failure, it provides a shock-
absorbing mechanism that is essential in developing econo-
mies. These economies—whether in the Middle East, Africa,
or east Asia—are often large, undiversified commodity pro-
ducers (mainly of oil) subject to boom-bust cycles and the
vagaries of export and import price changes. In addition,
most tend to have fixed or highly managed exchange rates, so
the exchange rate is less able to absorb shocks. A mechanism
that allows the sharing of business risk in return for a stake in
the profits encourages investment in such an uncertain envi-
ronment and satisfies Islam’s core tenet of social justice.
How Islamic banking spreads
Islamic banking is likely to continue to grow, because many
of the world’s 1.6 billion Muslims are underbanked; under-
standing how Islamic banking spreads will help guide the
formulation of policy recommendations. To that end, we
estimated the factors behind the diffusion of Islamic bank-
ing around the world using a sample of 117 countries during
1992–2006. We also tested for whether it substitutes for—or
complements—conventional banking.
We found, unsurprisingly, that the probability of increased
Islamic banking in a given country rises with the share of
Muslims in the population, income per capita, the price of
oil, and macroeconomic stability. Proximity to Malaysia and
Bahrain (the two main Islamic financial centers) and trade
integration with Middle Eastern countries also make diffu-
sion more likely.
Interest rates negatively affect the diffusion of Islamic
banking, reflecting the implicit benchmark they pose for
Islamic banks. Although pious individuals may have accounts
only with Islamic banks, other consumers allocate their sav-
ings based on interest rates set by conventional banks. High
interest rates hinder the diffusion of Islamic banking by rais-
ing the opportunity cost for the less pious (and individuals
from other denominations who are increasingly attracted to
Islamic banking) to put their savings in Islamic banks.
Some results, however, were unanticipated. First, Islamic
banks spread more rapidly in countries with established
banking systems. Islamic banks offer products not delivered
by conventional banks and thus complement rather than
substitute for conventional banks.
Second, we found that the quality of a country’s institu-
tions, such as the rule of law or the quality of the bureaucracy,
was not statistically significant in explaining the diffusion of
Islamic banking. This is not true for conventional banking.
Because Islamic banking is guided by Shariah, it is largely
immune to weak institutions: disputes can be settled within
Islamic jurisprudence.
Third, the September 11, 2001, attacks on the United States
were not an important factor in the diffusion of Islamic
banking. These events simply coincided with rising oil prices,
which appear to be the actual driver of Islamic banking.
Policy implications
During the past decade, Islamic banking has grown from
a niche market into a mainstream industry, and has likely
helped drive growth in the Islamic world by drawing under-
banked populations into the financial system and allowing
risk sharing in regions subject to large shocks.
Even though our findings suggest little need for institu-
tional reform, policy changes can still boost the spread of
Islamic banking. Encouraging regional integration through
free-trade agreements, maintaining a stable macroeconomic
environment that helps keep interest rates low, and raising
per capita income through structural reforms will lead to fur-
ther expansion. The spread of Islamic banking is not, how-
ever, a panacea—it is merely one of many elements needed to
sustain growth and development.
■
Patrick Imam is an Economist in the IMF’s Monetary and
Capital Markets Department and Kangni Kpodar is an
Economist in the IMF’s African Department.
is article is based on the authors’ IMF Working Paper 10/195, “Islamic
Banking: How Has It Diused?”
Reference:
King, Robert G., and Ross Levine, 1993, “Finance and Growth:
Schumpeter Might Be Right,” Quarterly Journal of Economics, Vol.
108, No. 3, pp. 717–38.
Finance & Development December 2010 45
Imam, 10/28/10
Islamic versus conventional banks
Islamic banks have a greater share of bank assets in the Gulf
region than elsewhere.
(average 1992–2006, percent of GDP)
Sources: Bankscope, Financial Development and Structure Database; and authors’
calculations.
0
20
40
60
80
100
120
140
Indonesia
Pakistan
Bangladesh
Sudan
Tunisia
Gambia, The
Yemen, Rep.
Malaysia
Mauritania
Egypt
Saudi Arabia
Qatar
Jordan
Brunei Darussalam
Kuwait
Bahrain
Iran, Islamic Rep.
Investment by Islamic
banks/GDP
Credit by commercial
banks/GDP
T
HE recent global crisis has renewed interest in the
relationship between Islamic banking and nan-
cial stability—and, more specically, the resilience
of the Islamic banking industry during crises.
Some argue that the lack of exposure to the types of loans
and securities associated with the losses conventional banks
experienced during the crisis—because of the asset-based
and risk-sharing nature of Islamic nance—shielded Islamic
banks from the crisis. Others contend that Islamic banks re-
lied on leverage and took on signicant risks, much like their
conventional counterparts, making them vulnerable to the
“second-round eects” of the global crisis.
Our study looks at the actual performance of Islamic banks
and conventional banks in countries where both have signifi-
cant market shares, and addresses three broad questions. Did
Islamic banks fare differently from conventional banks dur-
ing the financial crisis? If so, why? And what challenges for
Islamic banks has the crisis highlighted?
Using bank-level data covering 2007–10 for about 120
Islamic and conventional banks in eight countries—Bahrain,
Jordan, Kuwait, Malaysia, Qatar, Saudi Arabia, Turkey, and
the United Arab Emirates (UAE)—we focused on changes in
four key indicators: profitability, bank lending, bank assets,
and external bank ratings.
The Islamic banking model
The central concept in Islamic finance is justice, which is
achieved mainly through the sharing of risk. Stakeholders are
supposed to share profits and losses. Hence, charging interest
is prohibited.
While conventional intermediation is largely debt based
and allows for risk transfer, Islamic intermediation, in con-
trast, is asset based and centers on risk sharing (see table).
“Asset based” means that an investment is structured on
exchange or ownership of assets, placing Islamic banks closer
to the real economy than conventional banks, which can cre-
ate products that are mainly notional or virtual.
During the boom period of 2005 to 2007, Islamic banks’
profitability was significantly higher than that of conventional
banks. During this period, real GDP growth for countries in
our sample averaged 7.5 percent a year before decelerating to
1.5 percent during 2008–09. If this profitability was the result
of greater risk taking, one would then expect a larger decline
in profitability for Islamic banks during the crisis (defined in
our study as beginning at end-2007).
We found that factors related to Islamic banks’ business
model helped contain the adverse impact on this group’s prof-
itability in 2008. In particular, smaller investment portfolios,
lower leverage, and adherence to principles of Shariah (Islamic
law)—which precluded Islamic banks from financing or invest-
ing in the kind of instruments (such as collateralized debt obli-
gations and credit default swaps) that adversely affected their
conventional competitors—all contributed to better results for
Islamic banks than conventional banks that year.
In 2009, however, weaknesses in risk management prac-
tices in some Islamic banks led to a larger decline in profit-
ability than that seen in conventional banks. The weak 2009
performance in some countries was associated with sectoral
and name concentration—that is, too much exposure to any
one sector or borrower. In some cases, the regulatory author-
46 Finance & Development December 2010
People line up for an ATM in Rabat, Morocco.
Put to the
Test
Islamic banks were more resilient
than conventional banks during the
global financial crisis
Maher Hasan and Jemma Dridi
Risk Sharing and Risk Transfer
Islamic Banks’ Risk Sharing Conventional Banks’ Risk Transfer
Sources of funds: Investors (depositors)
share the risk and return with Islamic
banks. The return is not guaranteed and
depends on the bank’s performance.
Sources of funds: Depositors transfer
the risk to the conventional bank,
which guarantees a prespecified return
(interest).
Uses of funds: Islamic banks share
the risk in mudharabah (participation
financing or trust financing) and
musharakah (equity financing) contracts
and finance the purchase of assets
or services in most other types of
contracts.
Uses of funds: Borrowers pay interest
independent of the return on their
project. Conventional banks transfer
the risk through securitization or credit
default swaps. Financing is debt based.
ities exacerbated the problem by exempting certain
banks from concentration limits. (However, this con-
centration was limited to a few countries.)
While Islamic banks’ profitability over the busi-
ness cycle (2005–09) was, on average, higher than
that of conventional banks, the difference between the
cumulative impact (2008–09) of the crisis on the prof-
itability of the two groups was insignificant.
Contributor to stability
Islamic banks maintained stronger credit growth
than conventional banks in almost all countries in
the period studied—on average, twice that of conven-
tional banks. This suggests that Islamic banks’ market
share is likely to continue to increase—but also that
Islamic banks made a greater contribution to mac-
roeconomic and financial stability by making more
credit available. Interestingly, while for most banks
internationally, strong credit growth was followed by a sharp
decline in credit once the crisis hit, this was not the case
for Islamic banks. Because high credit growth is sometimes
achieved at the expense of strong underwriting standards, we
identified this as an area for supervisors to monitor.
The growth of Islamic banks’ assets likewise proved strong.
We found that, on average, their asset growth was more
than twice that of conventional banks during2007–09, but
it started decelerating in 2009, indicating that Islamic banks
were less affected than conventional banks by deleveraging.
The slower asset growth during 2009 could be attributable to
the weaker performance of Islamic banks that year or to the
fact that liquidity support in the form of government depos-
its is more easily directed to conventional banks.
Our findings were corroborated by external rating agen-
cies’ reassessment of Islamic banks’ risk, which was generally
found to be more favorable than—or similar to—that of con-
ventional banks (with the exception of the UAE).
Challenges must be addressed
While the global crisis gave Islamic banks an opportunity to
show their resilience, it also brought to light some important
issues that will have to be addressed if Islamic banks are to
continue growing at a sustainable pace.
Absence of a solid infrastructure for liquidity risk manage-
ment. While Islamic banks rely more on retail deposits than
conventional banks and hence have more stable sources of
funds, they face fundamental difficulties when it comes to
liquidity management, including
• a shallow money market due to the small number of
participants; and
• the lack of instruments that could be used as collateral
for borrowing or discounted (sold) at the central bank dis-
count window.
Some Islamic banks have responded by running an overly
liquid balance sheet (that is, having more cash-like assets
that generate a lower rate of return than loans and many
types of securities), thereby sacrificing profitability. Islamic
financial institutions carry 40 percent more liquidity than
their conventional counterparts (Khan and Bhatti, 2008).
This approach to liquidity mitigated risks during the cri-
sis, but it is not an ideal solution in normal circumstances.
The establishment of the International Islamic Liquidity
Corporation in October 2010 was a step toward enhancing
Islamic banks’ ability to manage international liquidity. But
such efforts need to continue.
More generally, monetary and regulatory authorities
should ensure that the liquidity infrastructure is neutral
to the type of bank (for example, by developing sovereign
sukuk, or Islamic bonds, in addition to conventional bonds
and certificates of deposits) and strong enough to address
the problems highlighted during the global crisis.
Need for appropriate institutional arrangements for the
resolution of troubled financial institutions. This is especially
relevant for Islamic banks, given the absence of precedents.
A mechanism for cooperation between regulators within
and across jurisdictions for the resolution of Islamic banks
is essential to contain spillovers beyond national boundaries.
Lack of harmonized accounting and regulatory stan-
dards. This proved a key problem for regulators and market
participants during the crisis—one exacerbated by the lack
of standard financial contracts and products across institu-
tions. The standards for Islamic banks’ operations continue
to be fragmented, despite initiatives by the Accounting and
Auditing Organization of Islamic Financial Institutions and
the Islamic Financial Services Board to create international
industry guidelines.
Insufficient expertise. Expertise in Islamic finance has not
kept pace with the rapid growth of the industry. Islamic bank-
ers, regulators, and supervisors need to be familiar with both
conventional finance and the different aspects of Shariah,
given the increasing degree of sophistication of Islamic finan-
cial products. The shortage of specialists also inhibits prod-
uct innovation and could hinder the effective management of
risks particular to the industry.
In the recent global crisis, Islamic banks proved their
mettle. But the crisis has led to greater recognition of the
ways in which they still need to develop. As financial regula-
tory reform presses ahead on a global level, now is the time
for the Islamic banking regulators to address the industry’s
challenges.
■
Maher Hasan is a Deputy Division Chief in the IMF’s Mon-
etary and Capital Markets Department, and Jemma Dridi is a
Senior Economist in the IMF’s Middle East and Central Asia
Department.
is article is based on the authors’ IMF Working Paper 10/201, “e Eects
of the Global Crisis on Islamic and Conventional Banks: A Comparative
S t u d y.”
Reference:
Khan, M. Mansoor, and M. Ishaq Bhatti, 2008, Developments in
Islamic Banking: e Case of Pakistan, Palgrave Macmillan Studies
in Banking and Financial Institutions (Houndmills, Basingstoke,
Hampshire, United Kingdom: Palgrave Macmillan).
Finance & Development December 2010 47
48 Finance & Development December 2010
C
ONSUMPTION, production, and investment de-
cisions of individuals, households, and rms oen
aect people not directly involved in the transac-
tions. Sometimes these indirect eects are tiny.
But when they are large they can become problematic—what
economists call externalities. Externalities are among the
main reasons governments intervene in the economic sphere.
Most externalities fall into the category of so-called techni-
cal externalities; that is, the indirect effects have an impact on
the consumption and production opportunities of others, but
the price of the product does not take those externalities into
account. As a result, there are differences between private
returns or costs and the returns or costs to society as a whole.
Negative and positive externalities
In the case of pollution—the traditional example of a nega-
tive externality—a polluter makes decisions based only on the
direct cost of and profit opportunity from production and
does not consider the indirect costs to those harmed by the
pollution. The social—that is, total—costs of production are
larger than the private costs. Those indirect costs—which are
not borne by the producer or user—include decreased qual-
ity of life, say in the case of a home owner near a smokestack;
higher health care costs; and forgone production opportu-
nities, for example when pollution harms activities such as
tourism. In short, when externalities are negative, private
costs are lower than social costs.
There are also positive externalities, and here the issue is
the difference between private and social gains. For example,
research and development (R&D) activities are widely con-
sidered to have positive effects beyond those enjoyed by the
producer—typically, the company that funds the research.
This is because R&D adds to the general body of knowledge,
which contributes to other discoveries and developments.
However, the private returns of a firm selling products based
on its own R&D typically do not include the returns of others
who benefited indirectly. With positive externalities, private
returns are smaller than social returns.
When there are differences between private and social costs
or private and social returns, the main problem is that mar-
ket outcomes may not be efficient. To promote the well-being
of all members of society, social returns should be maximized
and social costs minimized. Unless all costs and benefits are
internalized by households and firms making buying and pro-
duction decisions, market outcomes can lead to underproduc-
tion or overproduction in terms of a society’s overall condition
(what economists call the “welfare perspective”).
Consider again the example of pollution. Social costs grow
with the level of pollution, which increases as production
increases, so goods with negative externalities are overpro-
duced when only private costs are involved and not costs
incurred by others. To minimize social costs would lead to
lower production levels. Similarly, from a societal perspec-
tive, maximization of private instead of social returns leads
to underproduction of the good or service with positive
externalities.
Taxation and externalities
Neoclassical economists recognized that the inefficiencies
associated with technical externalities constitute a form of
“market failure.” Private market–based decision making fails
to yield efficient outcomes from a general welfare perspec-
tive. These economists recommended government inter-
vention to correct for the effects of externalities. In The
Economics of Welfare, British economist Arthur Pigou sug-
gested in 1920 that governments tax polluters an amount
equivalent to the cost of the harm to others. Such a tax would
yield the market outcome that would have prevailed with
adequate internalization of all costs by polluters. By the same
logic, governments should subsidize those who generate pos-
itive externalities, in the amount that others benefit.
The proposition that technical externalities require gov-
ernment regulation and taxation to prevent less than optimal
market outcomes was intensely debated after Pigou’s semi-
nal work. Some economists argued that market mechanisms
can correct for the externalities and provide for efficient
outcomes. People can resolve the problems through mutu-
ally beneficial transactions. For example, a landlord and a
polluter can enter into a contract under which the landlord
agrees to pay the polluter a certain amount of money in
exchange for a specific reduction in the amount of pollu-
tion. Such contractual bargaining can be mutually beneficial.
Once the building is less exposed to pollution, the landlord
can raise rents. As long as the increase in rents is greater than
the payment to the polluter, the outcome is beneficial for the
landlord. Similarly, as long as the payment exceeds the loss in
48 Finance & Development December 2010
BACK TO BASICS
What Are
Externalities?
What happens when prices do not fully capture costs
Thomas Helbling
Finance & Development December 2010 49
profit from lower pollution (lower production), the polluting
firm is better off as well.
The possibility of overcoming the inefficiencies from
externalities through bargaining among affected parties was
first discussed in 1960 by Ronald Coase in “The Problem of
Social Cost” (among the works that earned him a Nobel Prize
in economics in 1991). For bargaining solutions to be feasi-
ble, property rights must be well defined, bargaining transac-
tion costs must be low, and there must be no uncertainty or
asymmetric information, when one actor knows more than
the other about the transaction.
Against this backdrop, optimal government intervention
might be the establishment of institutional frameworks that
allow for proper bargaining among parties involved in exter-
nalities. Property rights—specifically intellectual property
rights, such as patents—allow a firm to earn most if not all
the returns from its R&D. But it is easier to assign property
rights for innovations and inventions. When it comes to
basic or general research, property rights are more difficult
to define, and government subsidies typically are needed to
ensure a sufficient amount of basic research.
Public goods
Problems in defining property rights are often a funda-
mental obstacle to market-based, self-correcting solutions,
because the indirect effects of production or consumption
activity can affect so-called public goods, which are a special
kind of externality. These goods are both nonexcludable—
whoever produces or maintains the public good, even
at a cost, cannot prevent other people from enjoying its
benefits—and nonrival—consumption by one individual
does not reduce the opportunity for others to consume it
(Cornes and Sandler, 1986). If the private benefits are small
relative to the social benefit but private costs to provide
them are large, public goods may not be supplied at all. The
importance of the public good problem has long been rec-
ognized in the field of public finance. Taxes often finance
governments’ delivery of public goods, such as law and order
(Samuelson, 1955).
The public good problem is especially notable in environ-
mental economics, which largely deals with analyzing and
finding solutions to externality-related issues. Clean air,
clean water, biodiversity, and a sustainable stock of fish in
the open sea are largely nonrival and nonexcludable goods.
They are free goods, produced by nature and available to
everybody. They are subject to no well-defined prop-
erty rights. As a result, households and firms do not place
enough value on these public goods, and efficient market
outcomes through bargaining typically are not feasible. In
other words, environmental issues often face a collective
action problem.
High transaction costs and problems related to uncer-
tainty are other obstacles that prevent parties involved in
technical externalities from internalizing costs and benefits
through bargaining solutions. Uncertainty problems are far
reaching. In fact, the well-known moral hazard is a form of
externality in which decision makers maximize their ben-
efits while inflicting damage on others but do not bear the
consequences because, for example, there is uncertainty or
incomplete information about who is responsible for dam-
ages or contract restrictions. An often-used example is a
situation in which an insured entity can affect its insurance
company’s liabilities but the insurance company is not in a
position to determine whether the insured is responsible
for an event that triggers a payout. Similarly, if a polluter’s
promised preventive actions cannot be verified because of a
lack of information, bargaining is unlikely to be a feasible
solution.
Today, the most pressing and complex externality problem
is greenhouse gas (GHG) emissions. The atmospheric accu-
mulation of greenhouse gases from human activity has been
identified as a major cause of global warming. Barring poli-
cies to curb GHG emissions, scientists expect this problem to
grow and eventually lead to climate change and its accompa-
nying costs, including damage to economic activity from the
destruction of capital (for example, along coastal areas) and
lower agricultural productivity. Externalities come into play
because the costs and risks from climate change are borne by
the world at large, whereas there are few mechanisms to com-
pel those who benefit from GHG-emitting activity to inter-
nalize these costs and risks.
The atmosphere, in fact, is a global public good, with ben-
efits that accrue to all, making private bargaining solutions
unfeasible. Identifying and agreeing on policies for inter-
nalization of the social costs of GHG emissions at the global
level are extremely difficult, given the cost to some individu-
als and firms and the difficulties of global enforcement of
such policies (Tirole, 2008).
Externalities pose fundamental economic policy problems
when individuals, households, and firms do not internal-
ize the indirect costs of or the benefits from their economic
transactions. The resulting wedges between social and pri-
vate costs or returns lead to inefficient market outcomes.
In some circumstances, they may prevent markets from
emerging. Although there is room for market-based correc-
tive solutions, government intervention is often required to
ensure that benefits and costs are fully internalized.
■
omas Helbling is an Advisor in the IMF’s Research
Department.
References:
Coase, Ronald, 1960, “e Problem of Social Cost,” Journal of Law and
Economics, Vol. 3, No. 1, pp. 1–44.
Cornes, Richard, and Todd Sandler, 1986, e eory of Externalities,
Public Goods, and Club Goods (Cambridge, United Kingdom:
Cambridge University Press).
Pigou, Arthur C., 1920, e Economics of Welfare (London: Macmillan).
Samuelson, Paul A., 1955, “Diagrammatic Exposition of a eory of
Public Expenditure,” e Review of Economics and Statistics, Vol. 37,
No. 4, pp. 350–56.
Tirole, Jean, 2008, “Some Economics of Global Warming,” Rivista di
Politica Economica, Vol. 98, No. 6, pp. 9–42.
Finance & Development December 2010 49
50 Finance & Development December 2010
A
MAJOR contributor to widespread poverty is the
lack of integration of poorer economies into the
global economy. Although trade is only part of the
solution, were poorer economies able to sell more
goods to advanced and emerging economies, they would ben-
et mightily.
But exporters in poorer economies face obstacles both
abroad and at home. Access to foreign markets is frequently
limited by import barriers, while inadequate infrastructure
and weak domestic policies often frustrate producers seeking
to compete abroad. As a consequence, exports of the poorest
countries have remained far below potential. The 49 poor-
est, or “least developed,” countries (LDCs; see box) account
for nearly 1 percent of global gross domestic product (GDP)
but less than 0.5 percent of global non-oil exports—a level
virtually unchanged over the past 15 years (see chart). Only
1percent of advanced economies’ imports come from LDCs.
There are steps the poorest economies themselves could
take to boost exports—such as reducing the often prevailing
antitrade bias in their trade, tax, customs, and exchange rate
regimes; issuing more transparent trade and customs regula-
tions; and taking steps to improve such key service sectors
as communications and transportation (see World Bank,
2010).
But the poorest exporting economies would benefit con-
siderably if emerging as well as advanced economies gave
them better opportunities for trade, which would improve
their growth and productivity prospects (see Elborgh-
Woytek, Gregory, and McDonald, 2010). There are a num-
ber of steps better-off countries could take to boost poor
economies’ export potential. Some of them are well known to
policymakers—in particular, concluding the current World
Trade Organization (WTO) trade-negotiation talks, known
as the Doha Round. Wide-ranging multilateral trade liberal-
ization could spur growth and foster secure and open global
Advanced and emerging economies can make it easier for the least
developed countries to sell more products abroad
Katrin Elborgh-Woytek and Robert Gregory
Poorest
Economies
Can Export More
Below potential
Although the poorest 49 countries account for about
1 percent of global GDP, they supply less than 0.5 percent of
global non-oil exports.
(percent)
Woytek, 10/27/10
Source: IMF, Direction of Trade Statistics, 2010.
1995 97 99 2001 03 05 07
Non-oil exports
GDP
All exports
0
0.2
0.4
0.6
0.8
1.0
1.2
Poorest
Economies
Can Export More
trading. Poorer countries would gain from successful Doha
Round conclusion through better access to advanced and
emerging export markets.
Although broad-based multilateral trade liberalization is
the ultimate policy target, there are less-obvious interme-
diate avenues—such as the extension and improvement of
duty-free and quota-free (DFQF) trade preferences both by
advanced and emerging economies—that could add nearly
$10 billion a year to the coffers of poorer economies. These
preference systems are designed to offset for the poorest
countries some of the high trade barriers in sectors such as
light manufacturing and agriculture—areas in which LDCs
are likely to export.
Main avenues of integration
There are three main avenues for the more advanced and
emerging economies to help integrate LDCs into the global
economy:
• Remove all tariffs and quotas on products from LDCs.
• Make the rules that determine whether a product
is deemed to originate from an LDC more flexible and
consistent—including relaxing so-called cumulation rules,
which govern the extent to which inputs from other coun-
tries affect compliance with rule-of-origin requirements for
LDC exporters.
• Tilt preference benefits more specifically toward poorer
economies.
First, if advanced and emerging markets ended all duties
and quotas on LDC exports, the effect would be sizable. Major
emerging market countries’ preference benefits to LDCs
could be very valuable and help them improve their export
performance. Exports from LDCs to Brazil, China, and India
grew by an annual average of more than 30 percent during
1999–2009, and these three countries account for a third
of all LDC exports. In 2008, China overtook the European
Union as the largest single importer of LDC products, buying
23 percent of their exports. With substantial reforms since
the 1990s, these emerging markets have reduced average tar-
iff rates for nearly all trade partners to about 11 percent, but
tariffs remain some 6percentage points higher than those of
the major advanced economies’ markets.
The share of exports from LDCs that are eligible for
preferential treatment has increased from 35 percent in
the late 1990s to over 50 percent today. However, prefer-
ence programs vary considerably in product and country
coverage, with sometimes significant gaps in coverage and
high administrative costs. Gaps in preference programs of
emerging market economies are usually wider than those
in industrialized countries’ programs, reflecting their rela-
tively recent development. High tariffs remain concentrated
in agriculture and labor-intensive low-wage manufactures,
the sectors in which LDCs have a comparative advan-
tage and where 90 percent of their non-oil exports are
concentrated.
In the 2000 United Nations Millennium Declaration,
advanced economies committed to “a policy of duty- and
quota-free access for essentially all exports from the least
developed countries.” Following up on this commitment,
WTO members agreed in the 2005 Hong Kong Ministerial
Declaration that developing countries “in a position to do
so” should make the same commitment. In practice, many
advanced and emerging market economies have agreed
to allow DFQF market access for LDC products under at
least 97 percent of tariff lines. While the difference between
97 percent and 100 percent may seem insignificant, many
LDCs export so few product categories that even a small
number of exclusions can sharply limit the benefits of trade
preference programs.
Exports would grow significantly
If all exports from developing countries were exempt from
tariffs and quotas, LDC exports to both advanced and emerg-
ing markets would grow significantly—on the order of
$10billion a year, or about 2percent of their combined GDP
(Laborde, 2008; and Bouët and others, 2010). Broadening the
coverage of preferences by major advanced markets could
generate increased exports from LDCs of about $2.2 billion a
year, or about 6percent of net official development assistance
from industrial countries to LDCs. The potential increase is
even larger for exports to emerging markets—about $7 bil-
lion a year in additional exports (Bouët and others, 2010).
Although the positive impact on LDCs would be sizable, the
negative effect on advanced and emerging economies would
be tiny because of the low level of LDC exports.
Second, if better-off economies were to make rules of origin
more flexible, LDCs would benefit too. Rules of origin deter-
mine whether a good “originates” in a country that benefits
from a preference system. The rules specify the minimum
amount of economic activity that must be undertaken in the
country benefiting from the preference and whether inputs
from other countries count toward this minimum. Rules of
origin differ widely across countries’ preference programs.
They are frequently based on the amount of value added in
the preference-eligible country or on the transformation a
good undergoes in that country (measured by a change in
tariff classification). These rules strongly influence where an
Finance & Development December 2010 51
The least developed countries
The United Nations identifies 49 countries as “least devel-
oped,” meaning that they are extremely poor, have structurally
weak economies, and lack the capacity for growth.
Africa: Angola, Benin, Burkina Faso, Burundi, Central
African Republic, Chad, Comoros, Democratic Republic of
the Congo, Djibouti, Equatorial Guinea, Eritrea, Ethiopia,
The Gambia, Guinea, Guinea-Bissau, Lesotho, Liberia,
Madagascar, Malawi, Mali, Mauritania, Mozambique, Niger,
Rwanda, São Tomé and Príncipe, Senegal, Sierra Leone,
Somalia, Sudan, Togo, Uganda, Tanzania, and Zambia.
Asia: Afghanistan, Bangladesh, Bhutan, Cambodia,
Kiribati, Lao People’s Democratic Republic, Maldives,
Myanmar, Nepal, Samoa, Solomon Islands, Timor-Leste,
Tuvalu, Vanuatu, and Republic of Yemen.
Western Hemisphere: Haiti.
LDC buys its inputs, which affects the overall economic con-
sequences of a preference program.
To qualify for a preference program, LDC exporters must
often limit input sourcing to suppliers in their own coun-
try or those from the country granting the preference—even
if it would be cheaper to buy inputs elsewhere. This can be
difficult for less-diversified LDCs, which depend on inter-
mediate goods, processes, or patents from other countries.
Rules of origin can also be a source of distortion, if exporters
turn to less-efficient, more costly input sources to qualify for
preferences. Moreover, the administrative burden of meet-
ing complex rules of origin can be substantial, costing as
much as 3 percent of export value (Hoekman and Özden,
2005). As a result, perhaps a quarter to a third of eligible
imports do not gain preference, and some trade that might
have benefited from better-designed preferences is likely
never undertaken.
Permitting more flexible sourcing
More liberal rules of origin allow producers to source inputs
flexibly. Such rules implicitly acknowledge LDCs’ low capi-
tal intensity and lack of horizontal or vertical integration.
Under China’s preference program, for example, origin (and
thus preference benefits) can be conferred on a product
based either on a minimum local value-added threshold or a
change in tariff classification—implicit acknowledgment that
the product is different and the LDC has added value. India’s
low 30 percent value-added threshold gives potential LDC
exporters flexibility in sourcing their inputs.
Moreover, better-off countries could make it even easier to
stimulate trade among LDCs if their rules of origin specifi-
cally allowed preference-eligible countries to buy inputs from
other preference-eligible countries. If these so-called cumu-
lation provisions allowed inputs from two or more coun-
tries to be counted together, it would make it easier for the
preference-eligible country to meet the minimum require-
ments under the rules of origin. In contrast, narrow or
restrictive cumulation provisions rules do not allow the use
of inputs from other countries, often fragmenting established
cross-border production relationships. Cumulation provi-
sions therefore determine how easily preference beneficiaries
can trade among themselves, using intermediate goods or
processes that originate in other countries.
Permitting wider cumulation would assuredly mean that
LDCs could meet the rules of origin more easily and at lower
cost and would also encourage south-south trade. Allowing
the poorest countries to source inputs from all LDCs and
other developing countries while remaining eligible for pref-
erences would provide the added flexibility needed for effec-
tive use of preference programs.
Tilting toward developing countries
Finally, both advanced and emerging economies could tilt
their preference benefits more specifically toward the poorest
developing countries. Some advanced economy market pref-
erence programs favor a wide range of developing countries,
not necessarily the poorest. Advanced economies also often
have regional trade agreements that grant preferences to the
countries in the pact. The combination of regional and less-
focused preference programs reduces the effective preference
margin available to LDCs. In those cases, phasing out ben-
efits to more developed countries over time could be consid-
ered, taking into account the impact both on exporters and
importers. Graduation provisions, which determine when
an economy is no longer eligible for preferential treatment,
should always be transparent and predictable, with ample
notice of withdrawal. In the interest of predictability, prefer-
ences for LDCs should be renewed well in advance, allowing
time for investors to make decisions accordingly.
In setting out changes in trade preference programs for
the poorest economies, emerging markets may play a more
important role than advanced economies, most of which have
had such programs for many years. Several major emerging
economies have introduced and expanded LDC trade prefer-
ences, but coverage remains selective. Because they are at an
earlier stage of implementation than those of advanced econ-
omies, these preference programs have room to grow, albeit
at a pace consistent with the remaining development needs
of the emerging economies that are the new preference pro-
viders. It may take longer for emerging economies to phase
in the proposed changes, but the key direction for expansion
and improvement of their programs is broadly similar to that
of advanced economies. Because adjustment pressure is likely
limited to a narrow range of product categories—in which
there could be direct competition with LDC exports—some
emerging economies may need several years to implement
these LDC benefits.
■
Katrin Elborgh-Woytek is a Senior Economist and Robert
Gregory is an Economist, both in the IMF’s Strategy, Policy,
and Review Department.
References:
Bouët, Antoine, David Laborde Debucquet, Elisa Dienesch, and Kimberly
Elliott, 2010, “e Costs and Benets of Duty-Free, Quota-Free Market
Access for Poor Countries: Who and What Matters,” CGD Working
Paper 206 (Washington: Center for Global Development).
Elborgh-Woytek, Katrin, Rob Gregory, and Brad McDonald, 2010,
“Reaching the MDGs: An Action Plan for Trade,” IMF Sta Position
Note 10/14 (Washington: International Monetary Fund).
Hoekman, Bernard, and Çaglar Özden, 2005, “Trade Preferences and
Dierential Treatment of Developing Countries: A Selective Survey,”
World Bank Policy Research Working Paper WPS 3566 (Washington).
Laborde, David, 2008, “Looking for a Meaningful Duty-Free Quota-Free
Market Access Initiative in the Doha Development Agenda,” Issue
Paper 4 (Geneva: International Centre for Trade and Sustainable
Development).
World Bank, 2010, Doing Business project trading across borders data.
Available at www.doingbusiness.org/Data/ExploreTopics/trading-
across-borders
World Trade Organization, 2007, Market Access for Products and
Services of Export Interest to Least-Developed Countries (Geneva:
World Trade Organization).
52 Finance & Development December 2010
W
ORLD exports grew substantially from 2000 to 2008,
particularly among the world’s top three exporters—
China, Germany, and the United States. In China, for example,
exports grew by nearly 700 percent during the period, paral-
leling the rapid growth of its economy. This growth came to a
halt as a result of the 2008–09 financial crisis. Between October
2008 and March 2009, foreign sales by the top 10 exporters—
which account for about 50 percent of world exports—dropped
by 34 percent. But since then exports have rebounded rapidly.
By the second quarter of 2010, the top 10 exporters had recov-
ered 55 percent of their decline during the crisis.
The growth in world imports that preceded the Great
Recession was equally impressive. During 2000–08, the
top 10 importers—who bought about 50 percent of world
imports—increased their foreign purchases by 51 percent,
with the United States the clear leader. As with exports, the
financial crisis caused a significant drop in imports of 35
percent during the same six-month period—October 2008
to March 2009. But there was a similar sharp rebound in
imports. By the second quarter of 2010, the top 10 importers
had recovered 58 percent of the crisis-induced decline.
Trade among the top 10 exporters and importers and other
country groups reveals some wide variations. When broken
down by destination region, sales by the top 10 exporters to
emerging Europe fell the most during the acute crisis period.
Exports to advanced economies, Africa, and developing
Asia were affected the least, although the declines were still
significant.
Turning to imports by the top 10 importers, those from
the Middle East fell the most in late 2008 and early 2009,
followed closely by those from Africa, while imports from
advanced economies and developing Asia declined the least.
Finance & Development December 2010 53
DATA SPOTLIGHT
Trade Impact
The Great Recession seriously disrupted international
trade, but some were hit harder than others
Foreign sales by the top 10 exporters grew substantially
from 2000 to 2008 but dropped signicantly as a result
of the 2008–09 crisis.
(billion dollars)
DS Chart 3, 11/17/10
China
Germany
United States
Japan
Netherlands
2000 02 04 06 08 10
0
100
200
300
400
500
France
Italy
Belgium
United Kingdom
Korea
Sales by the top 10 exporters to emerging Europe fell the
most during the acute crisis period.
(exports of top 10 countries, 2008:Q4–2009:Q1, percent change)
DS Chart 3, 11/17/10
Advanced Africa Developing Emerging Middle Western
economies Asia Europe East Hemisphere
–40
–30
–20
–10
0
The 2008–09 nancial crisis also caused a signicant
drop in imports of the top 10 importers.
(billion dollars)
DS Chart 3, 11/17/10
United States
Germany
China
France
United Kingdom
Japan
2000 02 04 06 08 10
0
100
200
300
400
500
600
Italy
Netherlands
Canada
Belgium
Purchases from the Middle East by the top 10 importers
saw the biggest drop during the crisis.
(imports of top 10 countries, 2008:Q4-2009:Q1, percent change)
DS Chart 4, 11/17/10
–60
–40
–20
0
Advanced Africa Developing Emerging Middle Western
economies Asia Europe East Hemisphere
Prepared by Kim Zieschang with assistance from Alex Massara, both of the IMF’s Statistics Department.
About the database
The data are from the Direction of Trade Statistics database,
which contains 100,000 time series covering bilateral and
multilateral merchandise trade data for more than 180 coun-
tries. Exports and imports are presented on an f.o.b/c.i.f. basis
in U.S. dollars. The data are reported by country authorities,
the United Nations, or Eurostat. When data are not reported,
estimation is undertaken using historical and/or partner data.
The database is available at www.imf.org/external/data.htm
Dani Rodrik
The Globalization Paradox
Democracy and the Future of the
World Economy
W.W. Norton & Company, New York and London,
2011, 288 pp., $26.95 (cloth).
D
ani Rodrik is a long-standing
critic of the existing inter-
national order. His excellent
new book is a sequel to an earlier
book about the oen disruptive im-
pact of international trade on national
labor markets and social policies. e
new book develops and extends this
theme to include nancial globaliza-
tion. ere is also a discussion about
the democratic legitimacy of the
existing international order. Rodrik
concludes by considering how the
world economy might be reformed.
The author’s target is not global-
ization as such. He robustly defends
both capitalism and globalization,
because they have the potential to
generate rapid economic develop-
ment if properly harnessed. His
target is “hyper-globalization,” which
involves the comprehensive elimina-
tion of barriers to trade and finance,
together with severe constraints on
the freedom of national governments
to intervene in their domestic econo-
mies. This is the program promoted
for several decades by “market funda-
mentalists” in the economics profes-
sion and within certain international
institutions.
Rodrik objects to the fundamental-
ist approach on two levels. First, such
a program rests on a crude version of
economic theory that rarely applies in
practice and runs counter to histori-
cal experience. During their take-off
phase, the majority of today’s devel-
oped economies actively promoted
industrialization through the use of
measures such as capital controls,
subsidies, and restrictions on imports
and foreign direct investment. The
same is true of China and India in the
recent past and even to some extent
today. Such policies do not guarantee
success, but few poor countries have
taken off without them.
There is also national sovereignty
to consider. Even if the program
advocated by the fundamentalists
is correct, there is no justification
for imposing it on supposedly sov-
ereign governments. Every country
has the right to be wrong, so long
as it does not cause serious harm
to others. The international system
needs rules, but these should be flex-
ible and give national governments
extensive freedom to experiment.
This was the case under the old
Bretton Woods system, which in its
heyday was a stunning success in
promoting economic growth and
reconciling national autonomy with
international order.
Market fundamentalism often
accompanies the view that nation
states are outmoded—that they are
being undermined by global com-
munications and market forces, and
their role will be progressively sup-
planted by supranational institutions.
The logical end of this process is
world government. Rodrik is skepti-
cal that world government is feasible.
He is even more skeptical about its
desirability:
“There is simply too much diver-
sity in the world for nations to be
shoehorned into common rules, even
if those rules are somehow the prod-
uct of democratic processes. Global
standards and regulations are not
just impractical; they are undesirable.
The democratic legitimacy constraint
ensures that global governance will
result in the lowest common denomi-
nator, a regime of weak and ineffec-
tual rules. We then face the big risk of
too little governance all round, with
national governments giving up on
their responsibilities and no-one else
picking up the slack.”
Rodrik concludes that the alter-
native to world government is to
strengthen the nation state. To this
end he proposes seven principles
for global reform that would restore
much of the policy autonomy for
individual countries that has been
lost since the demise of Bretton
Woods.
These principles are attractive,
although they raise some tricky ques-
tions about implementation. For
example, principle 7 states that “non-
democratic countries cannot count
on the same rights and privileges in
the international economic order as
democracies.” China is not conven-
tionally classified as a democracy,
since it is a one-party state without
free elections. Yet the country has
achieved miracles in terms of growth
and poverty reduction. To penalize
China because it is not a democ-
racy might put this achievement in
jeopardy. It would also be asking for
trouble. China will quite soon have
the largest economy in the world and
would not take kindly to this kind of
interference.
This raises a more general ques-
tion. What is the political constitu-
ency for Rodrik’s proposed reforms?
The Bretton Woods system and the
free market system that replaced
it were both shaped by the United
States and its richer allies in line
with their priorities at the time.
With Brazil, China, India, and
other economic giants looming on
the horizon, the world balance of
power is shifting. Without the sup-
port of these future superpowers, no
proposal for reform can succeed. It
will be interesting to see what kind
of reception Rodrik’s ideas have in
these countries.
Robert Rowthorn
Emeritus Professor,
University of Cambridge
54 Finance & Development December 2010
BOOK REVIEWS
Globalization on a Diet
Barry Eichengreen
Exorbitant Privilege
The Decline of the Dollar and
the Future of the International
Monetary System
Oxford University Press, New York, 2011,
224 pp., $27.95 (cloth).
B
arry Eichengreen’s new book
couldn’t be more timely: on
September 15, 2010—the sec-
ond anniversary of nancial services
rm Lehman Brothers’ collapse—the
Bank of Japan’s intervention to drive
down the yen sparked a wave of reac-
tions in Korea and Brazil and intensi-
ed the stando between China and
the United States over the value of the
renminbi. A new round of currency
wars broke out, and many fear that
1930s-style moves to push currencies
down will lead to trade protection-
ism, economic nationalism, and
increased international tension.
Eichengreen opens with an older
question—not so much about the
manipulation of weak currencies for
trade advantages as the advantages
of strength. How does the United
States benefit from the dollar’s role as
the world’s major reserve currency?
What is the “exorbitant privilege” that
French politicians have lambasted
since the 1960s? Can there be only
one major reserve currency?
Eichengreen’s responses to these
questions are elegant and pithy. He
convincingly argues that it is not the
status of a reserve currency that gives
great power status; instead, the role
of safe haven follows great power
preeminence. Investors—whether
private or official—are prepared to
accept lower returns for investing
in the United States simply because
it is a secure country, with a well-
understood and -enforced rule of law.
As its great power preeminence fades
and the catch-up effects of technical
diffusion erode its economic supe-
riority, a more multipolar currency
system is likely to replace the dollar’s
hegemony.
Eichengreen explains how a spe-
cific policy initiative led to the dollar’s
quick rise as a major world currency.
One of the purposes of the monetary
reforms following the 1907 financial
crisis was to enable U.S. merchants
to use dollar acceptances instead of
sterling bills via London to finance
international trade. The Federal
Reserve System was established to
support the new financial center.
By the 1920s, the dollar was a major
reserve currency, and the immediate
aftermath of World War I showed
that a multicurrency system could
work. Eichengreen also chronicles the
rise of a new challenger, the euro.
New global currencies—first the
dollar, then the euro—can emerge
quickly, as did the deutsche mark in
the late 1960s and 1970s. Eichengreen
sees the renminbi as a possible major
reserve currency, but argues that the
Chinese leadership is not yet ready
for financial liberalization. He consid-
ers China closer to late 1960s Japan
(which struggled against moves that
would lead to internationalization of
the yen) than to the Federal Republic
of Germany.
Could something besides exist-
ing currencies be an international
medium of exchange? Eichengreen
examines and dismisses the likeli-
hood of a return to gold or the use
of some other commodity standard.
A more intriguing and currently
fashionable idea is increased use
of the IMF-created international
reserve asset, the Special Drawing
Right (SDR). Created in 1969 to
supplement member countries’ offi-
cial reserves, its value is based on a
basket of four key international cur-
rencies, and SDRs can be exchanged
for freely usable currencies. But
Eichengreen is skeptical about the
feasibility of using the SDR as the
common international medium of
exchange. He describes the case for
a global currency as “compelling in
the abstract,” but impossible in prac-
tice. “As long as there is no global
government to hold it accountable
for its actions, there will be no global
central bank.”
The section on a global currency
seems at odds with the discussion of
the emergence of the euro, which is
after all issued by a central bank nei-
ther controlled by nor responsible to
any government. The euro grew out
of a sustained attempt at monetary
cooperation in the face of unease
about the global situation. Episodes
of dollar weakness fueled creation of
the euro: strains and then a breakup
of the par value system in the early
1970s and U.S. currency misman-
agement in the late 1970s and early
1990s. European cooperation was
subject to the same problems that
Eichengreen says confront a world
basket currency. During the 1980s,
the Europeans tried to promote pri-
vate use of the European Currency
Unit (ECU—a sort of precursor to the
euro). Bonds and credits were issued
in ECUs, but the market for a syn-
thetic currency proved too shallow
to survive the dramatic exchange rate
crises of the early 1990s.
A final section examines the pos-
sibility of a swift dollar collapse, most
plausibly, according to Eichengreen,
as a result of an uncontrolled U.S.
fiscal deficit. He argues that the
2010 euro crisis has already set euro
area countries on a course of fiscal
consolidation, whereas there is little
political backing in the United States
for similar reforms.
Harold James
Professor of History and
International Affairs,
Princeton University
Finance & Development December 2010 55
Strength in Reserve
56 Finance & Development December 2010
Deborah Brautigam
The Dragon’s Gift
The Real Story of China in Africa
Oxford University Press, Oxford, New York, 2009,
397 pp., $23.96 (cloth).
C
hina is making a huge splash
in Africa and in discussions
about African economies,
less because of the sheer size of
China’s aid, trade, and investment
than because of the rapid increase
in all three. African governments,
civil society organizations, donors,
and international organizations have
reacted with a mix of enthusiasm,
suspicion, and concern about the
benets and costs of Chinese eco-
nomic engagement with Africa.
Deborah Brautigam’s latest book is
not the first to take on this topic, but
it stands out in its efforts to convey
the experience of China in Africa
from a Chinese perspective, including
both official and unofficial sources,
on and off the record. Professor
Brautigam is supremely qualified to
write such a book: she has studied
Chinese and worked extensively both
in China and Africa for more than
two decades, and much of her work
has focused on Chinese-African eco-
nomic relations.
The Dragon’s Gift’s strength is
its extensive and varied array of
interviews with Chinese govern-
ment officials in Africa, Chinese
factory managers, and other Chinese,
African, and third-country par-
ticipants and observers. Through
these interviews, she conveys a rich
sense of Chinese perceptions of how
their own experience could benefit
African countries. She also offers a
snapshot of Chinese and African per-
ceptions of Chinese aid and invest-
ment projects in Africa, including
its successes, frustrations, and fail-
ures. Among the topics covered are
cultural tensions between Chinese
managers and African workers over
work hours and wages, frustra-
tions on the African side about the
high number of Chinese managers
and workers brought in for aid and
investment projects compared with
those of Western donors and inves-
tors (albeit at substantially lower cost
for Chinese than Western expatriate
staff), and mutual recriminations
about who is responsible for failures
in transfers of technical and manage-
rial expertise.
Professor Brautigam repeatedly
and convincingly makes the case
that Chinese economic involvement
in Africa is often misunderstood.
In particular, she notes that there is
often confusion between Chinese
corporate investment through state-
owned entities and foreign aid to
Africa, that Chinese policy is explic-
itly focused on mutually beneficial
opportunities for south-south coop-
eration. She also cites press reports
and speeches that are often misun-
derstood (for example, as a result of
errors in translating numbers or con-
fusion between U.S. dollar amounts
and renminbi figures).
The Dragon’s Gift points out that
reports of China’s aid, trade, and
investment flows to Africa are often
overstated, sometimes in alarm-
ist terms. It also explains that trade
between China and Africa has been
growing rapidly, albeit from a low
base. She tries to address many other
hot-button issues that dog China’s
economic engagement with Africa,
including corruption (making the
somewhat novel point that the direct
transfer of aid from the Chinese
state to the Chinese entities selected
to carry out investment projects in
Africa—often the funds never even
leave China—limits opportunities for
African officials to divert funds).
However, the book’s strength is
closely tied to its main weakness.
Given that Professor Brautigam’s
focus is in large part on Chinese aid
and the activities of state-owned
enterprises, her book is very heavily
and inevitably anecdotal. This stands
in contrast to the more data-driven
(but more trade- and investment-
focused) approach taken by the 2007
study by Harry G. Broadman of the
World Bank, Africa’s Silk Road.
For example, the author is forced
to adopt an anecdotal approach
when she attempts to estimate 2007
Chinese aid flows to Africa. Her
estimates include (1) a 2001 figure
for China Eximbank’s global conces-
sional lending, (2) use of the annual
growth rate of overall concessional
foreign aid loans from a 2005 annual
report to extrapolate the 2007 figure
from 2001 numbers, and (3) a late-
2003 report of discussions between
a Chinese official and African
ambassadors that mentions the share
of aid to Africa over the preceding
four years. Obtaining similar data
for any other major donor would
be a simple matter of looking up
a published figure, but the author
repeatedly notes that the Chinese
government treats quantitative
information on foreign aid, contract
terms, and most other relevant data
as state secrets.
Given these repeated difficulties,
the author’s criticisms of Chinese
government transparency are sur-
prisingly few and mostly implicit.
She quotes the old academic saw
“The plural of ‘anecdote’ is not ‘data’”
but proceeds to say that anecdotes
will have to do until better infor-
mation is available. Nevertheless,
the reliance on press reports and
interviews remains a frustration to
readers.
omas Dorsey
Advisor, IMF Strategy, Policy, and
Review Department
BOOK REVIEWS
The Misunderstood Dragon
A
Shekhar Aiyar and Rodney Ramcharan, A
Lucky Start, March
Rabah Arezki and Markus Brückner, Debt and
Democracy, June
Rabah Arezki, Bertrand Candelon, and
Amadou N.R. Sy, Bad News Spreads,
December
Vivek Arora and Athanasios Vamvakidis,
Gauging China’s Influence, December
Irena Asmundson, Supply and Demand, June
B
Back to Basics: What Is Inflation? March;
Supply and Demand, June; What Constitutes
Unemployment? September; What Are
Externalities? December
Bas B. Bakker and Anne-Marie Gulde,
Searching for Stability, June
Emanuele Baldacci, Sanjeev Gupta, and
Carlos Mulas-Granados, Getting Debt under
Control, December
Steve Barnett and Nigel Chalk, Building a
Social Safety Net, September
Andrew Berg and Luis-Felipe Zanna, Half
Empty or Half Full, September
Helge Berger and Martin Schindler, Return to
Form, September
Pelin Berkmen, Gaston Gelos, Robert
Rennhack, and James P. Walsh, Differential
Impact, March
Jagdish Bhagwati, Time for a Rethink, September
Ashok Vir Bhatia, After the Supernova,
September
Alan S. Blinder and Mark Zandi, Stimulus
Worked, December
Alex Bowen, Mattia Romani, and Nicholas
Stern, Challenge of the Century, March
Trung Bui and Tamim Bayoumi, Their Cup
Spilleth Over, March
Adelheid Burgi-Schmelz, Finding New Data,
September
C
Michel Camdessus and Renaud Guidée, By the
Rule, September
Jorge Ivan Canales-Kriljenko, Brahima
Coulibaly, and Herman Kamil, A Tale of Two
Regions, March
Florencia Carbone, Julian Ryall, Jacqueline
Deslauriers, Niccole Braynen-Kimani,
and Hyun-Sung Khang, Faces of the Crisis
Revisited, December
José M. Cartas, Dollarization Declines in Latin
America, March
José M. Cartas and Martin McConagha,
Credit to the Private Sector Remains Weak,
June
Kevin Cheng, Erik De Vrijer, and Irina
Yakadina, The Long Run Is Near, September
Benedict Clements, David Coady, and John
Piotrowski, Oil Subsidies: Costly and Rising,
June
Jeremy Clift, Prize or Penalty, March; People in
Economics: Avinash Dixit, December
Pedro Conceição and Selim Jahan, Making a
Breakthrough, September
D
Mai Chi Dao and Prakash Loungani, The
Tragedy of Unemployment, December
Data Spotlight: Dollarization Declines in Latin
America, March; Credit to the Private Sector
Remains Weak, June; Coping with Capital
Inflow Surges, September; Trade Impact,
December
David Dawe and Denis Drechsler, Hunger on
the Rise, March
Randall Dodd, Opaque Trades, March;
Municipal Bombs, June
E
Mohamed A. El-Erian, Sovereign Wealth Funds
in the New Normal, June
Katrin Elborgh-Woytek and Robert Gregory,
Poorest Economies Can Export More, December
Sara Elder, Youth for Hire, December
F
Harald Finger and Azim Sadikov, Lowering
Public Debt, June
G
Melinda Gates, Saving Mothers’ Lives,
September
Delfin S. Go, Reducing Child Mortality,
September
Delfin S. Go, Richard Harmsen, and Hans
Timmer, Regaining Momentum, September
Dominique Guillaume and Roman Zytek,
Reducing the Staggering Costs of Cheap Energy,
June
H
Maher Hasan and Jemma Dridi, Put to the
Test, December
Thomas Helbling, What Are Externalities?
December
Christian Henn and Brad McDonald, Avoiding
Protectionism, March
Mark Horton, How Grim a Fiscal Future?
September
I
Patrick Imam and Kangni Kpodar, Good for
Growth? December
J
Simon Johnson, Bonuses and the “Doom Cycle,”
March
K
Sanjay Kalra, Deeper Markets, Cheaper Capital,
June
Steven N. Kaplan, Should Bankers Get Their
Bonuses? March
May Khamis and Abdelhak Senhadji, Learning
from the Past, March
Hyun-Sung Khang, People in Economics: Jang
Hasung, June
Annamaria Kokenyne, Coping with Capital
Inflow Surges, September
M. Ayhan Kose and Eswar S. Prasad, Emerging
Markets Come of Age, December
Laurence J. Kotlikoff, A Hidden Fiscal Crisis,
September
Michael Kumhof and Romain Rancière,
Leveraging Inequality, December
L
Prakash Loungani, Housing Prices: More Room
to Fall? March
M
Hunter Monroe, Ana Carvajal, and Catherine
Pattillo, Perils of Ponzis, March
O
Ceyda Oner, What Is Inflation? March; What
Constitutes Unemployment? September
İnci Ötker-Robe and Ceyla Pazarbasioglu,
Risky Business, December
P
Arvind Panagariya, Growing out of Poverty,
September
People in Economics: Daron Acemoglu, March;
Jang Hasung, June; Maria Ramos, September;
Avinash Dixit, December
Picture This: Hunger on the Rise, March; Oil
Subsidies, June; Reducing Child Mortality,
September; Youth for Hire, December
William Poole, Principles for Reform, June
Eswar Prasad, After the Fall, June
Q
Marc Quintyn and Geneviève Verdier, Trusting
the Government, December
R
Rodney Ramcharan, Inequality Is Untenable,
September
Scott Roger, Inflation Targeting Turns 20, March
Andrew K. Rose and Mark M. Spiegel, The
Olympic Trade Effect, March
S
Anoop Singh, Asia Leading the Way, June
Duvvuri Subbarao, Redefining Central Banking,
June
U
Olaf Unteroberdoerster, Serving Up Growth,
June
W
Simon Willson, People in Economics: Daron
Acemoglu, March; Maria Ramos, September
Y
Linda Yueh, A Stronger China, June
Z
S. Raihan Zamil, Judgment Day, September
Min Zhu, On Asia’s Economy and More, June
Kim Zieschang, Trade Impact, December
Andrew Zimbalist, Is It Worth It? March
BOOK REVIEWS
Deborah Brautigam, The Dragon’s Gift: The
Real Story of China in Africa, December
Barry Eichengreen, Exorbitant Privilege: The
Decline of the Dollar and the Future of the
International Monetary System, December
Martin Gilman, No Precedent, No Plan: Inside
Russia’s 1998 Default, September
David Harvey, The Enigma of Capital,
September
R. Glenn Hubbard and William Duggan, The
Aid Trap: Hard Truths about Ending Poverty,
March
Harold James, The Creation and Destruction of
Value: The Globalization Cycle, March
Simon Johnson and James Kwak, 13 Bankers:
The Wall Street Takeover and the Next
Financial Meltdown, June
Simon Kuper and Stefan Szymanski,
Soccernomics, March
Henry M. Paulson, Jr., On the Brink: Inside
the Race to Stop the Collapse of the Global
Financial System, June
Raghuram G. Rajan, Fault Lines: How Hidden
Fractures Still Threaten the World Economy,
June
Carmen M. Reinhart and Kenneth S. Rogoff,
This Time Is Different: Eight Centuries of
Financial Folly, March
Dani Rodrik, The Globalization Paradox:
Democracy and the Future of the World
Economy, December
Nouriel Roubini and Stephen Mihm, Crisis
Economics: A Crash Course in the Future of
Finance, September
Andrew Sheng, From Asian to Global Financial
Crisis: An Asian Regulator’s View of Unfettered
Finance in the 1990s and 2000s, June
Muhammad Yunus, Building Social Business:
The New Kind of Capitalism That Serves
Humanity’s Most Pressing Needs, June
Finance & Development December 2010 57
INDEX 2010 VOLUME 47
Finance & Development, December 2010 $8.00
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