Washington, D.C: Olivier Blanchard is chief economist at the International Monetary Fund (IMF). A professor at the Massachusetts Institute of Technology, he is presently on leave for his IMF assignment. Blanchard spoke with Mint after the release of the latest World Economic Outlook (WEO) last Tuesday—a candid assessment of the challenges facing the global economy. Blanchard, among other things, dwelled on the imperatives of the latest global economic threat and the urgency to evolve a collective response from all stakeholders to fend it off. Edited excerpts:
When you released the latest World Economic Outlook, you talked about the downside risks even to the lowered growth projections you forecast.
The baseline is for slow growth, but the risks are there. The downside risks are no mystery. The main one is in Europe, which has allowed what was a small problem to become a large one. Unless they pursue the right policies, it could become a global problem and lead to lower growth.
The second, which is as important, but does not have the same baseline implications, is the US deficit. It has to be resolved. But in terms of clear and present dangers, Europe is on top of the list without any question.
Stephen Jaffe/IMF via Bloomberg
The key thing you said was that if countries fail to stick to the desired policy prescriptions, the downside risks would kick in. What is the worst-case scenario?
One scenario that is worrisome is the case where investors start having doubts not only about Greece—which they already have—but about other European countries, and they start taking their money out. The banks that are exposed react to this by deleveraging and reducing exposure as quickly as they can by selling sovereign bonds and reducing their willingness to lend to the private sector— both of which would only make things worse.
This leads to financial tensions in the US, a potential recession in Europe, and can eventually end up in a world recession. That is the scenario we want to avoid. And I think it can be avoided.
First, on Greece, there has to be clarity on what is needed going forward and its implementation. At the same time, we have to make sure markets appreciate the difference between the situation in Greece and in the other euro zone countries.
Take Italy, for instance. Growth has been low for a long time and debt is high. However, on fiscal policy, Italy has been quite responsible in the crisis; the government has pushed a package, which is very tough and there is no reason to think that it will not be implemented. If Italy can borrow at 3%, debt is sustainable. But if investors treat Italy and Greece alike and ask for 7-9% interest on its debt, then the debt is not sustainable.
So you have two types of equilibrium: a good one, with low rates, and a bad one, with high rates. The policy implications are clear: we need to get the good equilibrium. That means someone has to be there who is willing to buy Italian bonds at 3-4%—that somebody, for all practical purposes, has to be the European Central Bank (ECB).
Therefore, the commitment of the Europeans in general, and ECB in particular, to buy up bonds of member countries if needed, is essential. For the ECB to be able to do this, there has to be a commitment from euro zone members that if there were some losses, then it would be made good (to the central bank). You have to put this in place now.
Another thing which needs to be done is to increase the capital buffers of banks. Not because they misbehaved, they have not. But, given the uncertainty, banks want to increase their capital ratio, and they want to do this by selling assets, that is by deleveraging.
In the current environment, the last thing we want is for them to deleverage, as it would lead to a credit crunch and no growth. Thus, we want banks to increase their capital ratio, but to do so by increasing their capital. This can happen by either going to capital markets, or by public injections.
If you put these things in place, then the scary scenario I have talked about can be avoided.
A key to all of this is obviously political will. And here I note some important actions are taking place. On the fiscal side, all countries in Europe are taking measures to stabilize their debt. On strengthening the balance sheets of banks, the thing to do is to implement the 21 July decision. After that, the ESFS (European financial stability fund) money will be there potentially to help as appropriate. So yes, Europe is politically very complex.
When you look at the EU crisis, one fear is the survival of the euro zone. Do you subscribe to it?
I believe the euro will stay together. The Greeks want to stay in the euro; the Europeans are quite committed to the euro. The 21 July agreement says that, if the Greeks do what they have to do, then the other euro zone governments will be there to support them.
There is a trade-off when you undertake such structural adjustment programmes, particularly with respect to the pain that can be inflicted on the population. The IMF managing director, Christine Lagarde, alluded to this last week in her speech when she said that social tensions may bubble over.
One indeed has to be very conscious about the social implications of these programmes. You have to make sure that you protect the poor, and design the programme in a way that is socially acceptable.
Is that why the governments are now increasingly talking about taxing the rich?
Taking a step back, it is clear that advanced countries are facing a serious inequality problem: the rich have become richer. It is true of the US and other countries as well. With the decrease in the kind of manufacturing jobs that existed before, you have a hollowing of the middle (income groups) and an expansion at both extremes. That is a very serious issue. If you have a tax system that adds to this—unfortunately the case in some countries—then it is a very serious issue regardless of whether there is a crisis or not. If you are going to ask people to share the pain, then it becomes even more serious. I think it is an issue that we have to deal with not only in this crisis but for the next 10-20 years.
So, you would support redistribution of income through progressive taxation?
In general, progressive taxation is what most people think is fair. Take for example Warren Buffett; the fact that he has a lower tax rate than his secretary, most people would agree that it doesn’t seem right. And if Warren Buffett himself thinks it is not right, then who can say he is wrong?
The Financial Stability Report has noted that foreign investors have corrected their behaviour in the period of the crisis; they prefer to invest in countries not because of interest rate differentials, but instead on the ability of the emerging markets to deliver on growth through prudent macroeconomic management. Your thoughts?
It seems to me that investors are more discriminating. Take Latin America for example. Now, investors know the difference between Brazil, Argentina, Chile and so on. This is good as it means that contagion is less likely. It also puts a discipline on macroeconomic policy, which is desirable. Countries that have open capital markets and then misbehave are likely to feel the effects much more than in the past. That has to be seen as a good thing.
One palliative that you have discussed in the WEO is the need to rebalance demand, between countries and public and private demand. Do you see countries such as China going along with this proposition?
I think so. I don’t think China will eliminate its surplus (on the current account of balance of payments) just to be nice to the US; being nice has its limits. It has to be in the interest of China. We have clearly seen a shift. China’s five-year plan intends to do the right thing—basically move away from export-driven growth to more internal consumption driven growth. If they implement the five-year plan then they will go in the right direction and it will be good for the world.
The issue is that, from the point of view of the Chinese, there is no need for it to be all done today; it is something that they want to do, but there are a lot of structural changes involved—how do you deal with the countryside migration, cities and so on.
From the point of view of advanced countries, it would be great if it happened sooner. I am optimistic about the direction, but for the next few years, it will not make a major difference.