How To Emerge from the Crisis in 2009

In the maelstrom of events and news that characterize the current global crisis, it is often difficult to keep a clear head and a sense of what is really going on. But when one takes a step back (something easier to do on days when markets are closed), the picture becomes clearer, and so do the required policies.

Let me first set the scene by making three observations on where we are today. First, in the advanced countries, we have probably seen the worst of the financial crisis. There are still land mines, from unknowable credit default swap (CDS) positions to hidden losses on balance sheets, but the worst days of frozen money markets and obscene risk spreads are probably over.

Second, and unfortunately, the financial crisis has moved to emerging countries. In crossing borders, the sharp portfolio reallocations and the rush to safer assets are creating not only financial but also exchange-rate crises. Add to this the drop in output in advanced countries, and you can see how emerging countries now suffer from both higher credit costs and decreased export demand.

Third, in the advanced economies, the hit to wealth, and even more so the specter of another Great Depression, has led people and firms to curtail spending sharply. Not only have they revised their spending plans, but, in many cases, they have delayed purchases, waiting for the uncertainty to clear. The result has been a sharp drop in output and employment, reinforcing fears about the future, and further decreasing spending.

Let me now turn to policy. If my characterization of events is correct, then the right set of policies is straightforward:

First, the measures put in place earlier to repair the financial system must be refined and consolidated. One silver lining of the worst days of the crisis in October was to scare governments into action on the financial front. Central banks generously provided liquidity.

But governments soon realized that the main issue was solvency. They pledged to implement programs aimed at asset purchases (to clarify the balance sheets of financial institutions), recapitalization (to make sure that, if solvent, they could operate and continue to lend), and guarantees (to reassure depositors and some investors that their funds were safe).

The basic architecture for these measures is now in place, but the implementation has been often haphazard. Lessons from previous banking crises around the world could have been learned faster. The twists and turns in some of the programs, most notably in the United States, have left markets confused, and have led private investors to stay on the sidelines, waiting for policy clarification before taking a stake in financial institutions. I have little doubt that learning by doing will eventually lead to coherent programs. But time has been lost.

Second, emerging market countries must get help in adjusting to the financial crisis. It is not just a question of providing them with liquidity so that they can simply maintain their exchange rates in the face of a large capital outflows. Many investors who want out will not return for some time, and countries must accept this fact and adjust accordingly.

In some cases, they can do this on their own, so all that is needed is liquidity support to avoid a collapse of the exchange rate and allow for the adjustment to occur. In other cases, the capital outflows only worsen already difficult situations. These countries need more than liquidity; they need financial help to carry out the necessary adjustments.

Are the proper help measures in place? Yes and no. For a few countries, the main central banks have provided access to liquidity through swap lines. The International Monetary Fund, for its part, has created a new liquidity facility, enabling countries that pre-qualify to apply and get funds with little or no conditionality.

For the time being, these arrangements have been sufficient. But liquidity provision needs to be provided on a more coherent and comprehensive basis. As for countries that need more help, this is the IMF's natural function. A number of countries have already obtained funds under program lending. One may reasonably worry that the available funds will be depleted before the crisis is over.

Third, governments must counteract the sharp drop in consumption and investment demand. In the absence of strong policies, it is too easy to think of scary scenarios in which depressed output and troubles in the financial system feed on each other, leading to further large drops in output. It is thus essential for governments to make clear that they will do everything to eliminate this downside risk.

Can they credibly do it? The answer is yes. With interest rates already low, the room for monetary policy is limited. But the room for fiscal policy is wider, so governments must do two things urgently. First, in countries in which there is fiscal space, they must announce credible fiscal expansions; we -- the IMF -- believe that, as a whole, a global fiscal expansion about 2 percent of world GDP is both feasible and appropriate.

Finally, and just as importantly, governments must indicate that, if conditions deteriorate, further fiscal expansion will be implemented. Only with such a commitment will people and firms be confident that we are not headed for a repeat of the Great Depression, and start spending again.

My strong belief is that if these policies are followed, by the end of 2009, if not sooner, the world economy will start recovering from the crisis.

Olivier Blanchard is chief economist of the IMF and a professor of economics at MIT.