Source: PIMCO

The International Monetary Fund’s chief economist says a global economic recovery is underway but warns that the growth path of the past may not return and the economic crisis has left deep scars. Separately, the IMF says the US proposal to extend financial regulation breaks new ground.

“The crisis has left deep scars, which will affect both supply and demand for many years to come,” IMF Chief Economist Olivier Blanchard says in an article scheduled for publication today.

Even as recovery takes hold, “potential output may be lower than it was before the crisis,” the article, which will appear in the Fund’s Finance & Development magazine, said.

Economies may struggle to return to “normal” growth because of sluggish demand, and even the return of growth will not be strong enough to reduce unemployment, the article said. Unemployment is not expected to crest until next year.

Blanchard notes that financial systems in many advanced countries remain dysfunctional and warned it will take time for them to find their new shape. He expects capital inflows, which have plummeted during the financial crisis, may take years to rebound.

He suggests people have become more comfortable with the idea of higher taxation, writing that it“is inevitable.”

He supported governments’ actions to respond to the crisis with fiscal stimulus but predicted such measures can continue for“probably not very long.”

US proposal to extend Financial Regulation breaks new ground

The proposal by the United States to bring under stronger supervision large, systemically important firms, such as insurance companies and other financial institutions that are not banks, breaks new ground, the IMF said.

“In one sense, the task is to catch up with three decades of financial innovation,” said the IMF on July 31 in a paper issued as part of the Fund’s annual review of the US economy, known as an Article IV consultation, which is the annual assessment process for the IMF’s 186 member countries.

Other issues covered in the report include potential growth after the crisis, fiscal risks, and the effects of debt issuance on emerging markets.

The reforms are part of the U.S. plan to monitor risks across the financial system, which emerged as a critical regulatory gap in the current economic crisis; evident first in the U.S. subprime mortgage market in mid-2007.

“Systemic risk and the moral hazard it creates are economic spillovers, like pollution,”said Charles Kramer, chief of the IMF’s North American Division. “Environmental policy addresses pollution by regulating it and financial policy should do the same with systemic risk.”

New category of financial firm

Prior to the global economic crisis, US regulatory philosophy was focused on the “core” institutions, especially traditional banks and their holding companies. Despite these measures, the lack of rules and authority to resolve a failing non-bank institution, such as Lehman Brothers, in part contributed to the catastrophic nature of its failure.

The change in approach proposed by the United States would introduce a new category of financial firm, called a Tier I Financial Holding Company (FHC), which would come under group supervision by the Federal Reserve. A firm’s designation would be made based on size, leverage, and its interconnectedness in the financial system, to be set out in legislation. The firms would be subject to higher capital and risk management standards, as well as a special wind-down mechanism in case a firm fails.

Acknowledging that a primary cause of the crisis was lax financial regulation in the United States, the IMF said in its paper that a major test for financial reform will be to force systemically critical firms to control risk taking and moral hazard, and strengthen crisis management.

Observers said the IMF did a good job laying out the main issues that need to be addressed, but questions remain.

“How do you go about internalizing risk?”said Michael Mussa, a senior fellow with the Peterson Institute for International Economics, a think tank in Washington, DC. “That’s a tough nut to crack, and one of the things that makes it tougher is noted later in the paper, which is the problem of assuring that firms hold adequate capital in the good times so they don’t go under water in bad times.”

The IMF said the US proposal to rein in moral hazard “contains many bold and innovative suggestions,” including requiring non-bank firms to prepare resolution plans in advance and to purchase contingent capital. In practice, the rules should discourage size, leverage, and interconnectedness in order to properly address moral hazard, according to the IMF.

Overview of risk

On the issue of crisis management, the IMF pointed to a lack of details in the US administration’s plan.

“Many issues are yet to be finalized, including which criteria would trigger the special resolution mechanism and for which firms, how to mitigate uncertainty regarding which insolvency regime will apply, and how to ensure that the special resolution mechanism does not reinforce the perception that creditors will be insulated from losses,”the IMF said.

Extending the perimeter of financial regulation is part and parcel of the administration’s proposal to get a better handle on systemic risk. The crisis has laid bare the government’s need to have a big picture view across industries, in order to spot trouble on the horizon and, crucially, take action when needed.

The IMF’s view is that financial surveillance should be integrated into the broader work of assessing risk across the financial system. The US proposal, which includes broker-dealers, hedge funds, or insurance companies deemed to be systemic, is a “major improvement over the past,” according to the IMF’s report.

The IMF expects to complete its first detailed analysis of the risks and weak points of the US financial system, known as a Financial Sector Assessment Program (FSAP), in 2010.

Specifics open for debate

The IMF said the US government’s proposal leaves a number of issues unaddressed, including the risk posed by the collective risk taking of many smaller firms, the way the Fed would work with other regulatory agencies to identify and control risk, and the rules for identifying who is systemically important.

“This is the most controversial proposed function - the actual designation of systemically important institutions and who would supervise them,” Robert Litan, a Senior Fellow and expert on financial markets and their regulation at the Brookings Institute, a think tank in Washington, DC,aid.“There is huge disagreement in Congress.”

The IMF says with the detailed US proposal for financial regulatory reform before Congress, it remains to be seen what ultimately will be approved by the US legislature and when. It is unlikely Congress will pass a comprehensive bill by year’s end, according to Litan, but instead may choose to pass legislation on a few key issues, such as the regulation of derivatives, a new consumer protection agency, and rules on executive compensation.