Over this past weekend in a speech at a conference for South East Asian Central Bank governors, Dominique Strauss-Kahn, the Managing Director of the International Monetary Fund (IMF) outlined the current state of the global economy, the actions that governments worldwide must take to alleviate the financial crisis, and the dire consequences that would result should nations fail to take such actions. Strauss-Kahn stressed that the central problem facing the world currently is the loss of confidence by investors, employers and consumers, which has caused “profound effects on both advanced and emerging economies.”

In order to combat the loss of confidence in global economies, Strauss-Kahn urged action in the following three areas:

  • Restoring financial stability through financial market measures: While immediate threats to systemic stability have already been addressed through measures providing massive liquidity support and extending deposit insurance and other guarantees, governments must focus on additional measures. These additional measures include: reexamining bank balance sheets, determining the viability of various financial institutions and restructuring them if required; providing public support to banks that can be rehabilitated; selling or winding-up insolvent banks; and establishing new public resolution agencies to manage “bad assets.
  • Supporting aggregate demand through monetary and fiscal policy measures: Monetary policy must be eased and fiscal stimulus undertaken by some nations to offset the sharp decline in private sector demand. Furthermore, China should rebalance demand toward private consumption and allow greater flexibility for its currency to appreciate, which would stimulate both domestic demand and intra-regional trade.
  • Supporting crisis-hit countries: The worst effects of the global financial crisis appear to be felt by emerging economies, as “the cuts in exports and drying up of capital flows feed through” in their economies. While the IMF has already provided substantial support to Hungary, Ukraine, Pakistan, Iceland, Latvia and Belarus, the IMF must obtain additional resources from member countries and adapt to different circumstances faced by countries. The IMF has stated that it aims to double its lendable resources to approximately $500 billion.

Furthermore, Strauss-Kahn cautioned countries against the dangers of protectionism, stating that “some countries are trying to make government support of banks conditional on their giving priority to domestic borrowers, to the detriment of financing across borders [which] will hurt emerging economies, whose growth depends on access to foreign bank financing.”

Just days prior to Strauss-Kahn’s speech, the IMF, in a paper prepared for a meeting of deputies of the Group of 20 (G-20) countries planning for the London Summit in April, urged that the G-20 countries take more decisive actions to combat the global economic downturn, “as an adverse feedback loop between the real and financial sectors is taking its toll.” The IMF stated that the actions taken so far by governments had “not yet achieved a decisive breakthrough,” as “financial markets remain under heavy strain and systemic institutions are still perceived as fragile.”

Referencing its outlook for global growth in 2009 of just 0.5 percent, the IMF indicated that restoring financial health will require a three-pronged approach: (1) continuous provision of ample liquidity and term funding support from central banks; (2) dealing promptly and aggressively with troubled assets; and (3) recapitalizing viable financial institutions with public funds. The IMF further stated that “cleaning bank balance sheets – including through a transparent process for valuing distressed assets and putting a ceiling on losses – will be critical to restore confidence in financial institutions and reduce counterparty risk.”

Finally, the IMF emphasized that international cooperation in setting financial policies should receive high priority. These policies should include macroeconomic policy stimulus, fiscal policies intended to support aggregate demand, and maintaining confidence in medium-term fiscal sustainability.

In a related item, it was reported earlier this week that China issued its own position paper in preparation for the London Summit, a follow-up to the G-20 summit held in Washington last November, urging the IMF to toughen its stance on developed nations and apportion more power for developing countries in the IMF and World Bank.