Major Global Economic Downturn

Laura Ellen Kodres
Division Chief, Global Financial Stability Division, International Monetary Fund
Thursday, October 9, 2008; 2:00 PM

Global financial stability has taken a turn for the worse in recent weeks, with potentially detrimental effects on economies around the world. The United States remains at the epicenter of the crisis and its policymakers are trying to contain the fallout and reverse plummeting confidence in financial institutions and markets," says Laura E. Kodres, division chief of the Global Financial Stability Division in the Monetary and Capital Markets Department of the International Monetary Fund (IMF), in an e-mail interview with

Kodres was online Thursday, Oct. 9, at 2 p.m. ET to discuss the current global economic crisis and what to expect next.

A transcript follows.


Laura Ellen Kodres: This is Laura Kodres from the International Monetary Fund. I work in the area of what we call "multilateral surveillance"--that is looking at global financial issues. I will look through the questions and hopefully be able to get to a number of them.


Philadelphia, Pa.: From the standpoint of the general public, this crisis emerged quickly, was not well presented as to the urgency, and we saw a $700 billion bailout swiftly approved only to now be told that is not enough. In lay person's terms, to be understood by a public that is not smarter than the average fifth grader, how did this crisis emerge so quickly and why is this bailout necessary (or is it)?

Laura Ellen Kodres: The situation that resulted in the crisis took a while to build up. In fact a number of years. In the summer of 2007 we saw the beginnings of it--several entities that had been holding complex securities based on U.S. mortgages (mostly of the subprime variety) found that they were not worth as much because the borrowers were now having difficulty paying them.

The crisis has been building since then because as the housing prices have declined and some of those mortgages had resetting (higher)interest rates, the borrowers couldn't pay. More and more mortgages went into default. This in turn affected the banks that made those mortgage or held them in a securitized form.

Now that many people understand that these events have transpired, they realize that the banks are not doing very well and have sold the stocks in banks. Banks, in turn, are trying to get rid of the bad mortgages and the securities which drives their prices lower. These two factors are now coming together and that's why is looks particularly bad.

The added dimension is that some of these U.S.-based mortgages were packaged as securities and sold abroad, mostly to European financial institutions. So the losses from these have spread, weakening their banks as well.


San Francisco: Is there a role for IMF/World Bank in the financial mess? Does IMF/World Bank has the right to impose strict regulation on the U.S.? (Call me cynical, but I think this question won't get a response.) Thanks.

Laura Ellen Kodres: According to its Articles of Agreement, each member county in the IMF (recall we are a membership organization) must listen to the advice of the IMF at least once per year. This is called an Article IV consultation (from Article IV of the Agreement). We provide our analysis and our policy recommendations to each country--including the United States. The United States can act to implement our advice or not, as it sees fit. We cannot impose strict regulation on the United States. Our advice is publicly available on our website--you can go and look to see what we have been advising the U.S. to do and judge for yourself whether our advice was sound and whether you think the U.S. has implemented it. In general, we aim to provide good, unbiased economic advice and try to convince (by the weight of the evidence) countries to take in on board.

As to the IMF's role in the crisis--again we try to provide good analysis (in our Global Financial Stability Report) and elsewhere and discuss with countries, both individually and collectively, what can be done. During our Annual Meetings this weekend we will be doing exactly that. We think a joint response to the crisis is now needed whereby countries aim for consistent policy responses to stem the deteriorating confidence.


Bowie, Md.: Is the world economy really being beaten down because of subprime defaults; or is it more the fact that subprimes enabled borrowers to double the price of homes in five years, and there's so much leverage involved that:

Twenty times 2008 prices, minus fifteen times 2007 prices

Is less than nothing?

Laura Ellen Kodres: The subprime mortgages were a part of a larger picture in the global financial world. Investors in many countries have taken on more risky investments over the last several years leading up to the crisis. In the United States, mostly this was in the housing market, in other countries, it might have been in the equity market. The underpinning is really the low interest rates and low volatilities of asset prices across the globe that we were seeing. Many institutional investors (like banks and pension fund) thought they needed to take more risk in order to make a higher return.

So, while it is true, that subprime mortgages were sold by banks thinking that this was a good market to earn higher returns, a similar set of circumstances was present in other countries with other types of investments. Also, borrowers, too, thought that with housing prices rising, that they could refinance their mortgages again at these low rates. In sum, lots of people thought low rates, rising prices and a stable environment would continue.


Greenbelt, Md.: What's the significance of the currently wide spread between Treasury securities and the London Interbank Offered Rate? Are Treasuries artificially depressed because investors getting out of the stock market are running there, or is LIBOR inflated because banks are dubious of each other's credit risk?

Laura Ellen Kodres: There is a little of both going on. The LIBOR-Treasury spread- a benchmark spread for many types of instruments in financial markets--normally reflects the risks of interbank lending. This means that, since banks are not as credit-worthy as the U.S. treasury, money borrowed and lent between banks should have a higher interest rate associated with it. The very large spread we are seeing now reflect the very large counterparty mistrust among banks and the difficulties banks have in judging whether the other banks they normally deal with have illiqiud, hard-to-value assets on their books that may cause losses later. Over the last few weeks when this spread really widened out, we have the additional factor of the movement into Treasury securities by a a large number of investors for safety.

So, we are now seeing both reasons affect this spread.


Washington: How much money is the IMF injecting? I understand you guys usually do more short-term lending. How does this crisis fit in?

Laura Ellen Kodres: The IMF doesn't really "inject" money into the financial system. We are not like a central bank. What we do, however, is when member countries come to us and ask for a loan because they are suffering what we call a "external balance of payments" problem, we loan them money to help them out. Note that we only loan money to sovereign countries (the government) and not to banks, not to corporations and not to individuals.

The amount of the loans depend on how much the countries ask for, but also what their share of the IMF funds is--every country has a "share" based on their economy's size and how open it is to trade.

So far, in this crisis, no country has asked for a loan.


Falls Church, Va.: I fear that the credit default swap market will be the stick that breaks the camel's back. What would happen if CDS contracts on defaulted names (Lehman, etc.) aren't cleared by the counterparties in October? Also, it seems to me that the shadow banking and the Bretton Woods II systems are dead. Doesn't this mean that the system of the U.S. overconsuming and China buying our debt is kaput as well? Is a real devaluation of the U.S. dollar a reality?

Laura Ellen Kodres: There are many challenges facing the global financial system right now and you have identified a number of them. Perhaps, from the macroeconomic point of view, the US overconsumption and the Chinese oversaving (buying our debt) are altered rapidly this could be a problem for the U.S. dollar. At the IMF, this "global imbalance" problem has been discussed for quite a while and the policies to cure it were put forth several years ago and remain valid. As an aside, the dollar has depreciated quite a bit over the last few years and we reckon is close to its long-term equilibrium value.

Now we are facing more than just the adjustments of global imbalances problem since these imbalances have led to problems in our financial institutions. The growth a number of instruments (including CDS contracts and other types of derivatives) has gotten ahead the clearing and settlement systems in some of the major institutions. They have been working hard to rectify the situation and had made significant progress even through the summer. But, it was still not quite enough and it is going to take some time to sort through the Lehman situation. There is a centralized clearing house in the works and that should help sort out who owes who what to make sure it gets straightened out.

In all, the gradual unwinding of the global imbalances is now mixed in with the inwinding of several financial institutions make the situation fragile. We see progress that now that the stakes are high enough that a more comprehensive and coherent solution will be found.


Santa Fe, N.M.: What's your first-priority crisis fix? If you could wave a magic wand and change one thing about the current situation, what would it be? Increase consumer spending in the U.S.? Return commercial paper liquidity to its previous levels? Stabilize unemployment? Call a bank holiday? Create complete visibility into exposure to mortgage-backed securities and credit-default swaps? Something to stabilize European banks or Asian markets? I guess I'm asking what the government could do for us today to stabilize things, whether it is to send us all another $600 or shutting the market for a week while arranging to spend that $700 billion.

Laura Ellen Kodres: Your wish list is long and of course every kid at Christmas wants everything on the list.

Because the problem is multidimensional and interrelated to several aspects of the economy, I cannot just choose one item. Still, there are three elements that have to be in place to underpin the lack of confidence in the financial system--there have to policies in place to (1) deal with distressed assets (already in place in the U.S. plan) (2) injecting capital into viable financial institutions (being discussed right now in the US) and (3) improving the funding availability of banks since they are having difficulty getting funds to onlend in the economy.

If countries tackled these three items we would put the financial institutions back on a sounder footing and they could get lending going again, which would get consumers spending again and businesses investing again.

Note, none of this (unlike the magic wand technique) works overnight and we must all be patient, but it will help to move the economy forward again.


Philadelphia: The American government holds or insures debt, yet it seems un-American for government to share in the profits. What has been the experience in other countries of insisting upon an ownership interest in companies governments bail out, and what are your thoughts on our government considering doing the same?

Laura Ellen Kodres: Interesting observation. This is extraordinary times and extraordinary circumstances. At the IMF we look at a lot of countries' experiences and that can sometimes help to see what could be done when we get to where we are now. When countries get into systemic banking problems, the government sometimes has to step in--by government, we really mean the taxpayer. The government should only feel obligated to do this when the situation is "systemic"--when the financial system itself is under threat--and affects many of its citizens. We advise, however, when such a situation is reached that we try to minimize the costs to the taxpayer and put in place a framework that will make the event less likely to occur in the future. In many countries that have provided support to their banks, they have asked to participate in any gains that may occur over the longer-run (an equity stake), when the crisis has run its course. In many countries, Sweden is a good example--the government profited enough that over that longer period of time, the taxpayer was not burdened and the costs were less than if the government had not asked for a stake.

Whether this is "un-American" is debatable. One way to think about it that the government is taking the risk with the taxpayers money and should be compensated for it. Another way to think about it is that protecting the health of financial system as a whole is like protecting the country from attack--it is a "public good" and in that case, perhaps the government should just view it as money well spent out of the general revenues.


Laura Ellen Kodres: Thanks for all your good questions. Hope I managed in one hour+ to get to some of the major issues that the IMF looks at on an ongoing basis.

Many of the answers to your questions can be found in the last several Global Financial Stability Reports that can be found on our website. (look on the lower right for the green document)

Dr. Laura Kodres

_______________________ International Monetary Fund


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