There is near consensus among economists that fixing the world’s economy will involve at least these two steps: repairing the financial sector, and restarting economic growth. When in comes to financial sector policies, governments are already “on the case”. Much more surely needs to be done but governments are already deploying all the policies that eventually fixed every financial crisis since the dawn of the financial sector.
When it comes to macroeconomic stimulus measures, however, policy is in disarray. The US, UK and Japan have committed to fiscal stimulus, but other nations, such as Germany, don’t see the urgency of the situation – or, according to a more cynical interpretation – are hoping to free ride on the fiscal stimulus of others. Indeed, some economists question fiscal policy’s effectiveness.
Given the lack of clarity on fiscal policy, the IMF paper released on 29 December 2008, “Fiscal Policy for the Crisis”, presents some very welcome words of wisdom. Written by one of the world leading macroeconomists – Olivier Blanchard (who also happens to be the IMF’s chief economist) – with three coauthors, the report distils the lessons of five of the most relevant crises, namely the Great Depression, the Japanese 1990s banking crisis, the 1997 Asian crisis, the 1980s S&L crisis in the US, and the 1990s Nordic crisis.
The paper starts by reminding us that there are indications that this recession could be deeper than any since the Great Depression. The sources of the decline in aggregate demand are:
- Drops in real and financial wealth;
- An increase in precautionary saving on the part of consumers,
- A wait and see attitude on the part of both consumers and firms; and
- Increasing difficulties in obtaining credit.
The specific features of this crisis mean that two of the standard anti-crisis macro tools are ineffective.
- The global synchronisation of recession means export-promotion policies – such as devaluations – cannot work for the major economies (and they risk making things much worse if the ‘echo chamber’ of beggar-thy-neighbour policies starts resonating).
- The financial source of the crisis weakens the link between policy rates and banking lending – thus rending the traditional monetary transmission mechanism much less effective.
In any case, key nations have very little room to lower policy rates, so fiscal policy is the last best policy option for avoiding a deepening of the recession that could well exacerbate the financial sector crisis.
Based on lessons extracted from past crises, the IMF argues that fiscal stimulus should be
- Timely (as there is an urgent need for action),
- Large (because the drop in demand is large),
- Lasting (as the recession will likely last for some time),
- Diversified (as there is uncertainty regarding which measures will be most effective),
- Contingent (to indicate that further action will be taken, if needed),
- Collective (all countries that have the fiscal space should use it given the severity and global nature of the downturn), and
- Sustainable (to avoid debt explosion in the long run and adverse effects in the short run).
The challenge facing each national government is to gauge the right balance between these features – particularly, large-and-lasting actions versus fiscal-sustainability.
The IMF paper provides a survey of five well‑known crises: Korea in 1997, Japan in the 1990s, the Nordic countries in the early 1990s, the Great Depression in the 1930s, and the US during the Savings and Loans crisis in the 1980s.
Countries have reacted to these downturns quite differently, thus providing us with some evidence on how best to manage fiscal policy in a crisis. The key lessons are:
- Successful resolution of the financial crisis is a precondition for achieving sustained growth.
The counter-example is Japan where fiscal policy failed because financial sector problems were allowed to fester. By contrast, prompt and sizeable support to the financial sector by the Korean authorities limited the duration of the macroeconomic consequences thus limiting the need for other fiscal action.
- The solution to the financial crisis always precedes the solution to the macroeconomic crisis.
- A fiscal stimulus is highly useful (almost necessary) when the financial crisis spills over to the corporate and household sectors with a resulting worsening of the balance sheets.
- The fiscal response can have a larger effect on aggregate demand if its composition takes into account the specific features of the crisis.
In this regard, some of the tax and transfer policies implemented early in the Nordic crises did little to stimulate output.
Governments around the world are struggling with how to apply a fiscal stimulus. The IMF’s analysis points out two features of the crisis that are important when thinking about the nature of the fiscal stimulus.
First, this crisis is here for while, so slow-acting fiscal spending can be part of the picture. (In the usual recession, the simulative spending often kicks in after the recession is past and thus become part of the problem rather than part of the solution). Moreover, expenditure measures have the advantage of directly stimulating demand rather than giving money to consumers and companies who might not spend it.
Second, the usual macroeconomic conditions mean existing estimates of fiscal multipliers are less reliable guides to the relative effectiveness of various fiscal policies. This is why the IMF argues for fiscal policy diversification.
While each government will have to deal with national concerns, constraints and circumstances, the IMF offers some general words of wisdom.
- Governments should make sure that existing programs are not cut for lack of resources.
This bit of advice is aimed particularly at the US states, many of whom operate under constitutional balanced-budget rules that are forcing them to cut back spending on current programmes. (See Krugman’s column for examples.)
- Look for spending programs can be started or restarted quickly.
For example, the state could up its share in private-public partnerships for projects that would otherwise be suspended for lack of private capital. Public sector wage increases should be avoided as they are not well targeted, difficult to reverse, and similar to transfers in their effectiveness. Nevertheless, a temporary increase in public sector employment associated with some of new programs and policies may be needed.
- Public perceptions matter.
Much of this recession is coming from the sharp deterioration in expectations, and the sharp increased in perceived uncertainty about the economy’s prognosis. A few high profile programs – especially those good long-run justification and strong externalities – could help restore consumers’ and firms’ belief that things will get better. Such confidence can itself improve aggregate demand by reducing wait-and-see behaviour.
Getting consumers to spend again faces three crisis-specific factors: 1) wealth reductions are a key cause of reduced consumption; 2) credit constraints in some nations are forcing consumption reductions; and 3) uncertainty has spawned a wait-and-see attitude that results in the delay of planned purchases.
These factors suggest two broad recommendations: Tax cuts should target consumers who are most likely to be credit constrained, and should aim at restoring consumer confidence by committing to do ‘whatever it takes’. The goal is to overcome the wait-and-see attitudes.
The high degree of uncertainty surrounding this crisis fosters a wait-and-see attitude when it comes to firms’ investments. Consequently, subsidies are unlikely to have much effect. While acknowledging the political economic pitfalls, the IMF argues that there is also some scope for governments in supporting firms that are facing particularly difficult problems, could survive through restructuring, but find it difficult or impossible to receive the necessary financing from dysfunctional credit markets. Sector-wide policies like the US auto bailout are bad idea.
While the IMF’s call for deficit spending is unusual, the authors stay true to form in arguing that questions about debt sustainability would, especially in nations starting from weak fiscal postures, undercut the stimulus via adverse effects on financial markets, interest rates, and consumer spending. A fiscally unsustainable path can eventually lead to sharp adjustments in real interest rates, and these in turn can destabilize financial markets and undercut recovery prospects.
The IMF suggests a number of things that could help:
- Measures should be reversible or have clear sunset clauses contingent on the economic situation;
- Measures that increase the scope of automatic stabilizers are useful;
- Pre-commitments to future policies that help shore up fiscal accounts are useful.
- Pre-commitment to unwinding stimulus measures either at a specific date (like lowering VAT for just two years as the U.K. recently did) or on a contingent basis (reversing the VAT cut once GDP growth has risen above a certain level) are a good idea;
- Strengthening fiscal governance by, for example, setting up an independent fiscal council;
Sizable fiscal stimulus is required at the global level since this crisis is global. However not all nations are in a position to widen government deficits. Many low income and emerging market countries are constrained by volatile capital flows, high public and foreign indebtedness, and large risk premia – features that plague some advanced countries as well.
Given that some countries cannot pump up demand with fiscal policy, the IMF argues that it is imperative that the nations who can do. This includes some large emerging economies such as China. As fiscal stimulus is a policy that suffers from the classic free-rider externality, it is exactly one area where international coordination by the G20 nations would yield great benefits.