Saturday, January 3, 2009

IMF's fiscal policy prescriptions

Drawing lessons from five relevant economic crisis - Great Depression, the Japanese 1990s banking crisis, the 1997 Asian crisis, the US 1980s S&L crisis, and the 1990s Nordic crisis - the IMF has come up with its fiscal policy prescriptions (pdf here)to combat the decline in aggregate demand (AD) brought about by the economic recession. While most of them are standard prescriptions, there are a few interesting suggestions.

It traces the sources of decline in AD to four factors - 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. It also feels that specific nature of the crisis means that conventional macroeconomic policies aimed at exchange rate devaluations (for export promotion) and monetary loosening (to pump bank credit) are not likely to be effective, leaving the onus on fiscal policy as the only option.

Based on the experience of the five crisis, the IMF suggests that any fiscal policy should contain a right mix of six characteristics - timeliness, large in size, lasting till recovery is visible, diversified (as there is uncertainty regarding which measures will be most effective), contingent, collective action among nations of the world, and sustainable. It also feels that the successful resolution of the financial crisis is a precondition for addressing the macroeconomic crisis.

Unlike many others, the IMF argues that since the recession is likely to stay for sometime, slow-acting fiscal spending like infrastructure investments can be part of the picture. Further, since the existing estimates of fiscal multipliers are less reliable guides to the relatively effectiveness of various fiscal policies, it feels that fiscal policy diversification may be more effective. Like others, the IMF too favours spending programs that can be started or restarted quickly, ensuring that existing programs (especially of state governments) are not cut for lack of resources, and managing public expectations and restoring confidence about economic prospects so as to get people spend money.

To get consumers abandon their wait-and-see attitude, the paper favors targetted tax cuts at those who are most likely to be credit constrained. It argues against direct support to businesses in the form of subsidies and sector specific bailouts, and favours indirect efforts to get the credit tap flowing and encouraging firms to not postpone their investment decisions. It points out that a fiscal policy has a free-rider externality and therefore would help even those economies unable to indulge in singificant fiscal expansion, if those capable of doing indulge in the aforementioned policies.

Interestingly, if the two economic stimulus packages (rate cuts, fiscal stimulus I, and fiscal stimulus II) announced by the Government of India in recent weeks, were to be subjected to the IMF test, they are more likely to score negative (rate and duty cuts, export incentives) than positive (infrastructure spending and increased state borrowing limit) marks!

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