On Monday, the IMF released a new research “note” entitled “Fiscal Policy for the Crisis,” which sets out recommendations for fiscal policy to address the global economic downturn. The premises of the note are, first, that the financial system must be fixed before it is possible to increase demand and, second, that there is limited scope for monetary policy, leaving fiscal policy as the main weapon. The executive summary provides the main recommendation in short form:
The optimal fiscal package should be timely, large, lasting, diversified, contingent, collective, and sustainable: timely, because the need for action is immediate; large, because the current and expected decrease in private demand is exceptionally large; lasting because the downturn will last for some time; diversified because of the unusual degree of uncertainty associated with any single measure; contingent, because the need to reduce the perceived probability of another “Great Depression” requires a commitment to do more, if needed; collective, since each country that has fiscal space should contribute; and sustainable, so as not to lead to a debt explosion and adverse reactions of financial markets.
When it comes to global economic policy, the IMF is as close to the Establishment as exists. The Federal Reserve may be more powerful, but it lacks the IMF’s explicit mandate to oversee the global economy and step in when needed; the MITvard economics department in Cambridge, Massachusetts may have more intellectual prestige, but its members do not have hundreds of billions of dollars to throw around. As a result, the IMF is less likely to come up with radical new ideas than to show where the global consensus is moving.
Seen in this light, the IMF report confirms the general movement toward large stimulus packages composed largely of public spending that has gathered momentum in the capitals of several wealthy nations, and the U.S. in particular. The IMF recommends government spending over tax cuts, on the grounds that households and firms may choose not to exercise any additional purchasing power they get from tax cuts, and also because the time lags necessary to spend lots of money are compensated for by the expected length of the downturn. When it comes to boosting purchasing power, governments should target “those consumers who are most likely to be credit constrained” – the unemployed, the poor, and homeowners facing foreclosure.
There is one potentially controversial area that the IMF touches on: government support for “flagship” domestic industries (such as the auto industry in the U.S. and France). The authors warn against this type of policy because of its “inherent arbitrariness, and risk of political capture,” and perhaps most importantly because “direct subsidies to domestic sectors lead to an uneven playing field with respect to foreign corporations, and could lead to retaliation and possibly trade wars” – the risk Simon discussed in connection with the French bailout.
The report also raises perhaps the toughest issue in all of this, which is the issue of “fiscal sustainability:” “it is also essential that fiscal stimulus not be seen by markets as seriously calling into question medium-term fiscal sustainability.” Put another way, governments have to spend lots of money to stimulate their way out of this recession, but if they spend too much no one will lend them money anymore. This, of course, assumes that there is such an optimal point, where it is possible for a government to spend enough to get its economy going, but without reaching the point where no one believes it can pay the money back. Striking this balance will be harder for some countries than others, and there is no assurance that it will even be possible for some countries. The U.S. is better off than most, because we have the luxury of the world’s reserve currency, but even so there may be a point at which investors will back away from the dollar.
In short, this is the major risk of fiscal policy, and no one has a perfect answer to it. Right now I think a majority of economists (though not all) are of the opinion that the downturn is so severe that governments should err on the side of too much stimulus and worry about things like inflation, balanced budgets, and interest rates later. From one perspective, they are probably right, because long-term fiscal sustainability depends on economic growth more than anything else. The last time people were painting nightmare scenarios about the U.S. government debt was during the deficits of the 1980s – and a couple of tax hikes (under Bush Senior and Clinton) and a long economic boom took care of that. In putting the emphasis on spending, not on fiscal prudence, the IMF is also largely endorsing the stimulus package that will soon be forthcoming from the Obama administration.
The cynical will also note that these recommendations are more or less the opposite of the fiscal austerity measures imposed by the IMF during the emerging markets crisis of 1997-98. I don’t think that’s a completely fair criticism, however, because the problems are different – capital flight and government solvency, as opposed to a collapse in demand. But in any case, maybe the IMF learned something.