The Case for a Targeted Fiscal BoostA Commentary by Dominique Strauss-Kahn
Managing Director of the International Monetary Fund
Published in Financial Times
January 30, 2008
A global economic slowdown is under way: problems in US housing continue, the US and European financial systems remain under stress and growth in the rest of the world is beginning to be dragged down. Of course, from the International Monetary Fund's perspective, medium-term considerations are of critical importance. Nonetheless, this does not preclude potentially effective counter-cyclical policies.
Our latest forecasts, released on Tuesday, are for a marked US slowdown and a more moderate but still significant slowdown in other industrial countries. The precise timing of a slowdown in emerging markets is not completely clear, but we think it may come sooner rather than later given their strong linkages with industrialised countries.
What should policymakers around the world do if growth slows as sharply as we expect? Many countries have worked hard in recent years to build the credibility of monetary policy, so that inflation expectations are low and stable. Many have put their fiscal policy on to a more sustainable footing to deal with challenging demographics, including rising dependency ratios as populations age. And key industrialised countries and emerging markets have come together, through the multilateral consultation co-ordinated by the IMF, to reduce medium-term global imbalances between savings and investment.
It is this hard work that has created the space today for policies to be able to counter the slowdown. The first line of defence remains monetary policy. If growth slows and inflation remains under control, there is scope for cutting interest rates. Of course, countries face risks to inflation, from global forces such as oil prices or from internal ones such as a strong push for higher wages.
However, as long as expectations of inflation remain well anchored, the credibility that monetary policy currently enjoys creates the space for interest rate cuts to help economies facing a slowdown.
Leading central banks, in particular, have strong credibility—witness their ability to support liquidity in money markets over the past six months, while being clear about their continued commitment to low inflation.
But monetary policy may not be enough. Why? There are two main reasons.
First, the transmission mechanism for monetary policy is damaged. While cutting interest rates is still effective, it may not work to stimulate investment and consumption as fast as usual. Banks have suffered substantial capital losses and thus want to consolidate their balance sheets and avoid taking on additional risk. Moreover, normally low-risk assets (such as jumbo mortgages in the US) are at present regarded as higher-risk. These impediments may slow down the positive effects of monetary policy.
Second, there is a risk that if a slowdown really takes hold, it will be hard to shake off. The US and some emerging markets have a history of bouncing back quickly. Other countries, including some in Europe and some in the developing world, have traditionally found a rapid recovery to be more difficult.
In fact, the US also might find it harder to shake off a slowdown this time, given that households need to rebuild savings rates after many years in which their wealth was boosted by housing and equity market returns.
Timely and targeted fiscal stimulus can add to aggregate demand in a way that supports private consumption during a critical phase. Of course, it has to be temporary—there is still much work to be done to get ready for the approaching retirement boom. And it has to focus on adding to aggregate demand quickly. In a sense, medium-term fiscal policy is all about saving for a rainy day. It is now raining.
The appropriateness of this approach will vary country by country. Some countries have fiscal space given low debt levels and reasonable budget deficits or even surpluses; others have monetary space as inflation is low and likely to decline as output slows. Countries that have fiscal and monetary space should consider now what it would take to line up a temporary fiscal stimulus that can be deployed quickly if needed as events unfold in 2008.
Of course, there are risks to this use of fiscal policy. But doing nothing raises the risk of very bad outcomes. Identifying, trying to prevent and helping to reduce such risks is a core business of the IMF.
Industrial countries and emerging markets alike have built monetary policy credibility and strong fiscal frameworks, in ways that are consistent with the IMF's advice and its view of the world. The space created by these past efforts should now be used.
The global downturn can be short-lived and ultimately moderate if leading countries of the world understand the need for a sensible and well-timed policy response. And what is good for one country—a responsible combination of monetary and fiscal policy—will also be good for the world economy.
The writer is Managing Director of the International Monetary Fund