## _spn0801 — Executive Summary

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### Executive summary — overarching guidance
- Two main policy sets required: repair the financial system; and increase demand and restore confidence. This note focuses on fiscal policy given limited room for monetary policy.
- Optimal fiscal package characteristics:
  - Timely: the need for action is immediate.
  - Large: the current and expected decrease in private demand is exceptionally large.
  - Lasting: the downturn will last for some time.
  - Diversified: uncertainty argues against reliance on any single measure.
  - Contingent: a commitment to do more if needed to reduce the perceived probability of another “Great Depression”.
  - Collective: each country with fiscal space should contribute.
  - Sustainable: avoid a debt explosion and adverse reactions of financial markets.
- Composition guidance:
  - Spending increases, and targeted tax cuts and transfers, are likely to have the highest multipliers.
  - General tax cuts or subsidies for consumers or firms are likely to have lower multipliers.

### I. Context and policy framing — key points
- Crisis origin and impact:
  - Crisis began in housing and financial sectors and led to a strong fall in aggregate demand.
  - Indications that the fall could be larger than in any period since the Great Depression.
- Policy components:
  - Successful packages must address both financial crisis and fall in aggregate demand.
  - Financial measures (recapitalization, asset purchases, quantitative easing) affect credit flows and aggregate demand; fiscal measures sustain aggregate demand.
- Causes of demand fall:
  - Large decreases in real and financial wealth; increased precautionary saving; wait-and-see behavior; increasing difficulties obtaining credit.
- Monetary policy constraints:
  - Export-led recovery not an option globally.
  - Financial nature of crisis weakens traditional monetary transmission; many countries have limited room to lower policy rates.
  - Monetary policy should support fiscal stimulus by avoiding interest-rate increases until output begins to recover.
- Fiscal space heterogeneity:
  - Many low income and emerging market countries, and some advanced countries, face constraints (volatile capital flows, high public and foreign indebtedness, large risk premia).
  - Inability of some countries to engage in stimulus increases importance of contributions from others, including some large emerging economies.

### II. Fiscal policy in financial crises — historical lessons
- Empirical pattern: severe systemic financial crises are typically associated with severe economic downturns.
- Historical lessons:
  - Resolution of the financial crisis is a precondition for sustained growth; fiscal actions without resolving financial-sector problems often fail (Japan example).
  - Delaying interventions typically leads to worse macro conditions and higher fiscal costs later.
  - Prompt and sizeable support to the financial sector can limit duration of macroeconomic consequences (Korea, 1997).
  - Fiscal stimulus is highly useful when financial crisis spills over to corporate and household sectors and worsens balance sheets.
  - Fiscal response effectiveness rises when composition accounts for crisis-specific features.

### III. Composition of a fiscal stimulus — two crisis-relevant features
- Two shaping features:
  - Crisis will last at least several more quarters, so spending measures are more usable than usual (implementation lags less relevant).
  - Fiscal multiplier estimates are less reliable in current conditions, arguing for policy diversification.

A. Public spending on goods and services
- Rationale and constraints:
  - Public spending on goods and services has larger multiplier effects in theory and more certain first-round effects in current circumstances.
  - In practice, increases constrained by need to avoid waste.
- Policy prescriptions:
  - Ensure existing programs are not cut for lack of resources; counteract procyclicality in balanced-budget rules.
    - For sub-national entities, mitigate cuts through transfers from the central government.
  - Restart repair, maintenance, and investment projects delayed or rejected for lack of funding.
    - Use a few high-profile programs with strong long-run justification and externalities (example: environmental projects).
    - State can take a larger share in public-private partnerships when private capital is lacking.
  - Avoid public sector wage increases: poorly targeted, difficult to reverse; temporary public employment tied to new programs may be needed.

B. Fiscal stimulus aimed at consumers
- Current-consumption headwinds:
  - Decreases in wealth (housing, financial, human) reduce current and expected disposable income.
  - Tighter credit constraints as credit lines are eliminated or interest rates rise.
  - High uncertainty prompting increased precautionary saving and delayed purchases.
- Implications for marginal propensity to consume (MPC) out of transitory tax cuts/transfers:
  - Decreases in wealth and high uncertainty suggest low MPC; tighter credit constraints suggest high MPC.
  - Conflicting evidence from recent U.S. tax rebates: macro evidence suggests most was saved; micro evidence shows some consumption increase.
- Recommendations:
  - Target tax cuts/transfers to consumers most likely to be credit constrained:
    - Greater provision of unemployment benefits; increases in earned income tax credits; expansion of safety nets.
    - Support for homeowners facing foreclosures, including mortgage write-downs using public resources, appeals because they support aggregate demand and improve financial-sector conditions.
  - Provide clarity and strong commitment by policymakers to take whatever action needed to avoid tail risk of a depression to reduce uncertainty and precautionary saving.
- Other measures:
  - Broad-based tax cuts may have low MPC.
  - Temporary decreases in the VAT:
    - If termination date credible and not too distant, intertemporal incentives are attractive but pass-through to consumers is uncertain; unwinding can contribute to downturn.
    - Small VAT decreases (a few percentage points) may not be salient enough.
  - Focused incentives (e.g., cash transfers for purchases of new, more efficient cars) may attract more attention and have larger demand effects.

C. Fiscal stimulus aimed at firms
- Firm behavior and policy challenge:
  - Firms face sharp fall in demand plus high uncertainty, leading to wait-and-see investment behavior.
  - Subsidies lowering tax-adjusted user cost of capital are unlikely to have much effect.
  - Main challenge is avoiding firms cutting current operations for lack of financing.
  - Primary responsibility lies with monetary policy, but governments can support firms that can survive with restructuring but cannot access private financing.
- Policy instruments:
  - Combine Chapter 11-type restructuring procedures with government guarantees on new credit to facilitate plausible restructuring plans.
  - Caution on sector-wide support due to arbitrariness, political capture, and risk of raising uncertainty and protectionist pressures.

### IV. Sustainability concerns
- Fiscal expansions should be explicitly contingent on economic state; announce extent of stimulus will depend on conditions to avoid later measures appearing as "desperation repairs."
- Stimulus must not be perceived as calling into question medium-term fiscal sustainability; such perceptions can undercut near-term policy effectiveness via adverse effects on financial markets, interest rates, and consumer spending.
- Current market perceptions: not overly concerned about medium-term sustainability in largest advanced countries, though some widening of borrowing costs within the euro zone reflects sustainability concerns.
- Features to avoid sustainability concerns:
  - Use reversible measures or clear sunset clauses contingent on the economic situation.
  - Implement policies that eliminate distortions (example: financial transaction taxes).
  - Increase scope of automatic stabilizers.
  - Pre-commit to identified future corrective measures (examples: letting upper income tax cuts expire; pre-commit to unwinding VAT cuts contingent on GDP growth).
  - Provide more robust medium-term fiscal frameworks covering 4–5 years including:
    - accurate and timely projections of government revenues and expenditures;
    - a government balance sheet reporting government assets and liabilities;
    - a statement of contingent liabilities and other fiscal risks;
    - transparent arrangements for monitoring and reporting fiscal information for central and sub-national government, other public sector entities, and central bank quasi-fiscal operations.
  - Strengthen fiscal governance (example: independent fiscal councils).
  - Improve expenditure procedures to ensure stepped-up public works spending raises long-term growth potential.
- Long-term fiscal threat in rapidly-aging countries: rising net costs of publicly funded pension and health entitlements far exceed conceivable stimulus packages.
- Structural reforms to boost potential growth can help strengthen medium-term sustainability.

A. Some proposals for discussion
- Greater role of the public sector in financial intermediation:
  - State purchase and holding of private assets may partly replace private intermediation in extreme shifts toward liquid T-bills.
  - Public sector could issue T-bills and use funds to provide financing to ultimate borrowers; public sector lacks comparative advantage in credit evaluation—outsourcing management to private entities suggested.
- Provision of insurance by the public sector against large recessions:
  - Government could offer contracts with payments contingent on GDP growth falling below a threshold.
  - Banks could require such insurance for loan approvals; contracts could be open to individuals.
  - Widespread use would act as an automatic stabilizer.
  - Counterparty risk is a concern; contingent liabilities should be included in the budget and considered in medium-run fiscal sustainability calculations.

### V. A collective international effort
- Crisis international in nature; collective fiscal stimulus needed because of cross-border spillovers and potential adverse externalities.
- Spillover considerations:
  - High trade openness can discourage domestic stimulus because domestic demand expansions translate into trade-balance deterioration; if all countries act, required stimulus per country is reduced.
  - Collective efforts must be tailored to country circumstances (external imbalances, automatic stabilizers, fiscal space).
  - Subsidies to troubled industries may be perceived as hidden industrial policy, potentially triggering a costly race and efficiency losses.
  - Historic risk of pressures to raise trade barriers as crises deepen; non-tariff protection or export subsidies remain possibilities if measures are seen as unfair.
- Coordination examples and national packages cited:
  - EU commission recommended fiscal stimulus of 1.5 percent of GDP.
  - France announced a €19 bn plan and promised €20 bn for small business and construction.
  - Germany announced a package costing €12 bn in two years expected to trigger €50 bn in private investment.
  - Italy proposes a stimulus that will only amount to €5 bn in "new" money.
  - Spain announced measures for €40 bn to support infrastructure and the car industry.
  - U.K. announced temporary reduction of VAT rate from 17.5 to 15 percent until December 2009 at an estimated cost of £12.5 bn; government plans to invest £3 bn on infrastructure and has offered temporary targeted tax breaks for £3.5 bn.
- Regional tailoring to maximize demand impetus:
  - United States: likely focus on investment, other spending on goods and services, and targeted transfers.
  - Europe: with relatively large automatic stabilizers, additional fiscal impulse can probably be somewhat less than in the United States.

### VI. Conclusion — core messages
- Solution requires bold initiatives to rescue the financial sector and increase demand.
- Historical analysis shows:
  - Early resolution of financial sector problems is a prerequisite for return to sustained growth.
  - Early, strong, and carefully thought-out fiscal response is critical.
- Time and action are of the essence.

### Appendix I — selected spending and revenue measures (highlights)
- Investment spending instruments:
  - Frontload existing projects; increase maintenance spending; plan new projects now and implement if downturn continues.
  - Advantage: large short-term demand effect and long-term supply effect.
  - Risks: lags to implementation; potential quality deterioration when expediting.
- Targeted transfers:
  - Expand unemployment benefits; expand in-kind or cash transfers to low-income households.
  - Advantage: quick channeling through existing safety nets; well-targeted to those with higher MPC.
  - Risks: target groups may be small; labor-market distortions; perception of permanence making reversal difficult.
- Not recommended:
  - New large-scale entitlement programs; increases in public sector wage bill; increased subsidies to specific industries.
- Temporary reduction in consumption tax rates (not pre-announced):
  - Advantages: raises purchasing power and encourages current consumption.
  - Disadvantages: not well targeted; pass-through uncertainty; may not encourage spending amid confidence crisis.
- Lump-sum targeted rebates and temporary increases in earned income tax credit:
  - Advantages: well targeted to low-income, credit-constrained consumers; quick and temporary.
  - Disadvantages: may be ineffective if precautionary saving prevails.
- Temporary reduction in unemployment insurance contributions:
  - Advantages: targeted to increase employment by reducing employer cost; quick.
  - Disadvantages: may be ineffective if bleak prospects dominate employer decisions.
- Relaxation of rules on acquisition of tax losses of troubled banks and companies:
  - Advantages: incentivizes merging troubled companies with healthier ones.
  - Disadvantages: risks of subsequent liquidation or activity change by troubled firm.
- Adjustment in pre-payment rules and extension of carry-forward rules:
  - Advantages: improves cash-flow management.
  - Disadvantages: may not support aggregate demand in current context.

### Appendix II — fiscal multipliers: review of literature (key findings)
- Estimation challenges:
  - Identification problems; definition of multipliers; dynamic effects over several quarters.
- Heterogeneity of estimates: range from less than zero to larger than four.
- Lessons:
  - No strong evidence that government investment multipliers >> government consumption multipliers.
  - Short-run tax-change effects may be smaller than spending changes; medium-term relationships differ.
  - Multipliers vary across countries and tend to be larger for bigger economies.
- Micro studies (U.S. tax rebates):
  - Two-thirds or less of change in income was spent in some survey-based studies.
  - Preliminary evidence for 2008 tax rebates supports substantial saving.
- Macroeconomic VAR and narrative studies:
  - VARs give no clear conclusion on spending vs tax multipliers.
  - Romer and Romer (2008): output effects around 3 percent a few years after a tax change of 1 percent of GDP.
  - Ramey (2008): government spending elasticity 0.3 (multiplier ~1.5) after one year.
- Structural-model results sensitive to monetary accommodation and single-country vs worldwide fiscal expansion.
  - Elmendorf and Reifschneider (2002) illustrative numbers:
    - Temporary tax rebate costing 1 percent of GDP results in:
      - A 1 percent short-run increase in GDP if 50 percent is spent.
      - A 0.3 percent GDP effect if only 20 percent is spent.
  - European Commission’s QUEST: first-year revenue multipliers of 0.3 or smaller; expenditure multipliers between 0.3 and 0.7.
- Ways to increase effectiveness:
  - Target low-income and liquidity-constrained consumers:
    - Temporary increase in food stamps associated with multiplier of 1.73 (Moody’s Economy.com).
    - Extension of unemployment benefits associated with multiplier of 1.64 (Moody’s Economy.com).
  - Aid to states: general aid multiplier of 1.36 (Moody’s Economy.com).

### Appendix III — five case studies (selected quantitative indicators and findings)

A. Great Depression — selected figures and interpretations
- U.S. government purchases of goods and services increased from $13.6 billion in 1929 to $22.8 billion in 1939.
- New Deal initiatives examples and sizes:
  - Public Works Administration budget: $3.3 billion (approximately 6 percent of GDP).
  - Emergency Relief Appropriation Act: about $5 billion used to set up the WPA.
- Scholarly debate on drivers of recovery: competing views on the role of fiscal policy versus other forces (World War II spending, expectation shifts, monetary expansion).

B. Japan: Banking crisis in 1997 — selected numeric indicators
- Real GDP growth:
  - 1996: 2.75
  - 1997: 1.57
  - 1998: -2.05
  - 1999: -0.14
  - 2000: 2.86
- Change in overall balance (percent of GDP):
  - 1996: -0.41
  - 1997: 1.09
  - 1998: -1.57
  - 1999: -1.81
  - 2000: -0.23
- Change in structural balance:
  - 1996: -0.94
  - 1997: 0.85
  - 1998: -0.74
  - 1999: -1.58
  - 2000: -0.97
- Inflation:
  - 1996: 0.10
  - 1997: 1.88
  - 1998: 0.58
  - 1999: -0.29
  - 2000: -0.78
- Unemployment:
  - 1996: 3.36
  - 1997: 3.39
  - 1998: 4.11
  - 1999: 4.68
- NPL:
  - 1996: 5.40
  - 1997: 5.80
- Japan: Government support to financial sector (amounts in trillion yen; percent of GDP; recovery as of March 2008)
  - Grants for loss coverage: 18.6; 3.6; --
  - Purchase of assets: 9.7; 1.9; 97.9
  - Capital injection: 12.4; 2.4; 84.7
  - Others: 5.9; 1.1; 81.4
  - Total: 46.6; 9.0; 24.8; Recovery rate: 53.2
  - Total excluding grants: 28.0; 5.4; 24.8; Recovery rate: 88.6
- Fiscal stimulus:
  - April 1998: 16 trillion Yen package (3 percent of GDP).
  - November 1998: 24 billion package (5 percent of GDP) including permanent PIT and CIT cuts, increased credit guarantees, temporary consumption vouchers, and more public works.
  - Result: fiscal outturn visible in 1998–99; real growth rebounded to around 3 percent.

C. Korea: 1997 crisis — selected numeric indicators and outcomes
- Debt/equity ratio of thirty major companies: 500 percent (noted as vulnerability).
- Debt/Equity Ratio in Manufacturing Sector:
  - US 1997: 153.5
  - Japan 1997: 193.2
  - Taiwan 1995: 85.7
  - Korea 1997: 396.3
  - Korea 1998: 303
- Korea: Real GDP growth:
  - 1996: 7.00
  - 1997: 4.65
  - 1998: -6.85
  - 1999: 9.49
  - 2000: 8.49
- Korea: Change in overall balance (percent of GDP):
  - 1996: -0.07
  - 1997: -1.66
  - 1998: -2.46
  - 1999: 1.41
  - 2000: 3.60
- Korea: Change in structural balance:
  - 1996: -0.37
  - 1997: -1.78
  - 1998: -0.01
  - 1999: 0.24
  - 2000: 2.84
- Korea: Inflation and NPLs:
  - Inflation: 1996: 4.92; 1997: 4.44; 1998: 7.51; 1999: 0.81; 2000: 2.26
  - NPL: 1996: 7.40; 1997: 8.30; 1998: 8.90
- Use of public funds for financial restructuring by end-1999 (trillion won / percent of 1997 GDP):
  - Banks: Purchase of bad loans 17.3; Recapitalization 14.6; Deposit guarantees 13.3; Total 45.2
  - Non-banks: 3.2; 4.0; 11.6; 18.8
  - Total: 20.5; 18.6; 24.9; 64.0
  - Banks (percent): 3.5; 3.0; 2.7; 9.2
  - Non-banks (percent): 0.7; 0.8; 2.4; 3.8
  - Total (percent): 4.2; 3.8; 5.1; 13.0
- Key comparisons:
  - Korea: rapid, aggressive support for financial sector; package in support of financial institutions amounted to 13 percent of GDP in 1998–99.
  - Japan: slower recognition and cleanup; fiscal stimulus in 1998–99 equal to 8 percent of GDP in two years plus financial-sector support.

D. S&L crisis (U.S., 1980s–1990s) — selected figures and lessons
- From 1986 to mid-1995 about one half of all S&Ls (1,043) holding $519 billion in assets were closed or resolved.
- Resolution Trust Corporation (RTC): initial funds $50 billion; funds raised to $105 billion between 1989 and 1995 (only $91.3 billion used).
- Fiscal costs:
  - Total gross fiscal cost estimated at $180 billion (3.3 percent of 1989 GDP).
  - Net fiscal cost estimated at $124 billion (2.4 percent of GDP).
- Lessons:
  - Delayed resolution increased fiscal cost.
  - Asset management companies and equity partnerships with private sector can be effective.
  - Insufficient early recognition and recapitalization raised costs.

E. Nordic crises (Sweden, Finland, Norway) — summarized messages
- Finland: cumulative GDP fell by 14 percent over 1990–94; unemployment rose from 3 to 20 percent.
- Over 1990–93 overall fiscal deficit deteriorated by 6, 16 and 13 percentage points of GDP in Norway, Sweden, and Finland, respectively.
- Key messages:
  - Room for discretionary fiscal action over prolonged periods is limited even with initially strong fiscal positions.
  - Addressing financial market vulnerabilities is necessary to prevent prolonged downturns.
  - If fiscal position deteriorates significantly, sustainability concerns may prevent continued countercyclical fiscal policy.

*Source: Executive Summary and selected excerpts from _spn0801.*

### Executive Summary ......................................................................................................

### _spn0801 - Executive Summary

### Executive summary — overarching guidance
- The current crisis calls for two main sets of policy measures: repair the financial system; and increase demand and restore confidence. The focus of this note is on the second set, and more specifically, on fiscal policy given limited room for monetary policy.
- The optimal fiscal package should be: timely, large, lasting, diversified, contingent, collective, and sustainable.
  - Timely: the need for action is immediate.
  - Large: the current and expected decrease in private demand is exceptionally large.
  - Lasting: the downturn will last for some time.
  - Diversified: uncertainty argues against reliance on any single measure.
  - Contingent: a commitment to do more if needed to reduce the perceived probability of another “Great Depression”.
  - Collective: each country with fiscal space should contribute.
  - Sustainable: avoid a debt explosion and adverse reactions of financial markets.
- Composition guidance: spending increases, and targeted tax cuts and transfers, are likely to have the highest multipliers. General tax cuts or subsidies for consumers or firms are likely to have lower multipliers.

### I. Introductory remarks — context and policy framing
- Crisis origin and impact:
  - The crisis started in the housing and financial sectors and has led to a strong fall in aggregate demand.
  - There are indications the fall could be larger than in any period since the Great Depression.
- Policy components:
  - A successful package should address both the financial crisis and the fall in aggregate demand.
  - Financial measures (recapitalization, asset purchases, quantitative easing) affect credit flows and aggregate demand; this note focuses on fiscal measures to sustain aggregate demand.
- Causes of demand fall: large decreases in real and financial wealth; increased precautionary saving; wait-and-see behavior by consumers and firms; increasing difficulties in obtaining credit.
- Monetary policy constraints:
  - Export-led recovery is not an option for the world as a whole.
  - The financial nature of the crisis weakens traditional monetary transmission; many countries have limited room to lower policy rates.
  - Monetary policy should support fiscal stimulus by avoiding increases in the policy interest rate until output begins to recover.
  - Quantitative easing is considered part of financial measures and not discussed further in this note.
- Fiscal space heterogeneity:
  - Not all countries have fiscal space; many low income and emerging market countries, and some advanced countries, face constraints (volatile capital flows, high public and foreign indebtedness, large risk premia).
  - The inability of some countries to engage in stimulus increases the importance of contributions from others, including some large emerging economies.
- This note emphasizes general features fiscal stimulus should have rather than precise magnitudes or cross-country distribution.

### II. Fiscal policy in financial crises — lessons from history
- Empirical pattern:
  - Severe systemic financial crises are typically associated with severe economic downturns (see Chapter 4, World Economic Outlook, October 2008).
- Key historical lessons:
  - Successful resolution of the financial crisis is a precondition for sustained growth; fiscal actions without resolving financial-sector problems often fail to achieve recovery (Japan example).
  - Delaying interventions (e.g., Hoover administration, Savings and Loans crisis) typically leads to worse macroeconomic conditions and higher fiscal costs later.
  - Prompt and sizeable support to the financial sector can limit duration of macroeconomic consequences (Korea in 1997).
  - 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 corporate and household sectors and worsens balance sheets.
  - Fiscal response effectiveness rises when composition accounts for the specific features of the crisis; some early Nordic tax and transfer policies did little to stimulate output.
- Policy implication: fix the financial system and support aggregate demand concurrently; many advanced countries have initiated unprecedented financial-sector actions.

### III. Composition of a fiscal stimulus — two crisis-relevant features
- Two relevant features shaping composition:
  - The crisis will last at least several more quarters, so spending measures are more usable than usual (implementation lags less relevant).
  - Existing estimates of fiscal multipliers are less reliable in current conditions, arguing for policy diversification.

#### A. Public spending on goods and services
- Theoretical and practical considerations:
  - Public spending on goods and services has larger multiplier effects in theory and more certain first-round effects in current circumstances.
  - In practice, increases in public spending are constrained by the need to avoid waste.
- Key policy prescriptions:
  - Ensure existing programs are not cut for lack of resources; counteract procyclicality in balanced-budget rules.
    - For sub-national entities, mitigate cuts through transfers from the central government (suspending sub-national rules is not appropriate because reversal is difficult).
    - Example: in the U.S., increased federal transfers would help states avoid cutting programs.
  - Restart repair, maintenance, and investment projects that were delayed, interrupted, or rejected for lack of funding or macroeconomic considerations.
    - Use a few high-profile programs with strong long-run justification and externalities (for example, environmental projects) to affect demand and expectations.
    - State can take a larger share in public-private partnerships for valuable projects when private capital is lacking.
  - Avoid public sector wage increases: they are poorly targeted, difficult to reverse, and similar to transfers in effectiveness.
    - Temporary increases in public sector employment associated with new programs may be needed.

#### B. Fiscal stimulus aimed at consumers
- Three specific factors affecting consumption now:
  - Decreases in wealth (housing, financial, human), reducing current and expected disposable income and leading consumers to cut consumption.
  - Tighter credit constraints as credit lines are eliminated or interest rates rise, forcing consumption cuts.
  - High uncertainty prompting increased precautionary saving and delayed purchases.
- Implications for marginal propensity to consume out of transitory tax cuts or transfers:
  - Decreases in wealth and high uncertainty suggest low marginal propensities to consume; tighter credit constraints suggest a high marginal propensity to consume.
  - Micro and macro evidence on recent U.S. tax rebates gives conflicting answers: macro evidence suggests most was saved; micro evidence shows some increase in consumption.
- Two broad recommendations:
  - Target tax cuts or transfers to consumers most likely to be credit constrained:
    - Examples include greater provision of unemployment benefits, increases in earned income tax credits, and expansion of safety nets where limited.
    - Support for homeowners facing foreclosures, including mortgage write-downs using public resources, is appealing because it supports aggregate demand and improves financial-sector conditions.
  - Provide clarity and strong commitment by policymakers to take whatever action may be needed to avoid the tail risk of a depression; this reduces uncertainty, lowers precautionary saving, and encourages spending.
- Other measures:
  - Broad-based tax cuts may have low marginal propensity to consume.
  - Temporary decreases in the VAT:
    - If the termination date is credible and not too distant, intertemporal incentives are attractive but pass-through to consumers is uncertain; unwinding can contribute to a downturn.
    - Small VAT decreases (a few percentage points) may not be salient enough to change purchase timing.
  - More focused incentives (e.g., cash transfers for purchases of new, more efficient cars, as adopted in France) may attract more attention and have larger effects on demand.

#### C. Fiscal stimulus aimed at firms
- Firm behavior in current environment:
  - Firms face a sharp fall in demand plus high uncertainty, leading to wait-and-see investment behavior.
  - Subsidies or measures lowering the tax-adjusted user cost of capital (reductions in capital gains or corporate tax rates) are unlikely to have much effect.
- Policy challenge:
  - Avoid firms having to cut current operations for lack of financing, including reasonably priced credit.
  - Primary responsibility lies with monetary policy, but governments can support firms that can survive with restructuring but cannot access private financing.
- Policy instruments:
  - Combine Chapter 11-type restructuring procedures with government guarantees on new credit to facilitate plausible restructuring plans (approach similar to IMF-supported program lending: lending plus policy adjustment).
  - Caution on sector-wide support:
    - Support to entire high-visibility sectors may be argued for because of expectation effects, but inherent arbitrariness and risk of political capture make implementation difficult and potentially counterproductive, raising uncertainty and domestic protection concerns.

*Source: Executive Summary of _spn0801.*

### 25.       Indeed, direct subsidies to domestic sectors lead to an uneven playing field with

### _spn0801 - 25.       Indeed, direct subsidies to domestic sectors lead to an uneven playing field with

### IV. SUSTAINABILITY CONCERNS
- Fiscal expansions should be explicitly contingent on the state of the economy; announce upfront that the extent of the stimulus will depend on conditions to avoid later increases appearing as "desperation repairs."
- Fiscal stimulus must not be perceived by markets as seriously calling into question medium-term fiscal sustainability because such perceptions can undercut near-term policy effectiveness via adverse effects on financial markets, interest rates, and consumer spending.
- Markets currently are not overly concerned about medium-term sustainability in the largest advanced countries, though some widening of borrowing costs within the euro zone likely reflects sustainability concerns.
- A fiscally unsustainable path can lead to sharp adjustments in real interest rates that can destabilize financial markets and undercut recovery prospects.
- Features to help avoid sustainability concerns:
  - Implement mostly measures that are reversible or that have clear sunset clauses contingent on the economic situation.
  - Implement policies that eliminate distortions (example given: financial transaction taxes).
  - Increase the scope of automatic stabilizers that, by their nature, are countercyclical.
  - Pre-commit to identified future corrective measures—example: letting the current administration’s upper income tax cuts expire (U.S.)—and to future increases in upper income tax rates (just announced as part of the U.K. package).
  - Pre-commit to unwinding stimulus measures either at a specific date (example: 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); consider a smooth unwinding to avoid cliff effects.
  - Provide more robust medium-term fiscal frameworks covering a period of 4–5 years and ideally including:
    - accurate and timely projections of government revenues and expenditures;
    - a government balance sheet reporting data on government assets and liabilities;
    - a statement of contingent liabilities and other fiscal risks;
    - transparent arrangements for monitoring and reporting fiscal information for central and sub-national government, other public sector entities, and central bank quasi-fiscal operations, on a regular and timely basis.
  - Strengthen fiscal governance (example: independent fiscal councils to monitor fiscal developments and advise on policies and medium-term budgetary frameworks).
  - Improve expenditure procedures to ensure that stepped-up public works spending raises long-term growth (and tax-raising) potential.
- Long-term fiscal threat in rapidly-aging countries arises primarily from rising net costs of publicly funded pension and health entitlements, whose net present values far exceed conceivable stimulus packages.
- Structural reforms to boost potential growth by removing distortions (including those from taxation and public interventions) can help strengthen medium-term sustainability; growth-led reductions in public debt have succeeded in many countries.

### A. Some Proposals for Discussion
- The crisis may require new solutions addressing financial disintermediation and loss of confidence.
- Greater role of the public sector in financial intermediation:
  - Extreme shift toward liquid T-bills and away from private assets may justify state purchase and holding of private assets, effectively partly replacing private intermediation.
  - In the U.S. context, the government could issue T-bills and use the funds to provide financing to ultimate borrowers.
  - Public sector lacks comparative advantage in evaluating credit risk and administering a diverse asset portfolio; possible solution is outsourcing management of banking activities to a private entity.
- Provision of insurance by the public sector against large recessions:
  - Government could offer insurance contracts with payments contingent on GDP growth falling below some threshold level.
  - Banks could condition loan approvals on firms purchasing such insurance; contracts could also be open to individuals.
  - Widespread use would act as an additional automatic stabilizer because payments occur in bad times.
  - Such a market would provide a market-based view of future output and the likelihood of severe shocks (GDP-linked bonds discussed as related).
  - Counterparty risk is a concern; contingent liabilities created by providing insurance should be included appropriately in the budget and considered when calculating medium-run fiscal sustainability.

### V. A COLLECTIVE INTERNATIONAL EFFORT
- The international nature of the crisis calls for a collective approach to fiscal stimulus because of cross-border spillovers and potential adverse externalities.
- Key spillovers and considerations:
  - High trade openness can discourage fiscal stimulus because domestic demand expansions translate more into deteriorations of the trade balance; if all countries act, the required stimulus per country is reduced.
  - Collective fiscal efforts must be tailored to individual country circumstances, taking into account external imbalances, automatic stabilizers, and fiscal space.
  - Subsidies to troubled industries may be perceived as hidden (unfair) industrial policy by trading partners, potentially triggering a costly race and efficiency losses.
  - History of the Great Depression shows increasing pressure to raise trade barriers as crises deepen; while tariff increases may be improbable given WTO commitments, non-tariff protection or export subsidies remain distinct possibilities if measures are seen as unfair industrial policy.
- Need for concerted international effort and stricter coordination among closely tied countries (example: European Union); financing some national expenditures from the EU budget is noted as a step in this direction.
- Examples of announced national packages cited:
  - EU commission recommended a fiscal stimulus of 1.5 percent of GDP.
  - France announced a €19 bn plan, which includes a boost for the construction and car sectors; government also promised €20 bn for small business and the construction industry.
  - Germany announced a package costing €12 bn in two years, expected to trigger €50 bn in private investment; package includes generous amortization rules for companies and incentives for climate-friendly home renovation.
  - Italy proposes a nominally large stimulus that will only amount to €5 bn in "new" money.
  - Spain announced measures for €40 bn to support infrastructure investment and the car industry.
  - U.K. announced a temporary reduction of VAT rate from 17.5 to 15 percent until December 2009 at an estimated cost of £12.5 bn; government plans to invest £3 bn on infrastructure and has offered temporary targeted tax breaks for £3.5 bn.
- Some countries have questioned the need for fiscal action; recent data indicate a worldwide growth slowdown, suggesting widespread action is needed to maximize effectiveness.
- To maximize demand impetus, policies across regions should be tailored to actions with largest multipliers:
  - United States: likely focuses on investment, other spending on goods and services, and some targeted transfers.
  - Europe: with relatively large automatic stabilizers, the additional fiscal impulse can probably be somewhat less than in the United States.

### VI. CONCLUSION
- Solution requires bold initiatives aimed at rescuing the financial sector and increasing demand.
- Analysis of previous severe financial distress cases shows:
  - Early resolution of financial sector problems is a prerequisite for return to sustained growth.
  - Early, strong, and carefully thought-out fiscal response is critical.
- Time and action are of the essence.

### APPENDIX I: SPENDING AND REVENUE MEASURES (selected points)
- Appendix provides a list of measures to consider consistent with principles in the note, with pros and cons.
- Investment spending instruments:
  - Frontloading existing projects, particularly in countries with multi-year expenditure frameworks.
  - Increasing maintenance spending.
  - Planning new investment projects now and implementing if downturn continues.
  - Advantage: large short-term demand effect and long-term supply effect; if projects were planned anyway, anticipation will not change NPV of public debt.
  - Risks: significant lags to implementation and potential quality deterioration when expediting; maintenance spending tends to be small.
- Targeted transfer payments instruments:
  - Expansion of unemployment benefits (extending duration and/or eligibility and/or size).
  - Expansion of in-kind or cash transfers to low-income households by lowering threshold income level or increasing support.
  - Advantage: channels support quickly through existing safety nets; well-targeted to the neediest who have higher marginal propensities to consume.
  - Risks: target groups may be small limiting stimulus; undesirable labor market effects (work incentive problems); measures may be perceived as permanent entitlements, making reversal difficult; some measures may require institutional changes (example: U.S. coordination with states for welfare access).
- Not recommended measures (examples):
  - Introduction of new large-scale entitlement programs as they are hard to reverse.
  - Increase in public sector wage bill: politically unpopular, difficult to reverse, and not well targeted.
  - Increase subsidies to specific industries: could elicit undesirable protectionist responses.
- Temporary reduction in consumption tax rates (not pre-announced):
  - Advantages: raises purchasing power and encourages current consumption by lowering its price relative to future consumption.
  - Disadvantages: not well targeted; may not be passed through to final prices; may not encourage spending amid crisis of confidence; in the U.S., would require matching transfers from central government to sub-national governments to incentivize sub-nationals to lower rates.
- Lump sum targeted tax rebates and temporary increases in earned income tax credit rates or ceilings:
  - Advantages: well targeted to low-income and credit-constrained consumers; quick to implement; temporary.
  - Disadvantages: may be ineffective if precautionary saving prevails and highly indebted households increase savings rather than consumption.
- Temporary reduction in unemployment insurance contributions:
  - Advantages: targeted to increase employment by reducing employer cost; can be implemented quickly; temporary.
  - Disadvantages: may be ineffective if bleak economic prospects dominate employers’ decisions; limited evidence of impact under current circumstances; temporary cuts in pension contributions risk not being reversed and could weaken social insurance viability.
- Relaxation of rules on acquisition of tax losses of troubled banks and companies:
  - Advantages: incentives for merging troubled companies with healthier ones; allows symmetric treatment of profits and losses; targeted to restore confidence in banking and corporate sectors.
  - Disadvantages: troubled firm may be liquidated right after merger or its activities may change; strict provisions could address this but be hard to implement; unclear if enhancement is needed to encourage mergers.
- Adjustment in pre-payment rules to make them more forward-looking and extension of carry-forward rules:
  - Advantages: improves companies’ cash-flow management and symmetric treatment of profits and losses.
  - Disadvantages: companies may understate expected liabilities (remediable by penalties); unclear whether such measures would support aggregate demand in current context.
- Not recommended measure example cut-off in appendix: Reduction in corporate tax rates, dividends and capital gains taxes (section truncated in source).

*Source: IMF staff note excerpt as provided in the content unit.*

### introduction of special incentives such as accelerated depreciation

### introduction of special incentives such as accelerated depreciation

### Disadvantages of special incentives and related tax measures
- Special incentives such as accelerated depreciation:
  - Are likely to be ineffective given that business profits and capital gains are low, except possibly in countries with very high corporate rates (e.g., Japan).
  - Like all such tax changes, they are often difficult to reverse.
- Amnesties/temporary exemptions for companies in trouble:
  - Very distortionary, likely to be ineffective, inefficient.
  - With well-designed system of pre-payment and loss carry forward, tax payments of troubled companies are automatically reduced.
  - Could be seen as unfair industrial policy by international competitors, eliciting a “run to state subsidies.”
- Extension of carry back rules (setting current losses against past profits and receiving refund for past taxes):
  - Are ineffective in stimulating aggregate demand and are distortionary.
- Tax changes that worsen existing distortions, e.g., increases in tariffs:
  - Distortionary, likely to be ineffective.
- Measures aimed at bolstering financial markets and prices (e.g., reduction in capital gain taxes):
  - Distortionary, likely to be ineffective.
  - May have unintended side effects (reclassification of income into categories subject to lower taxes).

### APPENDIX II: FISCAL MULTIPLIERS—A REVIEW OF THE LITERATURE — Methodological issues
- Main challenges in estimating multipliers:
  - Identification problems: discretionary fiscal policy is typically used in a period of recession when many other factors are at play; effects of the stimulus could be confounded with other factors.
  - Definition of multipliers: fiscal multipliers have dynamic effects for several quarters; measuring these dynamic effects over time presents additional challenges, and multipliers may differ depending on whether other policy tools are held constant.
- Estimation methods and complications:
  - Methods include structural VARs, narrative approaches, model simulations, and case studies; each has different strengths and weaknesses for identification.
  - Identification problems in VARs relate to difficulty isolating exogenous movements in taxes or government spending.
  - Variation in multiplier estimates may relate to the frequency of the underlying data as lower frequency may complicate identification of shocks.
  - Dynamic adjustment: taxes, government spending, and monetary policy often respond endogenously after fiscal shocks, producing output effects arising also from factors other than the initial shock.
  - Macro studies aim at estimating overall multipliers including dynamic second-round effects; micro studies generally focus only on first-round effects.

### Different stimuli — key findings from the literature
- Heterogeneity across multiplier estimates: estimates range from less than zero to larger than four.
- Lessons from the literature:
  - There is no evidence that government investment multipliers are substantially larger than those associated with government consumption.
  - Short-run effects of tax changes may be smaller than those from spending changes, but this is not necessarily the case over the medium term.
  - Multipliers vary considerably across countries.
  - Multipliers tend to be larger for bigger economies.

### Micro studies
- Focus on first-round effects of fiscal stimulus.
- Findings for tax rebates/changes in the U.S.:
  - Less than the full income effect of tax rebates or changes is consumed on impact.
  - Some survey-based studies (e.g., Johnson and others, 2006; Coronado and others, 2005) find that two-thirds or less of the resulting change in income was spent.
  - Preliminary evidence for the 2008 tax rebates (Broda and Parker, 2008) supports this finding.

### Macroeconomic VAR and narrative studies for the U.S.
- VAR studies do not provide a clear conclusion on whether multipliers are larger for spending or taxes.
  - Short-run multipliers may be larger following a spending shock; longer-run multipliers potentially show the reverse.
  - Structural VAR (Blanchard and Perotti, 2002) shows larger or smaller output effects from taxes versus spending across time depending on trend assumptions.
- Narrative study (Romer and Romer, 2008):
  - Finds output effects of around 3 percent a few years following a tax change of 1 percent of GDP.
- Ramey (2008) (based on U.S. military dates):
  - Finds a nonproductive government spending elasticity of 0.3 (corresponding to a multiplier of around 1.5) after one year, indicating government spending multipliers may be larger than one.

### Structural models
- Structural models vary in assumptions about endogenous policy responses and forward-looking behavior.
  - Models allowing interest rate adjustment may have more muted fiscal multipliers than models that hold other policy variables constant.
  - Comparative study (Bryant and others, 1988) finds U.S. real GNP effects of government spending varying from close to zero to two percent across different models.
  - Freedman and others (2008) show effects are sensitive to degree of monetary policy accommodation and whether fiscal expansion is single-country or worldwide.
- Specific model findings:
  - Elmendorf and Reifschneider (2002) (open-economy, forward-looking model for the U.S.):
    - “A sustained cut in personal income taxes raises real GDP by less than the amount of the tax cut itself.”
    - A temporary tax rebate costing 1 percent of GDP results in:
      - A 1 percent short-run increase in GDP if 50 percent is spent.
      - A 0.3 percent GDP effect if only 20 percent is spent.
    - Increases in federal purchases have larger output effects than permanent tax cuts and investment tax credits (Elmendorf and Furman, 2008).
  - European Commission’s QUEST model:
    - First-year revenue multipliers of 0.3 or smaller for nine European countries.
    - Expenditure multipliers between 0.3 and 0.7 (HM Treasury, 2003).
  - Longer-run effects of tax changes may be larger if supply-side effects become more important over time.

### Ways to increase effectiveness of fiscal stimulus
- Target low-income and liquidity-constrained consumers with high marginal propensity to consume:
  - Temporary increase in food stamps associated with multiplier of 1.73 (Moody’s Economy.com).
  - Extension of unemployment benefits associated with multiplier of 1.64 (Moody’s Economy.com).
- Aid to states:
  - Can relax constraints from balanced-budget rules, allowing potentially quick output effects.
  - General aid to state governments has a multiplier of 1.36 (Moody’s Economy.com).

### Differences across country and time
- Multipliers differ substantially across countries and tend to be larger for bigger countries.
- Evidence:
  - Fiscal contractions can have expansionary effects in some countries (Giavazzi and Pagano, 1990 and 1996).
  - Output effects of revenue- and expenditure-based policy changes are close to zero for a set of advanced countries (IMF, 2008).
  - High range of estimates provides multipliers larger than four (Perotti, 2006).
  - Some studies (e.g., IMF, 2008) find multipliers may have decreased across time.
- Cross-country model results:
  - Structural VAR on quarterly data for Australia, Canada, Germany, the U.K., and the U.S. yields one-year cumulative government spending multipliers ranging from around one half to more than twice as large, depending on the country (Perotti, 2006).
  - Corresponding multipliers for public investment range from potentially less than zero to larger than four.
  - NiGEM comparisons for five European countries find Germany tends to have larger multipliers from one-year shocks to indirect and direct taxes and transfers than France, Italy, Spain, and the U.K. (Al-Eyd and Barrell, 2005).
  - OECD INTERLINK model leads to one-year responses of 1.1 percent or larger for the U.S., Japan, and Germany; responses in France, Italy, the U.K., and Canada are in the range from 0.2 to 0.9 percent.
- Trends over time:
  - Recent studies suggest multipliers have decreased over time.
  - For infrastructure, associated multipliers may be decreasing as marginal productivity of infrastructure falls with its expansion; investment projects also have potentially long implementation lags, leading to uncertain short-run effects.

### Conclusion (from Appendix II)
- Accurate fiscal multipliers estimated from macro studies are difficult to obtain given identification problems isolating exogenous fiscal shocks.
- Micro studies do not provide the full extent of output effects from fiscal policy as they primarily focus on first-round effects.
- A review suggests substantial heterogeneity across multiplier estimates, depending on identifying assumptions, type of fiscal policy, and country of interest.

### APPENDIX III: FIVE CASE STUDIES OF FISCAL POLICY DURING FINANCIAL CRISIS — A. Great Depression and Fiscal Policy
- Scholarly debate on recovery drivers:
  - Smithies (1946): “fiscal policy did prove to be an effective and indeed the only effective means to recovery.”
  - Hansen (1941): argues fiscal policy was not used extensively in the 1930s.
  - Brown (1956): using Keynesian multiplier model, supports Hansen's view concluding fiscal policy “seems to have been an unsuccessful recovery device in the thirties—not because it did not work, but because it was not tried.”
- U.S. government purchases of goods and services in the 1930s:
  - Increased from $13.6 billion in 1929 to $22.8 billion in 1939 (Brown, 1956).
- New Deal initiatives (examples and figures):
  - Public Works Administration had a budget of $3.3 billion (approximately 6 percent of GDP) to provide funding to local governments for public projects.
  - Civil Works Administration (CWA) created in 1934 to employ people directly on projects (city halls, docks, public roads).
  - Emergency Relief Appropriation Act provided about $5 billion for relief projects; used to set up the Works Progress Administration (WPA) which hired workers to build hospitals, schools, playgrounds, and airports.
  - Some criticism that WPA spent public money to pay idle hands to do unproductive work (Rauchway, 2008).
- Tax changes during the 1930s:
  - Revenue Act of 1932 pushed up rates across the board, notably on low- and middle-income groups:
    - Personal income tax exemptions were slashed.
    - Normal tax and surtax rates were sharply raised.
    - Earned-income credit equal to 25 percent of taxes on low incomes was repealed.
    - Corporate tax rate was raised slightly and exemptions sharply reduced.
    - Estate tax rates were pushed up, exemptions sharply reduced, and a gift tax was provided.
    - Broad new list of excise taxes introduced and substantially higher rates for the old ones.
    - “Processing taxes” were introduced later in the 30s.
    - Social security taxes began in 1937.
- What ended the Great Depression? Competing views:
  - Traditional view: public spending associated with World War II brought the economy to potential output.
  - Vernon (1994): fiscal policy relating to WWII was most important factor in the recovery during 1941 and 1942; half of recovery from 1933 low point occurred during 1941 and 1942.
  - Delong and Summers (1988): five-sixths of the decline in output relative to trend had been made up before 1942 and “hard to attribute any pre-1942 catch-up to the war.”
  - Romer (1992): recovery essentially complete prior to 1942; fiscal policies “contributed almost nothing to the recovery before 1942.”
  - Bernanke and Parkinson (1989): suggest the “New Deal is better characterized as having cleared the way for a natural recovery... rather than as being the engine of recovery itself,” pointing to trend reversion and strong self-corrective forces; Romer (1992) also notes monetary expansion via huge gold inflows in mid and late 1930s may have stimulated the economy by lowering real interest rates.

*Source: _spn0801 - introduction of special incentives such as accelerated depreciation*

### 63.      Finally, a recent paper by Eggertsson (2008) uses a stochastic general equilibrium

### _spn0801 - 63.      Finally, a recent paper by Eggertsson (2008) uses a stochastic general equilibrium 

### Eggertsson (2008) on U.S. recovery from the Great Depression
- Uses a stochastic general equilibrium model to argue the U.S. recovery was driven by a shift in expectations brought about by the policy actions of President Roosevelt.
- Increases in federal expenditures and rise in federal (as opposed to states’) deficit in the 1930s changed expectations from being deflationary to being inflationary.
- This expectation shift reduced the real rate of interest and stimulated demand.

### B. Japan: Banking Crisis in 1997 — overview and triggers
- After a short-lived recovery in 1996, Japan plunged back into recession in 1997.
- Downturn initiated by:
  - Larger-than-expected fall in household spending after the April 1997 consumption tax hike.
  - Cuts in public investment.
  - Reduction in domestic bank lending as banks shrank balance sheets in advance of financial reforms and impending overhaul of bank regulation.
  - Failure of a major bank and two large securities firms in November 1997.
- Government response: large fiscal stimulus package and public money to support bank restructuring; little fundamental progress toward resolving banking problems while recession continued.

### Japan: Macro-Fiscal Developments (selected numeric indicators)
- Real GDP gowth: 1996: 2.75; 1997: 1.57; 1998: -2.05; 1999: -0.14; 2000: 2.86
- Change in overall balance (in percent of GDP): 1996: -0.41; 1997: 1.09; 1998: -1.57; 1999: -1.81; 2000: -0.23
- Change in structural balance: 1996: -0.94; 1997: 0.85; 1998: -0.74; 1999: -1.58; 2000: -0.97
- Change in structural revenue: 1996: 0.34; 1997: 0.10; 1998: -0.42; 1999: -0.13; 2000: 0.24
- Change in structural expenditure: 1996: 1.28; 1997: -0.76; 1998: 0.32; 1999: 1.45; 2000: 1.21
- Inflation: 1996: 0.10; 1997: 1.88; 1998: 0.58; 1999: -0.29; 2000: -0.78
- Unemployment: 1996: 3.36; 1997: 3.39; 1998: 4.11; 1999: 4.68
- NPL: 1996: 5.40; 1997: 5.80
- Source: World Economic Outlook; and Fund staff estimates.

### Financial crisis and government support (Japan)
- February 1998: Government provided 30 trillion Yen in public funds:
  - 17 trillion for deposit insurance
  - 13 trillion for capital injection
- First round usage by end-March 1998: only 1.8 trillion Yen (0.24 percent of GDP) injected to 21 large banks as subordinated capital.
- Table: Japan: Government Support to the Financial Sector
  - Grants for loss coverage: Amount in trillion yen: 18.6; In percent of GDP: 3.6; Recovery as of March 2008: --
  - Purchase of assets: Amount in trillion yen: 9.7; In percent of GDP: 1.9; Recovery as of March 2008: 97.9
  - Capital injection: Amount in trillion yen: 12.4; In percent of GDP: 2.4; Recovery as of March 2008: 84.7
  - Others: Amount in trillion yen: 5.9; In percent of GDP: 1.1; Recovery as of March 2008: 81.4
  - Total: Amount in trillion yen: 46.6; In percent of GDP: 9.0; Recovery as of March 2008: 24.8; Recovery rate: 53.2
  - Total excluding grants: Amount in trillion yen: 28.0; In percent of GDP: 5.4; Recovery as of March 2008: 24.8; Recovery rate: 88.6

- October 1998: Government expanded public funds to total 60 trillion Yen (12 percent of GDP):
  - 17 trillion used for deposit insurance
  - 25 trillion for capital injection to solvent banks
  - 18 trillion for resolution of failing banks
- Nationalizations and recapitalizations:
  - Long-Term Credit Bank of Japan and Nippon Credit Bank nationalized in late 1998.
  - Additional 7½ trillion Yen injected into 15 major banks in March 1999.
- Result: rebound in domestic credit to the private sector.

### Fiscal stimulus (Japan, 1998–99)
- April 1998: 16 trillion Yen package (3 percent of GDP) of public works and temporary income tax cuts.
- November 1998: 24 billion package (5 percent of GDP) including:
  - Permanent cuts in PIT and CIT rates
  - Increased credit guarantees for bank loans to SMEs
  - Temporary consumption vouchers
  - Further boost to public works spending
- Further stimulus in 1999.
- Effects: fiscal outturn visible in 1998–99 calendar year; real growth rebounded to around 3 percent.
- Empirical evidence: varies in size but generally indicates positive short-term stimulus effects.

### C. Korea: Economic Crisis in 1997 — roots and balance-sheet vulnerabilities
- Corporate and financial sector vulnerabilities relative to other crisis countries:
  - Debt/equity ratio of thirty major largest companies: 500 percent
  - Corporate-sector profitability weak, partly due to overinvestment
  - Substantial currency and maturity mismatches of bank assets and liabilities
- Debt/Equity Ratio in the Manufacturing Sector (selected figures):
  - US 1997: 153.5
  - Japan 1997: 193.2
  - Taiwan 1995: 85.7
  - Korea 1997: 396.3
  - Korea 1998: 303
- Total borrowings and bonds payable to total assets: 25.6; 33.1; 26.2; 54.2; 50.8 (as shown in table)
- Source: Bank of Korea

### Korea: Macro-Fiscal Developments (selected numeric indicators)
- Real GDP gowth: 1996: 7.00; 1997: 4.65; 1998: -6.85; 1999: 9.49; 2000: 8.49
- Change in overall balance (in percent of GDP): 1996: -0.07; 1997: -1.66; 1998: -2.46; 1999: 1.41; 2000: 3.60
- Change in structural balance: 1996: -0.37; 1997: -1.78; 1998: -0.01; 1999: 0.24; 2000: 2.84
- Change in structural revenue: 1996: 0.81; 1997: -0.06; 1998: 0.96; 1999: 0.41; 2000: 3.09
- Change in structural expenditure: 1996: 1.17; 1997: 1.73; 1998: 0.97; 1999: 0.17; 2000: 0.25
- Inflation: 1996: 4.92; 1997: 4.44; 1998: 7.51; 1999: 0.81; 2000: 2.26
- NPL: 1996: 7.40; 1997: 8.30; 1998: 8.90
- Source: World Economic Outlook; and Fund staff estimates.

### Korea: crisis dynamics and policy response
- Late 1997: Korean banks could not roll over short-term loans despite government guarantees for foreign debt.
- Japanese banks withdrew a large percentage of their loans to Korea; foreign loans by Japanese financial institutions dropped from USD22 billion at end-1996 to USD9 billion by end-1997.
- Currency runs: Korean won depreciated 25 percent in late November from its pre-crisis level.
- Currency-market intervention left less than USD6 billion in usable foreign exchange reserves in December.
- By early 1998: most commercial banks and financial institutions technically in default due to severe depreciation and high interest rates.
- Twin crisis (BOP and financial sector) plus tight monetary policy led to severe recession: real GDP shrinking by 8.4 percent in the third quarter of 1998 compared with the same quarter in the previous year.

### Korea: stabilization and restructuring measures
- Recovery strategy focused on improving financial and corporate sector balance sheets.
- Actions taken:
  - Two major commercial banks nationalized.
  - Exit process for non-viable financial institutions via mergers, debt-equity swaps, and liquidations.
  - In 1998, five of 33 banks were closed, and three banks were merged.
  - Government provided full deposit guarantees, recapitalization, and purchase of bad loans.
- Outcomes:
  - Stabilized the financial sector quickly.
  - Centralized support packages enabled government to control most financial-institution decision-making.
  - From July to November 1998, 90 percent of loans to SMEs were rolled over (accounting for 36 percent of total loans to firms).
  - Eight major creditor banks negotiated workouts with 64 major corporate groups based on firm-prepared workout plans.
  - Debt/equity swaps proved effective for restructuring highly leveraged corporations and creditor banks.
- Legislative and structural reforms to facilitate corporate restructuring:
  - Liberalization of hostile takeover by foreigners
  - Removal of limit to foreign ownership
  - Provision of tax incentives
  - Measures to improve labor market flexibility
- Fiscal stance: little fiscal stimulus directly supporting aggregate demand; most public resources spent on stabilizing financial and corporate sector balance sheets.
- Recovery: real growth at 9½ in 1999 and 8½ in 2000.

### Use of Public Funds for Financial Sector Restructuring by End-1999 (Korea)
- Purchase of bad loans, Recapitalization, Deposit guarantees, Total (In trillion won / In percent of 1997 GDP)
  - Banks: 17.3; 14.6; 13.3; 45.2
  - Non-banks: 3.2; 4.0; 11.6; 18.8
  - Total: 20.5; 18.6; 24.9; 64.0
  - Banks (percent): 3.5; 3.0; 2.7; 9.2
  - Non-banks (percent): 0.7; 0.8; 2.4; 3.8
  - Total (percent): 4.2; 3.8; 5.1; 13.0

### Key comparison: Korean vs Japanese government responses
- Korean response:
  - Supported full-scale evaluations of all financial institutions to assess balance sheets.
  - Quickly decided which institutions would survive.
  - Fast and aggressive support: package in support of financial institutions amounted to 13 percent of GDP in 1998–99.
  - Support provided with strong conditionality on managerial issues.
  - Active government role moderating financial markets and facilitating corporate restructuring through creditor banks.
  - Did not wait for market forces; aggressively controlled financial institutions to keep credit system intact and push corporate restructuring.
- Japanese response:
  - Much slower in recognizing scale of distress and in dealing with problem.
  - Initial support was small; no initial comprehensive clean-up of bank balance sheets.
  - Provided fiscal stimulus during 1998–99 (8 percent of GDP in two years) in addition to fiscal support to financial sector.
- Fiscal contrast:
  - Japan: fiscal stimulus during 1998–99 equal to 8 percent of GDP in two years plus financial-sector support.
  - Korea: did not provide broad fiscal stimulus; large amount of public resources used to improve balance sheets of financial and corporate sectors.

### D. Savings and Loan (S&L) Crisis in the US (1980s–1990s) — overview
- Nature of the crisis:
  - Collapse of thrift industry financing long-term fixed-rate residential mortgages with savings/time deposits at restricted interest rates.
  - Maturity mismatch exposed S&Ls to interest rate risk when inflation rose in the 1970s and monetary policy tightened.
  - S&Ls experienced enormous losses of net worth in 1979–82; early 1980s recession exacerbated the problem.
- Resolution scale:
  - From 1986 to mid-1995 about one half of all S&Ls (1,043) holding $519 billion in assets were closed or otherwise resolved.
  - Resulting slowdown in finance industry and real estate market may have contributed to the 1990–91 recession.
- Government intervention:
  - Restored stability of the financial sector but no traditional fiscal stimulus was implemented due to concerns about rapidly rising public debt.

### S&L crisis: government response and regulatory changes
- Initial response: slow and inadequate
  - Delayed recognition of losses; accounting standards altered and capital requirements reduced so many thrifts remained legally solvent.
  - Asset and liability powers of S&Ls expanded (phasing out of regulation Q).
  - Deposit insurance increased and tax incentives for acquisition of troubled S&Ls granted.
  - These changes aggravated the problem by incentivizing risky investments by under-capitalized S&Ls.
- FSLC became insolvent by 1986; recapitalized twice with government money (total $25.75 billion in 1986–87), abolished in 1989.
- 1989 Financial Institutions Reform, Recovery and Enforcement Act (FIRREA):
  - Narrowed role of S&Ls, subjected them to more stringent capital requirements and regulatory scrutiny.
  - FIRREA dismantled FSLC; consolidated banks and S&L insurance agencies within FDIC; reformulated public policy goals of Freddie Mac and Fannie Mae.
- Resolution Trust Corporation (RTC):
  - Government-owned asset management company with initial funds of $50 billion; assumed control of assets of insolvent S&Ls and liquidated their assets.
  - Funds subsequently raised to $105 billion between 1989 and 1995 (only $91.3 billion of the authorized $105 billion were eventually used).
  - RTC pioneered “equity partnerships” with private sector partners acquiring partial interest in asset pools; RTC retained residual interest.
- Fiscal costs:
  - Total gross fiscal cost of S&L cleanup estimated at $180 billion (3.3 percent of 1989 GDP).
  - Net fiscal cost estimated at $124 billion (2.4 percent of GDP).
  - Most costs could have been avoided with earlier recognition and response in the early 1980s.

### Lessons from S&L crisis (bulleted findings and implications)
- Delay in resolution of financial sector problems, including failure to close promptly insolvent institutions, increased the fiscal cost of the crisis.
- Favorable initial conditions (strong financial position of households and firms, moderate credit growth, moderate asset price build-up) tended to minimize output loss and need for additional fiscal stimulus.
- Insufficient funds allocated for capitalization of the insurance fund or the asset management company delayed resolution and increased cost.
- Asset management company operating through equity partnerships with the private sector proved a good solution for liquidating assets of insolvent financial institutions.
- Government bailout related to mortgages during the S&L crisis may have created moral hazard and possibly encouraged lenders to make high risk loans during the current sub-prime mortgage crisis; crisis-resolution strategies should include measures to prevent moral hazard implications in the future.

*Source: Excerpt from IMF staff paper in _spn0801 PDF chapter/section.*

### 77.      Although the timing and severity of the crisis in the three Nordic countries (Norway,

### 77.      Although the timing and severity of the crisis in the three Nordic countries (Norway, Sweden and Finland) were different, there are important common elements.

### Crisis overview and impact
- Finland experienced a severe depression: cumulative GDP fell by 14 percent over 1990–94 and the unemployment rate rose from 3 to 20 percent over that period.
- Norway’s crisis preceded the others and was closely linked to international oil price fluctuations.
- Sweden, Finland, and Norway all saw significant adverse movements in unemployment rates, real GDP growth, fiscal deficits (in percent of GDP), and total debt (in percent of GDP) during 1988–1995 (charts in source).

### Causes and transmission mechanisms
- Positive economic performance, liberalization of financial markets, and increased international capital flows occurred without a sufficiently robust supervisory regime while exchange rates were fixed and terms of trade were positive; this environment led to a credit boom.
- Credit boom effects:
  - Large increases in real estate and stock prices.
  - Record levels of household indebtedness directed towards consumer durables and real estate (the ratio of household debt to net disposable income doubled).
  - A corporate investment boom concentrated in residential and nonresidential construction, real estate, and services.
  - Higher inflation and increased external imbalances.
- Triggers for the reversal and financial distress:
  - Negative terms of trade shocks at the beginning of the 1990s (including the collapse of the Soviet Union in the case of Finland).
  - Higher interest rates after German reunification.
  - Higher domestic interest rates to defend the peg.
- These factors led to corrections in real estate and stock prices, causing severe problems for highly indebted households and corporations and resulting in crises in the financial systems.

### Crisis resolution and banking sector interventions
- Very few small banks were liquidated.
- In the majority of cases authorities either assumed ownership or provided funds for banks to continue to operate.
- Governments in all three countries established crisis resolution agencies to manage public support and restructure the banking system.
- Finland and Sweden created separate asset management companies to deal with non-performing assets from troubled banks.
- Treatment of ‘old’ shareholders varied, but in practice they either lost everything or suffered significant losses.
- Most of the total costs of bank support were channeled through the budget.
- Evidence on the effectiveness of asset management companies in other countries has been mixed; they work better when the assets to be disposed are primarily real estate (Laeven and Valencia, 2008).

### Credit crunch and real economy
- While the financial crises had a significant impact on real economic activity, there is at best weak evidence of a credit crunch defined as lack of bank capital and quantitative finance constraints (as opposed to lack of credit demand from households and corporations).

### Fiscal outcomes and constraints
- Authorities provided significant budget support to banks and pursued fiscal policies to support activity and employment.
- Despite only moderate real GDP contraction in Norway and Sweden (except Finland), unemployment increases were large and persistent.
- The overall fiscal balance deteriorated significantly in all three countries.
  - Over 1990–93 the overall fiscal deficit deteriorated 6, 16 and 13 percentage points of GDP in Norway, Sweden, and Finland, respectively.
  - Staff reports at the time argued that only about half of the deterioration can be attributed to cyclical factors.
- Implication: The deterioration of the fiscal position was faster than anticipated and only partially related to cyclical factors.

### Key messages and policy implications
- The room for discretionary fiscal action over prolonged periods is limited even in countries where the initial fiscal position appeared to be strong. Sweden and Finland started the crisis with relatively low debt and fiscal deficits; the fiscal situation deteriorated to the point where attention shifted from counter-cyclical fiscal policies to fiscal sustainability.
- Addressing financial market vulnerabilities is a necessary (although not sufficient) condition to prevent prolonged economic downturns.
- When designing fiscal stimulus packages, preventing future spillovers from weaker economic activity into financial markets should be considered.
- If the fiscal position deteriorates significantly and the economic downturn persists, sustainability concerns may prevent fiscal policy from continuing to play a countercyclical role.

*Source: Excerpt from IMF chapter text (content unit _spn0801 - 77).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/spn/2008/_spn0801.pdf_