Consumer spending has fallen sharply due to lower household wealth, tighter credit conditions, high uncertainty (photo: Frances Roberts/Newscom)
FINANCIAL CRISIS RESPONSE
In November, the IMF cut its forecast for global growth by ¾ percentage point to 2.2 percent for 2009. But, with the crisis spreading rapidly, IMF First Deputy Managing Director John Lipsky has said that the Fund is likely to make further downward revisions in the new global forecast it will announce in January 2009.
In this interview, Olivier Blanchard, Economic Counsellor, and Carlo Cottarelli, Director of the Fiscal Affairs Department, flesh out the call for a global fiscal stimulus, first proposed by IMF Managing Director Dominique Strauss-Kahn in the context of the November 15 emergency summit called by the leaders of the Group of 20 (G-20) industrialized and emerging market economies.
IMF Survey online: Almost every day, we hear about companies cutting back on production or going out of business because people have stopped consuming. Why are we witnessing such a dramatic fall in demand almost everywhere in the world?
Blanchard: The financial crisis has now evolved into a broader economic crisis, triggered by a freeze of the credit market, large wealth losses, and a loss of confidence. The result is a sharp fall in private demand. There are indications that the contraction in demand could exceed anything seen since the Great Depression in the 1930s. So this is a crisis of historical proportions.
IMF Survey online: The IMF has spoken of the need for a large fiscal stimulus totaling 2 percent of global GDP. What can a fiscal stimulus achieve that cuts in interest rates or bank restructuring hasn't been able to fix?
Blanchard: The question is not what policy, but what set of policies, to pursue. Three types of measures are needed, and they need to be implemented in parallel.
First, we need to repair the financial system by recapitalizing banks and isolating bad assets. Frameworks have been put in place, but execution is complex and will take time. Only when this is achieved can we hope for a sustained flow of credit and a lasting recovery.
Second, we should use monetary policy to increase demand. Here, the room for further monetary easing—at least in a traditional sense—is shrinking: in some countries, policy interest rates are approaching zero. Moreover, the effect of lower interest rates on demand is weakened by the disruption in credit markets.
This point to a central role for the third set of measures, fiscal stimulus. In the short run, such a stimulus, if designed right, can limit the decline in demand as well as output. Our article talks about what "designed right'' means in the current circumstances.
IMF Survey online: Some people are questioning the wisdom of taking on new debt when the effect of past stimulus packages has been uneven at best. Aren't countries running a big risk of saddling future generations with massive new debt at the very time when the effects of population aging will hit many developed countries?
Blanchard: In normal times, the Fund would indeed be recommending to many countries that they reduce their budget deficit and their public debt. But these are not normal times, and the balance of risks today is very different.
If no fiscal stimulus is implemented, then demand may continue to fall. And with it, we may see some of the vicious cycles we have seen in the past: deflation and liquidity traps, expectations becoming more and more pessimistic and, as a result, a deeper and deeper recession. If, instead, a fiscal stimulus is implemented but proves unnecessary, the risk is that the economy recovers too fast. Surely, this risk is easier to control than the risk of an ever deepening recession.
I would put it even more starkly. What is needed is not only a fiscal stimulus now but a commitment by governments that they will follow whatever policies it takes to avoid a repeat of a Great Depression scenario. If they do so, the fear that people and firms have today will fade, and demand will pick up.
Cottarelli: That said, it is critical that this fiscal stimulus isn't seen by markets as undermining medium-term fiscal sustainability. That would be counterproductive, including in its effects on demand today. Indeed, we've said that not all countries can afford a fiscal expansion.
How the stimulus package is designed is also key: fiscal measures should be reversible, and governments may want to precommit to unwinding some of the policies. Also, any stimulus should be formulated within a robust medium-term fiscal framework, which could be made more credible by strengthening independent oversight of fiscal policy.
"Fiscal measures should be reversible, and governments may want to precommit to unwinding some of the policies."
Also, don't forget that the main threat to the long-term viability of public finances in advanced countries comes from publicly funded pension and health entitlements. In net present value terms, the magnitude of these future fiscal costs far exceeds any fiscal stimulus package. A credible commitment to address these long-term fiscal pressures can help reassure markets about fiscal sustainability.
Finally, structural reforms to boost potential growth can also help strengthen medium-term fiscal sustainability: indeed, many countries have succeeded in reducing their public debt ratios through growth.
IMF Survey online: What policies should governments adopt, then?
Cottarelli: I would make two points here. Given the complexity of this crisis, policymakers have to recognize that there is an unusual degree of uncertainty about the impact of specific policies. Thus, they should not put all their fiscal eggs in just one basket, and the right package probably includes a mix of different policies.
As for the balance between spending increases and tax cuts, we think that there are two arguments why spending increases should be part of the package, probably more so than in the past.
"Consumers who are credit constrained are likely to spend any extra money derived from a lower tax bill."
First, the decline in private sector demand is likely to be prolonged. This implies that fiscal policy can rely more than in the past on spending measures, including investment in infrastructure, because we don't need to worry so much about implementation lags.
Second, we believe that, in the current circumstances, the marginal propensity of consumers to spend tax cuts or transfers may be low, leading to low multipliers. That said, selectivity is needed in raising spending: direct purchases of goods by the government—investment spending in particular—has a direct effect on demand and will also have positive supply-side effects. In contrast, increasing public sector wages is unlikely to help and may be difficult to reverse.
IMF Survey online: If countries want to target consumers directly, to rebuild confidence and get people to spend again, what should they do?
Blanchard: To answer that question it is important to understand why consumer spending has fallen so sharply. We believe this reflects three key factors. Households are feeling poorer because of the steep declines in housing prices, the stock market and, increasingly, their disposable income. Credit conditions have tightened as banks have reduced credit lines or increased interest rates. And high uncertainty is leading many consumers to take a wait-and-see attitude, for example, waiting to buy a car until they have a better sense of how bad the recession is likely to be.
This gets me back to the issue of tax cuts: Consumers who are credit constrained are likely to spend any extra money derived from a lower tax bill. But wait-and-see consumers are more likely to save any extra cash.
Cottarelli: That's why tax cuts and transfers targeted to the most cash-strapped consumers would probably work best. Some examples of policies we think would work better include extending unemployment benefits, increasing earned income tax credit or equivalent tax cuts targeted to households that are likely to be credit constrained, and expanding social safety nets. In some countries, governments may want to support homeowners facing foreclosures.
IMF Survey online: There is a lot of debate right now on whether governments should step in to help firms that are in trouble. The U.S. car industry is a case in point. What would be your advice to countries?
Blanchard: One argument for helping firms is that the crisis has made financial markets dysfunctional so that many firms have no access to reasonably priced credit. So the state may need to step in to provide credit guarantees for firms undergoing credible restructuring. That said, generalized support to sectors would create an uneven playing field with respect to foreign companies, which could trigger retaliation and possibly trade wars.
IMF Survey online: You propose that the public sector offer insurance against extreme recessions. What would be the benefits and how would it work?
Blanchard: We've been brainstorming about alternative measures that governments could consider. One idea is that governments could offer insurance against extreme recessions. For example, governments could offer a contract with payments contingent on GDP growth falling below some threshold level, and banks may condition loan approvals on firms having purchased such insurance. In principle, this would work a bit like the flood insurance many mortgage holders are required to take out.
IMF Survey online: Finally, isn't there a risk that some countries will enjoy a free ride at the expense of taxpayers in other countries? What role can the IMF play in helping coordinate a global fiscal response?
Blanchard: When economies are linked by a high degree of trade openness, fiscal expansion in one country translates in part into an increase in demand for the goods of other countries, and so may result in a larger trade deficit. Thus, each country is, rightly, reluctant to embark on a fiscal expansion on its own.
The best solution is for all countries to act jointly. But this requires some form of commitment or coordination. This is why the IMF has been closely engaged in discussions with member countries on how to design an appropriate fiscal response. Given our global membership, we are uniquely placed to do so.
Comments on this article should be sent to imfsurvey@imf.org
