"When it comes to macroeconomic stimulus measures, however, policy is in disarray. "

Richard Baldwin on Vox:

"No one knows exactly how to stop the global economic crisis, but all agree that fiscal stimulus has a key role to play( NOT EVERYONE ). By reducing the length and depth of the recession, it should reduce bankruptcies, foreclosures, and further asset-price drops( THAT'S THE HOPE ). This column presents the main logic in a recent IMF paper authored by one of the world’s leading macroeconomists, Oliver Blanchard, and others.

There is near consensus among economists that fixing the world’s economy will involve at least these two steps:( 1 ) repairing the financial sector, and( 2 ) restarting economic growth. When in comes to financial sector policies, governments are already “on the case”. Much more surely needs to be done but governments are already deploying( PLEASE STOP ) all the policies( YEP. THAT'S HOW WE DO THINGS ON PLANET EARTH, AS OPPOSED TO PLANET THEORY. ) that eventually fixed every financial crisis since the dawn of the financial sector.

When it comes to macroeconomic stimulus measures, however, policy is in disarray( EXCEPT FOR THE MILDLY HELPFUL IDEA THAT KEYNES IS BACK IN VOGUE ). The US, UK and Japan have committed to fiscal stimulus, but other nations, such as Germany, don’t see the urgency of the situation – or, according to a more cynical interpretation – are hoping to free ride on the fiscal stimulus of others( THE SAVER COUNTRIES DO NOT WANT TO END THE CURRENT SAVER/SPENDER SYMBIOSIS. THE FREE RIDE IS TRYING TO GET OUT OF THIS CRISIS WITHOUT THE SYMBIOSIS COMING APART. ). Indeed, some economists question fiscal policy’s effectiveness.( TRUE )

The IMF’s paper on fiscal policy in the crisis

Given the lack of clarity on fiscal policy, the IMF paper released on 29 December 2008, “Fiscal Policy for the Crisis”, presents some very welcomed words of wisdom. Written by one of the world leading macroeconomists – Olivier Blanchard (who also happens to be the IMF’s chief economists) – with 3 coauthors, the report distils the lessons of five of the most relevant crises, namely the( 1 ) Great Depression,( 2 ) the Japanese 1990s banking crisis,( 3 ) the 1997 Asian crisis,( 4 ) the US 1980s S&L crisis, and the( 5 ) 1990s Nordic crisis.( DIDN'T ROGOFF AND REINHART SURVEY 800 YEARS? )

Why the drop in aggregate demand?

The paper starts by reminding us that there are indications that this recession could be deeper than any since the Great Depression. The sources of the decline in aggregate demand are:

· Drops in real and financial wealth( FROM THE FORECLOSURE AVALANCHE AND CALLING RUN );

· An increase in precautionary saving( FEAR AND AVERSION TO RISK ) on the part of consumers,

· A wait and see attitude on the part of both consumers and firms( FEAR AND AVERSION TO RISK ); and

· Increasing difficulties in obtaining credit( FEAR AND AVERSION TO RISK ).

Things that won’t work

The specific features of this crisis mean that two of the standard anti-crisis macro tools are ineffective.

· The global synchronisation of recession means export-promotion policies – such as devaluations ( DON'T EXACTLY AGREE. PRINTING MONEY MIGHT HELP. )– cannot work for the major economies (and they risk making thing much worse if the ‘echo chamber’ of beggar-thy-neighbour policies starts resonating). ( GOOD LUCK. IT'S HAPPENING )

· The financial source of the crisis weakens the link between policy rates and banking lending – thus rending the traditional( YES. WE'VE TRIED THAT. ) monetary transmission mechanism much less effective.

In any case, key nations have very little room to lower policy rates, so fiscal policy is the best last policy option for avoiding a deepening of the recession which could well exacerbate the financial sector crisis.

Optimal fiscal policy in the crisis

Based on lessons extracted from past crises, the IMF argues that fiscal stimulus should be

· Timely (as there is an urgent need for action),( TRUE )

· Large (because the drop in demand is large),( TRUE )

· Lasting (as the recession will likely last for some time),( NOT SO SURE )

· Diversified (as there is uncertainty regarding which measures will be most effective),( OK )

· Contingent (to indicate that further action will be taken, if needed),( OK )

· Collective (all countries that have the fiscal space should use it given the severity and global nature of the downturn), and( HERE THERE'S A PROBLEM. )

· Sustainable (to avoid debt explosion in the long run and adverse effects in the short run).( TRUE )

The challenge facing each national government is to gauge the right balance between these features – particularly, large-and-lasting actions versus fiscal-sustainability.

Lessons from earlier crises

The IMF paper provides a survey of five well‑known crisis: Korea in 1997, Japan in the 1990s, the Nordic countries in the early 1990s, the Great Depression in the 1930s, and the US during the Savings and Loans crisis in the 1980s.

Countries have reacted to these downturns quite differently, thus providing us with some evidence on how best to manage fiscal policy in a crisis. The key lessons are:

· Successful resolution of the financial crisis is a precondition for achieving sustained growth.( MAKES SENSE )

The counter-example is Japan where fiscal policy failed because financial sector problems were allowed to fester. By contrast, prompt and sizeable support to the financial sector by the Korean authorities limited the duration of the macroeconomic consequences thus limiting the need for other fiscal action.

· The solution to the financial crisis always precedes the solution to the macroeconomic crisis.( OK )

· A fiscal stimulus is highly useful (almost necessary) when the financial crisis spills over to the corporate and household sectors with a resulting worsening of the balance sheets.( OK )

· The fiscal response can have a larger effect on aggregate demand if its composition takes into account the specific features of the crisis( THIS I AGREE WITH ).

In this regard, some of the tax and transfer policies implemented early in the Nordic crises did little to stimulate output.

Composition of a fiscal stimulus

Governments around the world are struggling with how to apply fiscal stimulus. The IMF’s analysis points out two features of the crisis that are important when thinking about the nature of the fiscal stimulus.

First, this crisis is here for while, so slow-acting fiscal spending can be part of the picture( INFRASTRUCTURE SPENDING IS FINE. ). (In the usual recession, the simulative spending often( MIGHT HAPPEN HERE AS WELL ) kicks in after the recession is past and thus become part of the problem rather than part of the solution.) Moreover, expenditure measures have the advantage of directly stimulating demand rather than give money to consumers and companies who might not spend it( THAT'S THE REASON FOR GOVERNMENT SPENDING THE MONEY. ).

Second, the usual macroeconomic conditions mean existing estimates of fiscal multipliers are less reliable guides to the relatively effectiveness of various fiscal policies. This is why the IMF argues for fiscal policy diversification.( IT'S A GOOD IDEA )

Direct government spending

While each government will have to deal with national concerns, constraints and circumstances, the IMF offers some general words of wisdom.

· Governments should make sure that existing programs are not cut for lack of resources.( OK )

This bit of advice is aimed particularly at the US states, many of whom operate under constitutional balanced-budget rules that are forcing them to cut back spending on current programmes. (See Krugman’s column for examples.)

· Look for spending programs can be started or restarted quickly.

For example, the state could up its share in private-public partnerships for projects that would otherwise be suspended for lack of private capital. Public sector wage increases should be avoided as they are not well targeted, difficult to reverse, and similar to transfers in their effectiveness. Nevertheless, a temporary increase in public sector employment associated with some of new programs and policies may be needed( A JOBS BILL ).

· Public perceptions matter.( VERY IMPORTANT )

Much of this recession is coming from the sharp deterioration in expectations, and the sharp increased in perceived uncertainty about the economy’s prognosis( ABSOLUTELY. THE FEAR AND AVERSION TO RISK.). A few high profile programs – especially those good long-run justification and strong externalities – could help restore consumers’ and firms’ belief that things will get better. Such confidence can itself improve aggregate demand by reducing wait-and-see behaviour.( I WOULD ARGUE THAT THIS IS IN FACT THE SOLUTION )

Stimulus aimed at consumers

Getting consumers to spend again faces three crisis-specific factors: 1) wealth reductions are a key cause of reduced consumption ( TRUE. BUT PERCEPTIONS OF IT VARY. ); 2) credit constraints( REALLY THE FEAR AND AVERSION TO RISK. ) in some nations are forcing consumption reductions; and 3) uncertainty has spawned a wait-and-see attitude that results in the delay of planned purchases( THE MOST IMPORTANT REASON ).

These factors suggest two broad recommendations: Tax cuts should target consumers who are most likely to be credit constrained( I AGREE ), and should aim at restoring consumer confidence by committing to do ‘whatever it takes’( I AGREE. THAT'S WHY GOVERNMENT GUARANTEES ARE SO IMPORTANT, AS WELL AS INCENTIVES TO ALLEVIATE THE FEAR AND AVERSION TO RISK. ). The goal is to overcome the waiting-and-see attitudes( EXACTLY ).

Fiscal stimulus aimed at firms

The high degree of uncertainty surrounding this crisis fosters a wait-and-see attitude when it comes to firms’ investments. Consequently, subsidies are unlikely to have much effect( I BELIEVE THAT TAX INCENTIVES MIGHT ). While acknowledging the political economic pitfalls, the IMF argues that there is also some scope for governments in supporting firms that are facing particularly difficult problems, could survive through restructuring, but find it difficult or impossible to receive the necessary financing from dysfunctional credit markets. Sector-wide policies like the US auto bailout are bad idea( THIS WAS DONE FOR SOCIAL REASONS, WHICH ARE IMPORTANT IN RESTORING CONFIDENCE. ).

Sustainability concerns

While the IMF’s call for deficit spending is unusual, the authors stay true to form in arguing that questions about debt sustainability would, especially in nations starting from weak fiscal postures, undercut the stimulus via adverse effects on financial markets, interest rates, and consumer spending( A GOOD WARNING ). A fiscally unsustainable path can eventually lead to sharp adjustments in real interest rates, and these in turn can destabilize financial markets and undercut recovery prospects.( A PROBLEM GOING FORWARD )

The IMF suggests a number of things that could help:

Measures should be reversible or have clear sunset clauses( WHICH IS WHY I FAVOR A SALES TAX DECREASE OR PAYROLL TAX REDUCTION ) contingent on the economic situation;

Measures that increasing the scope of automatic stabilizers are useful;

Pre-commitments to future policies that help shore up fiscal accounts are useful.( I AGREE )

Pre-commitment to unwinding stimulus measures either at a specific date (like 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) are a good idea;( I AGREE )

Strengthening fiscal governance by, for example, setting up an independent fiscal council( NOT SO MUCH );

Coordination: The G20’s role

Sizable fiscal stimulus is required at the global level since this crisis is global. However not all nations are in a position to widen government deficits. Many low income and emerging market countries are constrained volatile capital flows, high public and foreign indebtedness, and large risk premia – features that plague some advanced countries as well.

Given that some countries cannot pump up demand with fiscal policy, the IMF argues that it is imperative that the nations who can do. This includes some large emerging economies such as China. As fiscal stimulus is a policy that suffers from the classic free-rider externality, it is exactly one area where international coordination by the G20 nations would yield great benefits."( THE SAVER COUNTRIES AND STIMULUS PROBLEM )

Some good points.

"to underestimate the amount of risk they faced and overestimate the amount of leverage they could handle"

Thomas F. Cooley gives the general consensus view of risk in Forbes:

"There is another, deeper possible link between the Great Moderation and the financial crisis that is worth thinking about, because it may help to inform the financial regulation of the future. The idea is simply that the decline in volatility led financial institutions to underestimate the amount of risk they faced and overestimate the amount of leverage they could handle, thus essentially (though unintentionally) reintroducing a large measure of volatility into the market.

Financial institutions typically manage their risk using what they call value at risk or VaR. Without getting into the technicalities of VaR (and there is a very long story to be told about the misuse of these methods), it is highly likely that the Great Moderation led many risk managers to drastically underestimate the aggregate risk in the economy. A 50% decline in aggregate risk is huge, and after 20 years, people come to count on things being the same.

Risk managers are supposed to address these problems with stress testing--computing their value at risk assuming extreme events--but they often don't. The result was that firms vastly overestimated the amount of leverage they could assume, and put themselves at great risk. Of course, the desperate search for yield had something to do with it as well, but I have a hard time believing that the managers of Lehman, Bear Stearns and others knowingly bet the firm on a systematic basis. They thought the world was less risky than it is. And so, the Great Moderation became fuel for the fire.

If there is a moral to this story it is probably to do with the filters we put on historical events. Succession and causality are often confused. As are the limits on our ability to think historically. What we see right now is only the great conflagration that consumes us, leaving us little appetite, and even less oxygen, to moderate our responses and hold onto a broad historical outlook."

I don't credit this, and now I think that I can explain why.

Many years ago, I read an essay which I've tried to find, but can't, about the modern conflict between Great Britain and the IRA. The essay started by stating that each side dated the conflict differently. For Great Britain, it began in the 20th Century, but for the IRA, it began in the 17th Century. The differences in dating led to completely opposite developments in the narrative and explanation of the problem.

So, when Cooley says this:

"Take, for example, "the Great Moderation."

The last really sharp recession in the United States was from 1981 to 1982, when real output fell by more than 4% below trend, and the unemployment rate rose to over 10%. It is often referred to as the Volcker Recession because it was triggered in part by then Fed Chairman Paul Volcker's efforts to squeeze inflation out of the U.S. economy.

Following that recession, something remarkable happened. The volatility in the U.S. economy declined sharply. Even though we have had two recessions in the ensuing years--in 1991 and 2002--both were relatively mild and short-lived.

Surprisingly, the U.S. economy remained dramatically more stable in spite of some major disruptions in financial markets in the U.S. and abroad over the same period. There was a major stock market crash in the U.S. in October 1987; the Mexican Financial Crisis in 1994; the Asian Financial Crisis in 1997 and 1998; the Russian debt crisis and the Long-Term Capital Management crisis in 1998 and the bursting of the dot-com bubble. In addition, there were the terrorist attacks of 9/11, and the U.S. got itself involved in two wars. In short, there were many dramatic events both in the U.S. and abroad--and yet the aggregate U.S. economy was relatively calm."

He leaves out the S & L Crisis. To me, the obviously most important factor. The implicit and explicit government guarantees to intervene in a crisis. So, we approach the history of this debacle from, not only philosophical differences, but historical differences. To me, the most important fact is how humans react to crises in real life, and what they are actually acting upon.

I've used this example before. Take illegal immigration. It's illegal. What do the government's actions over the last 20 years tell you about any implicit or explicit guarantees about whether the illegal immigrants will basically all allowed to remain in the end?

I don't know how to resolve this difference.

"IMF officials said it would benefit a “discrete and not particularly large group” of nations. "

Here's good news from the FT:

"The International Monetary Fund was on Wednesday set to approve a new emergency lending programme which it hopes will encourage rich governments to join in large-scale rescues to troubled countries.

The new liquidity facility is the culmination of a decade of attempts at the IMF, after the Asian financial crisis of 1997-98, to come up with a way of getting money quickly to relatively well-run emerging market countries hit by financial contagion."

It's about time. Why? More on that later.

"The new facility is similar in intent to the so-called “contingent credit line” (CCL), a pre-approved insurance-style policy developed by the IMF and the US Treasury in the aftermath of the Asian financial crisis.

But despite strong encouragement, no country ever applied for the CCL, fearing it would signal to investors that the government was worried about financial contagion. The new programme aims to avoid the stigma problem by having countries apply confidentially as they need it rather than in advance."

The stigma problem again. Good luck on the confidentiality.

"But fund officials said they hoped the programme would catalyse lending from rich governments and central banks. “It provides an assessment that the country involved has a stable debt position and good policies, and hopefully will provide a vehicle for others to supplement it if necessary,” the IMF official said.

A rescue package for Hungary, announced late on Tuesday, involved $8bn of European Union lending as well as $15.7bn from the IMF, although that was under the fund’s traditional “stand-by” arrangements rather than the new facility.'

Okay. So we have two distinct lending programs to monitor, and the real purpose of the new program is to buttress loans from the larger countries.

Now why do this? Well, for me, it's something like a chain only being as strong as its weakest link. Also, I think that Doha and other free trade agreements, which I ultimately want to see adopted, need such agencies and programs to facilitate that transition politically.

Brad Setser:

"The Fund cannot be a true global lender of last resort so long as it only has $200 billion to lend. Arend Kapteyn of Deutsche Bank noted recently that emerging markets have about $1.3 trillion in short-term external debt (with over $800b owned by emerging market banks) — a sum that far exceeds the Fund’s resources. But even if its lending is constrained, the Fund can provide financing in way that resemble the financing made available by a traditional lender of last resort.

That is the right move. I agree with Dani Rodrik. The scale of the current crisis demands innovation."