Global Economic Crises & Responses_METP

8/13/2019 Global Economic Crises & Responses_METP

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Global Economic Crises: A

Typology and Fiscal and

Monetary Policy Responses

Rajeev Anantaram

Professor of EconomicsInternational Management Institute


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Introduction Keynesian Economics was widely considered to be responsible for

pulling the world out of a global recession in the 1930s, which

explained its subsequent popularity.

The idea behind Keynesian economics was simply that government

consumption and investment compensated for a contraction in

private demand, thereby restoring the economy to trend growth.

(Recall Keynes made no distinction between government

consumption and investment) .

Keynesian policy is most effective when both domestic and external

demand have collapsed and monetary policy is largely ineffective

with interest rates reaching their lower-bound limit.


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Introduction [continued] Fiscal policy is useful in the expansionary phases, but is difficult to

withdraw once trend growth has been reached. Severalgovernments tend to continue with stimuli even when unnecessarythereby crowding out private investment and eventually depressing

demand in the medium to long run. Too, Expansionary fiscal policyhas an inherent inflationary bias.

The Friedman revolution was bringing monetary policy center-stageas the key to economic stabilization. Inflation was seen as a largelymonetary phenomenon. The revolution was aided by the gradualdecline of the public sector and also deepening of financial markets,

through which monetary policy is mainly transmitted. Fiscal policy was restricted to automatic stabilizers such as

unemployment benefits that could be withdrawn when not needed.


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Introduction (Contd.) The response to the current global economic crisis has been through a

combination of fiscal and monetary policies. This has beennecessitated by the fact that even extremely aggressiveunconventional monetary policy such as Quantitative Easing have had

a very limited impact other than preventing financial collapse in 2008and thereafter.

This has led to the revival of Keynesianism again to stimulateeconomic growth (recall class discussion of the spending hypothesis).In particular, discretionary fiscal stimulus remains a powerful tool incertain circumstances, which governments all over the world a re

using.


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Economic Slowdowns and Crises: ATypology

Type A Crises: Caused by a demand slump (both domestic andexternal) due to spare capacity and inflation falling below target.

Type B Crises: Decline in growth is because of a supply shock (oilprice increase, monsoon collapse). Usually associated with rising

inflation and falling real growth. Type C crises: Both demand and supply collapse. This is usually

associated with financial crises and the associated deleveraging. Thisis what the world is currently experiencing.


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Policy Responses to the Crises For Type Acrises: Conventional easy monetary policy along with

small doses of fiscal stimulus should be adequate as the demand

movement is cyclical. Public debt would go up as a result of falling

revenues (lower taxes and increased government spending) but the

effects a re short term.

For Type BCrises: Fiscal stimulus may make a bad situation worse.

The key is monetary tightening to curb inflation (recall Volckers

strategy to deal with stagflation). This however would do little to

address the supply shocks that may have to be dealt with through a

combination of structural reform and policy adjustment. Growth is acasualty in the short term and there is political pressure for more

expansionary fiscal and monetary policy which must be resisted

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Policy Responses (Contd.) For a Type Ccrises: Main aim is to revive demand again.

Monetary policy may be ineffective because the interest ratesare at or just above their lower bound. Thus fiscal policy will

play an important role in the economy. Optimal strategy is to

first finish the deleveraging, and then pursue aggressivefiscal policy in areas such as infrastructure development,which has both demand and supply side features.


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Caveats to the Policy Prescriptions If the crisis is national or regional, the country could rely on external

demandto work itself out of the crisis. For example, exports could

help power the recovery as happened in East and Southeast Asia after

the Asian financial crisis.

If trend growth is permanently impaired, aggressive fiscal and

monetary policy could lead to overstimulation. In such situations,

inflation(both consumer and asset price) should be the dominant

signal and NOT economic growth. In these situations, the emphasis is

on economic stability rather than levels of growth or employment.

If aggressive fiscal policy is employed, it may lead to high levels ofpublic debt, whose long-term consequences would have to be

carefully monitored.

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Caveats (contd.) Growth crises caused by financial crises can be long and protracted

(as is the case today). It is clear from the above discussion that fiscalpolicy is clearly the most important policy tool available to policymakers to address the underlying problems.

Note, that Keynes never explicitly stated how the public debt that

arose from additional government expenditure would be financed. If public debt is matched by high levels of private surpluses (as in

Japan), the governments can continue to embark on aggressivefiscal policies, without crowding out private investment by meansof a higher interest rate. Besides, there is no fear of a crash in thecurrency etc. because the debt is denominated in domestic currency.

In situations where the private savings are not as high, increasinglevels of public debt eventually leads to market revolt (as seen inthe European Union). In such cases, Central Banks have to intervene

by buying up all the bonds issued by the government to restore marketstability (sometimes called taking a haircut).


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Caveats (contd.) Governments can continue to pursue aggressive fiscal and monetary

policies even when they do not have high private surpluses whenthere is high demand for domestic debt (like the US). When Chinaand other countries buy US G-Secs, they are in effect funding the US

public debt. Central Banks are the lenders of last resort and they can financeany level of budget deficit to meet their nominal interest rate target.This is what QE3 is all about. The only factor that prevents themfrom following uncontrolled expansion is the impact it could have oninflation and macroeconomic stability.

In conclusion, countries with deep pockets can continue withaggressive fiscal policy, even if that results in bigger and longer fiscaldeficits.


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The Anatomy of a Crisis Response: QE3 Quantitative Easing was a response to a Type C crisis, wherein both

supply and demand had collapsed. In such cases, the responsesadopted are a mix of fiscal and monetary policy. QE3 is the monetary

policy component of the total policy response.

QE3 involves the purchase of private financial assets by the US

Federal Reserve (central bank) in return for money which would thenbe pumped into the economy. QE3 was adopted only afterconventional monetary policy had ceased to be effective. The FederalFunds Rate (the rate at which banks borrow from each other) hadreached its lower bound and so the government had to respondthrough Open Market Operations (OMO).

The immediate impact of QE3 is that domestic interest rates (in theUS)declined (due to an increase in money supply), though that impactwas muted because the interest rate was already low.


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QE3[contd.] Economic agents borrowed at low interest rates in the US to invest at

much higher interest rates in Emerging Markets (EM) which were

rapidly growing. This resulted in huge profits for financial

institutions by way of arbitrage.

The EMs were suddenly faced with a spate of dollar inflows that ledto an appreciation of the domestic currency (there was an excess

supply of dollars, which led to the dollar depreciating). This made

exports of the EM less competitive, as many EMs still depended on a

depreciated currency to keep their products competitive.

Thus the Central Banks of EMs were forced to buy up the extradollars to keep their countries exports competitive. This exercise

leads to excess liquidity in the form of rupees that were used to buy $.

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QE3[contd.] To suck out this excess liquidity, the Central banks had to issue

bonds, on which they had to pay interest (coupon rate). This process is

called Sterilization. In the case of India, the bonds used to suck out

the rupee liquidity were called MSS (Market Stabilization Scheme)

bonds. In 2007-08, the RBI paid out Rs 60,000 crores as interest onthese bonds.

The other impacts of QE3 are an increase in inflation globally because

financial agents use the cheap money to speculate in commodities,

driving up their prices. This could result in a supply side shock in

Emerging Markets. In short, the response to a Type C crisis by developed countries could

lead to a Type A crisis (due to depressed demand in the from of falling

exports or a Type B crisis (supply side shocks due to speculative

activities).

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QE3 [contd.] Most of these capital flows to EMs are short term in nature, which

can lead to considerable instability in EMs. Indeed, central banks of

EMs lose control over monetary policy in the face of these flows.

To counter this, many countries (South Korea, Brazil, Taiwan)

imposed a tax on short term capital flows. Such a tax is called theTobin tax.

In short, developed and developing countries will have very different

responses to a global financial crisis. Band aid solutions will be of

little use. The focus needs to be on addressing the underlying supply

shocks and proceeding with structural reforms.

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