New Washington consensus
To make a long story short, Washington consensus was a set of mantra-like rules that made good economic policy in the past 20 years. Then the rules begin to change, as nicely summarized by Dani Rodrik in his 2006 paper , Good bye Washington consensus, hello Washington confusion.
The ten commandments of Washington consensus were:
Reorientation of public expenditures
Unified and competitive exchange rates
Openness to FDI
10.Secure Property Rights
First commandment was worshiped, celebrated and cherished. When an emerging market country faced financial crisis, IMF has always recommended to cut fiscal deficit by cutting spending, which often if not always led to severe recession. No wonder, if you go out today on the street in Jakarta and scream I am from IMF you will be lynched.
However, this is a distant past. IMF has just released its crisis user manual, that explains what countries should do to reduce the crisis impact on the real economy. Brief excetutive summary in below:
“The optimal fiscal package should be timely, large, lasting, diversified, contingent, collective,and sustainable: timely, because the need for action is immediate; large, because the current and expected decrease in private demand is exceptionally large; lasting because the downturn will last for some time; diversified because of the unusual degree of uncertainty associated with any single measure; contingent, because the need to reduce the perceived probability of another “Great Depression” requires a commitment to do more, if needed; collective, since each country that has fiscal space should contribute; and sustainable, so as not to lead to a debt explosion and adverse reactions of financial markets. Looking at the content of the fiscal package, in the current circumstances, spending increases, and targeted tax cuts and transfers, are likely to have the highest multipliers. General tax cuts or subsidies, either for consumers or for firms, are likely to have lower multipliers”.
In less technical language it reads: Spend, spend, spend. Subsidize, subsidize, subsidize. Taxes cut, cut, cut. FAST.
In detail IMF recommends for example expanding social safety nets in countries where such nets are limited, or giving tax credit to those consumers that are credit constrained (read my lips, to those that used 10 credit cards and can’t repay today). I am not saying that these proposals are wrong, but I did notice that IMF threw Washington consensus manual to the garbage and is writing a new one. We have just seen first few chapters, but a lot remains to be written. IMF recognizes dangers of massive fiscal easing, take a look at the following two quotes:
“Financial markets do not seem, at present, overly concerned about medium-term sustainability in the largest advanced countries, though there has been some widening of borrowing costs within the euro zone that likely reflect sustainability concerns. This is however limited comfort, as markets often react late and abruptly. Thus, 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 […].
“What can be done to avoid this danger? The following features can help:
- Implementing mostly measures that are reversible or that have clear sunset clauses contingent on the economic situation;
- Implementing policies that eliminate distortions (e.g., financial transaction taxes);
- Increasing the scope of automatic stabilizers that, by their nature, are countercyclical;[…]
- Providing more robust medium-term fiscal frameworks. These should cover a period of four to five years and ideally include: 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; and transparent arrangements for monitoring and reporting fiscal information for central and subnational government, other public sector entities, and central bank quasi-fiscal operations, on a regular and timely basis. Such frameworks should be designed to give confidence that increases in public debt resulting from the stimulus are eventually offset;
- Strengthening fiscal governance. For example, independent fiscal councils could help monitor fiscal developments, thus increasing fiscal transparency, and could also advise on specific short-term policies or medium-term budgetary frameworks, to reduce the public’s perception of possible political biases; and
- Improving expenditure procedures to ensure that stepped-up public works spending is well directed to raise long-term growth (and tax-raising) potential.
IMF also goes outside the box (which is good) and recommends several activities to cope with the credit crunch:
“One of the characteristics of the current financial crisis is an extreme shift in investors’ preferences towards liquid treasury bills and away from private assets. To the extent that the state is in a better position than private investors to buy and hold these private assets, it may want to do so, in effect, partly replacing the private sector in financial intermediation. In the U.S. context, the government could issue treasury bills and use the funds to provide financing for some of the ultimate borrowers. The issue is clearly that the public sector does not have a comparative advantage in evaluating credit risk, nor in administering a diverse portfolio of assets. A possible solution may be to outsource the management of the banking activities to a private entity.”
In the present environment of extreme uncertainty, there may be a high private value to delaying consumption and investment decisions until part of the uncertainty is resolved. Equally important, banks may delay their decisions on which projects to finance for similar reasons.
In this context, the government could provide insurance against extreme recessions by offering contracts, with payment, for example, contingent on GDP growth falling below some threshold level. Banks could condition loan approvals on firms having purchased such insurance from the government. This is analogous to the flood insurance that mortgage companies often require from borrowers. While such contracts would most likely be attractive to firms, which suffer disproportionately during large recessions, they could be open to individuals as well. Widespread use of such contracts would provide an additional automatic stabilizer because payments would be made when they are most needed, namely in bad times. Such a market would also provide a market-based view of future output and the likelihood of severe shocks. (GDP-linked bonds, which have been discussed in the academic literature for some time, would also go some way towards the same goal.)
An obvious worry about such a scheme is counterparty risk, i.e., that the government may not be able or willing to honor its obligations. The contingent liabilities created by providing insurance should be included appropriately in the budget and should be taken into consideration when calculating medium-run fiscal sustainability.”
There is also a long list of to-do list and avoid-to-do list. A very interesting reading, highly recommended to policy-makers. It remains to be seen whether Obama economic dream team will use these recommendations. What IMF is missing completely, is focus on intellectual assets, issue raised in two previous posts.