IMF research hints at another Great Depression

Written by Sanjay Jog | Mumbai | Updated: Dec 31 2008, 06:57am hrs
International Monetary Fund (IMF) in its research report released on December 29 has made a strong case for optimal fiscal package to avoid another Great Depression. IMF report said the current crisis, which started in the housing and financial sectors, has now led to a strong fall in aggregate demand. There are indications that this fall could be larger than in any period since the Great Depression. A successful policy package should address both the financial crisis and the fall in aggregate demand, and thus, should have two components: one, aimed at getting the financial system back to health; the other, aimed at increasing aggregate demand.

The fall in aggregate demand is due to a large decrease in real and financial wealth, an increase in precautionary saving on the part of consumers, a wait and watch attitude on the part of both consumers and firms in the face of uncertainty, and increasing difficulties in obtaining credit. A further fall in demand will increase the risk that the perverse dynamics of deflation, rising debt, and associated feedback loops to the financial sector, may materialise. The report has analysed some well-known cases, including Korea in 1997, Japan in the 1990s, the Nordic countries in the early 1990s, the Great Depression in the 1930s, and the United States during the Savings and Loan crisis in the 1980s.

Moreover, while a fiscal response across many countries may be needed, not all countries have sufficient fiscal space to implement it since expansionary fiscal actions may threaten the sustainability of fiscal finances. In particular, many low income and emerging market countries, but also some advanced countries, face additional constraints such as volatile capital flows, high public and foreign indebtedness, and large risk premia. The fact that some countries cannot engage in fiscal stimulus makes it all the more important that others, including some large emerging economies, do their part.

We argue that a fiscal stimulus should be timely (as there is an urgent need for action), large (because the drop in demand is large), lasting (as the recession will likely last for some time), diversified (as there is uncertainty regarding which measures will be most effective), contingent (to indicate that further action will be taken, if needed), collective (all countries that have the fiscal space should use it given the severity and global nature of the downturn), and sustainable (to avoid debt explosion in the long run and adverse effects in the short run). The challenge is to provide the right balance between these sometimes competing goals-particularly, large and lasting actions versus fiscal sustainability, the report said.