Thursday, 26 February 2009

Fiscal Leeway Determines Whether Keynesian-Like Expansionary Policies Work During Recession Times, IADB Says

The Inter American Development Bank (IADB) yesterday published a study (''Dealing with an International Credit Crunch: Policy Responses to Sudden Stops in Latin America´´) in which it assesses lessons of past crises in Latin America and the role of multilateral agencies during such market moments. The crisis ''has brought Keynesianism back to the centre stage of the global policy debate,´´ the IADB says. As Latin American and Caribbean nations unveil their fiscal stimulus packages to fend off the global recession, those policy lessons can be useful to avoid mistakes of the past.

Lesson 1:
Recessions are far less severe in countries with room to adopt more flexible monetary and fiscal policies, or better, those that did their homework well during the boom years. Our observation: Two problems we see here -- see the contrast between Peru and Colombia. Both did their homework relatively well (Peru fared better than Colombia.) But Peru has good leeway, Colombia has a very limited one. The IADB defends its position: ''This is not something for all nations, as success depends on economic initial conditions at the time of the crisis.´´

Lesson 2:
The study alerts that countries in which governments have saved little during the commodity boom years will have limited scope to increase spending to alleviate the upcoming recession stemming from the current crisis. Any attempt to boost spending dramatically could erode confidence in the country’s ability to repay its debts in the future. Our observation: Is saving equivalent to repaying debt? or creating sovereign wealth funds? If so, Venezuela and Brazil have a an edge over the rest of Latin countries in pulling out of the crisis via fiscal packages. But for the case of Venezuela, no one is at all convinced of its ability to pull through; in fact, some people bet on a default (to us, rather exaggerated a concern.) The IADB defends its position: ''Some nations in Lain America will be forced to cut spending in the face of the current crisis because of insufficient savings. For others, the most feasible policy will be to maintain the current level of government spending but only a few such as Chile are in a position to increase spending.´´ It doesn't mention what countries are well suited for aggressive policy steps.

Lesson 3:
Countries that were able to adopt fairly more flexible fiscal and monetary policies in the aftermath of a financial crisis had a loss in output of less than 5 percent, while nations with much less flexibility had output contractions above 10 percent. Our observation: Argentina was a case in 2002. But Brazil wasn't -- in the aftermath of the currency crisis of 2002, with little access to credit, the economy managed to grow 0.7 percent! The IADB defends its position: ''The study analyzed policy responses by 19 developing countries during the Tequila, Asian and Russian crisis in the 1990s, periods of broadening sovereign interest rate spreads and capital flow reductions that affected a large set of emerging countries at the same time.´´

Lesson 4:
Countries that adopted anti-cyclical policies definitely did better but that doesn’t mean that countries that didn’t adopt counter-cyclical policies would have performed better if they had done the opposite. Our observation: We believe aggressiveness and determination matter in these circumstances. Markets are watching that closely. Investors are endorsing Brazil and Chile packages, by betting on a rise in their currencies. Take a look at Colombia's currency and see it being smashed; Venezuela's bolivar fuerte isn't fuerte anymore. Mexico's anti-recession package is that little credible that the peso is testing new lows almost every day. The IADB defends its position: ''In some cases their economic conditions were so weak to begin with that any attempt to be a more aggressive could have made the situation worse by eroding confidence on their creditworthiness.´´

Lesson 5: Successful anti-cyclical policies during financial crises work when governments can
boost spending in a sustainable way and conduct looser monetary policy that does not fuel inflation or lead to balance-sheet problems in both public and private sectors when both have debts denominated in dollars.
To boost aggregate demand sustainably, governments need to ensure their actions won’t affect the country’s credibility and solvency. Therefore, countries need to have credible central banks that can keep inflation expectations at bay by using genuine resources to fight the crisis. Our observation: We agree. Financial stability is a condition sine qua non for a successful policy package. No matter what Brazilian Finance Minister Guido Mantega (our beloved Criswell) thinks. The IADB defends its position: Countries will need to have a reasonable level of reserves to cover payments of international obligations and provide financing for trade. Low levels of debt denominated in dollars will give central banks more flexibility to depreciate the country’s currency in order to make its products more competitive to global trade.

Lesson 6:
The IADB says Latin America and the Caribbean have improved their economic conditions since the Russian crisis, giving them some leeway, particularly regarding monetary policy, to implement measures to fight the crisis. Countries have ramped up international reserves by $400 billion since 1998 (I think it's too little in the wake of about $1 trillion in proceeds from exports of raw materials and all that in the past six-seven years.) Additionally, the countries have substantially reduced dollar-denominated debts, particularly within the banking system and the government. Our observation: Lower levels of external debt allowed Brazil to loosen monetary policy amid the credit crunch in ways that other countries were not able to do during the aftermath of Russian crisis. Moreover, loose monetary policy typically leads to currency depreciation, with a subsequent increase in exports (as it happened with Brazil in the wake of the 2002 crisis.) The IADB defends its position: The currency depreciation, which boost exports as a way out of the crisis for several emerging markets in the past, may not fully work this time because of the ongoing global recession, particularly in rich nations. Our observation: We agree 100 percent with the IADB assessment.

The Role of the Multilaterals, According to the IADB

For multilaterals, the current crisis offers an opportunity for a different approach when compared with the policy options taken during the Russian crisis, says the IADB. The prevailing view in 1998 was that emerging nations needed to reassure creditors about the solvency of their economies. As a result, emerging countries around the globe were asked to cut spending and raise interest rates, which deepened the recession. ''The bank's study of successful policy responses during past crises suggests multilaterals must take into account initial conditions from each country before supporting a certain type of policy. Countries with good initial conditions do not need to go over strong adjustment policies to signal credibility. The multilateral system can help governments by boosting their foreign currency reserves and provide financing for government with a sustainable fiscal position,´´ according to the study.


  1. Guillermo: I've read a draft version of the IADB paper and assist to a presentation of it. I have big doubts about the way the data are managed and the power of the test used. But I am not an specialist, so ... I only wolud like to be careful about studies like this one.

  2. Hi, thanks a lot for your comment. I have my doubts too about the conclusions (I didn't see the full presentation, but the conclusions in general looked like ... weak to me.)

    I am not an specialist either but sometimes you see study cases and ... the IADB policy recommendations are rather weak. Think the two of us agree on that we have to take these studies with a grain of salt.

    Do you happen to have a powerpoint presentation or sth? If so, please send it my way to ... guaranteed discretion!


    Have a nice day and thanks for reading us.