Would Fiscal Policy defense work?

IMF's John Lipsky at UCLA Economic Forecasting Conference;

Fiscal policy provides a second line of defense. It has played a role in the United States already and automatic stabilizers are appropriately providing support elsewhere in other advanced economies. In many emerging economies, fiscal policy will have to play a supportive role to monetary policy in helping to bring down inflation.

Fiscal policy is broadly appropriate across the advanced economies, but room for maneuver is limited given the need for medium-term fiscal consolidation in many of these countries. However, support for the financial sector inevitably will involve budgetary costs that must be taken into account in considering policy alternatives.

In emerging economies where inflation remains a problem, fiscal policy should play a more supportive role in restraining demand growth and easing inflation pressures. In particular, greater restraint on spending growth would be helpful as a complement to tighter monetary policy.

Direct intervention is the third line of defense. It has become obvious that direct fiscal intervention is going to be needed in the United States and elsewhere in order to attain the goals of removing distressed assets from financial institutions' balance sheets, and in recapitalizing the financial system where appropriate.

In this context, we welcomed the decisive actions taken by the U.S. authorities to shore up the GSEs, providing crucial support for the U.S. housing market, the banking system, and the broader economy. Over the longer term, a deep restructuring of the GSEs remains essential to restore market discipline, minimize fiscal costs, and limit systemic risks for the future. Ultimately the conflict of private ownership and public policy objectives within the GSEs' former business model needs to be resolved.

The challenge of removing distressed assets from financial institutions' balance sheets currently is front and center, with the US authorities' TARP proposal currently being examined by Congress. The discussions of the TARP have underscored the myriad difficult judgments that have to be made in order to make such a program a success. It is possible that similar challenges will be faced by other advanced economy authorities in the coming months. Earlier this year, the IMF proposed a solution based on long-term swaps of mortgage securities for government bonds. The advantage of such an approach is that it provides near-term relief for bank balance sheets, while ultimately leaving the underlying credit risk with the banks, rather than the taxpayers. In any case, the current discussions also have underscored the importance that moral hazard issues play in direct fiscal intervention in resolving financial sector crises.

More broadly, efforts aimed at alleviating systemic risks, including notably the provision of support to key financial institutions, will require sound judgment. For example, the current market strains to some degree reflect solvency risks. underscoring the need for a systematic and comprehensive approach to deal with distressed assets of failed institutions and in the financial sector more broadly.

In these circumstances, the key is to strike the right balance between safeguarding present financial stability and limiting future moral hazard. This task is by no means an easy one, but the consequences—either in the short- or longer-term—would be severe if the pendulum swings too far in either direction.