The IMF and Fiscal Policy: Back to the Keynesian Solution?

The IMF's long-standing position on fiscal policy austerity, especially in its dealings with countries facing financial or balance-of-payments crisis (up until recently, mainly developing and emerging countries), is well known. However, in a recent commentary, the fund's managing director, Dominique Strauss-Kahn, gave his blessings for fiscal stimulus to ward off the risks of a global economic slowdown due to financial-market turmoil that originated in the US housing market in summer 2007.

While Mr. Strauss-Kahn directed his commentary to developed countries and emerging economies, he did not say a word on how a fiscal package could or could not work in developing countries. Clearly, developing countries are not immune to the problem facing the rest of the world. Rather, as strong global growth over the past few years has helped them earn higher export revenues, any risk of a global slowdown will have the opposite effect. Thus, developing countries face the same sort of policy dilemmas as anyone else.

Actually, the argument for fiscal support rests on the apparent weakness of monetary policy to prop up domestic demand. The reason is that monetary policy is effective only when the banking system is well functioning, which, judging by the recent events, is not the case at the moment. Due to heightened uncertainty about risk exposures, banks are reluctant to lend as much as one would like them to. By this standard, the problem for monetary authorities in developing countries is even be worse because their financial markets are underdeveloped, making monetary policy ineffective as a tool for demand management. The case for using fiscal policy to support their economies is, therefore, stronger than that in developed countries.