Not this time. Tightening the fiscal belt when domestic economic conditions are deteriorating exacerbates the cyclical momentum of the economy (i.e., it is pro-cyclical), while good policies should smooth the cycle. The pro-cyclical fiscal policies of the past were predicated on the unsustainability of the fiscal position before shocks brought havoc and the lack of foreign financing to support a more gradual adjustment, even in the context of IMF-supported programs.
But this time is different. Most emerging market countries are running roughly sustainable fiscal positions. Granted, most countries could have done more to save for the rainy days and spend more wisely. But only a few countries have followed irresponsible expansionary fiscal policies during the boom years—by the way, these are the same countries that run bad policies across the board—and most tried to contain the political pressures to squander the windfall gains associated with terms of trade improvements, the easy access to external finance, and exceptionally strong global demand. As a result, if the shocks that are presently hitting these economies were not of epochal dimension, most of these countries today would be able to implement some counter-cyclical policies responses to these shocks, or at least to avoid an outright pro-cyclical adjustment, without asking anybody’s permission. In contrast, countries that did not provision for the rainy days in good times will probably face the unpleasant prospect of either adjusting dramatically or litigate with their domestic and foreign creditors.
This time is different also because the shocks buffeting emerging markets are global in nature. Terms of trade have collapsed, foreign financing has dried up, and demand is falling all over the world, and the there are no export markets in which to depreciate out of the current deflationary conditions: the G3 is in recession, while China and India are slowing very fast. Yet, wasting precious foreign exchange reserves to defend any particular value of their battered currencies would be very costly. Better to aim at smoothing the exchange rate adjustment and using reserves to insulate as much as possible government budgets, to support the financial sector, and, in the limit, to try substituting for private credit to the extent possible.
Likewise, trying to push on the monetary policy string is also going to be ineffective. The transmission mechanism of monetary policy is notoriously weak in emerging markets. With banks balance sheets under strain because tightened liquidity conditions and global lending aversion, the transmission mechanism of monetary policy is impaired. Aggressive monetary policy easing, at this juncture, also risks setting off inflationary expectations and squandering hard won inflation-fighting credibility.
The only “deep-pocket” investors around possibly willing to re-leverage are the governments, as advanced economies are reluctantly coming to accept. The problem for emerging markets is that governments are not high enough quality borrowers to be able to re-leverage in the present circumstances. So this is the time for the multilateral financial institutions such as the IMF, the World Bank, and the regional development banks to step up to the plate and lend aggressively on generous price and non-price terms: There is little point in offering short term home insurance when the house is already on fire. What is now needed is medium-term financing to prevent massive fiscal adjustments and a wave of corporate sector bankruptcies in sustainable and systemically important emerging markets like Mexico, Brazil, and South Korea.
Multilateral lending to support sustainable fiscal positions in the development world is desirable and feasible. It is desirable from both the individual country viewpoint, as well as from the global perspective. As long as the international trade regime remains open, there are positive, large externalities from sustaining aggregate demand in large systemically important emerging markets. In addition, the international community should also be mindful of rewarding the good policies implemented in that past by helping to avoid unwarranted fiscal adjustments. A multilaterally financed fiscal expansion in the development world is feasible because lending to support the working of automatic stabilizers on that scale would require only tens of billions per country, as opposed to the hundreds of billions per country needed if financial collapse were to materialize in these economies in the near future, possibly stemming from real shocks feeding into financial panics and runs on emerging market liabilities.
This time around solvent and well run emerging markets should not tighten their belt in response to the global shocks they are facing. The international community must prevent that inevitable, and in certain cases desirable, economic slowdowns turns into recessions by supporting counter-cyclical policy responses, or at least avoiding the pro-cyclical fiscal policies of the past, financed in part with previously accumulated international reserves and in part with multilateral financial institution support. This would minimize the risk of global a financial catastrophe with the associated risk that the first global recession in modern times turns into the second global depression in less than 100 years.