Dani Rodrik on coordinated international fiscal stimulus

By Jon Fernquest

Will the new US president Obama engage in protectionist policies?

This is the big question many export businesses in Asia are worrying about.

The US is about to embark on a massive programme of government spending and tax cuts also known as fiscal stimulus or Keynesian policies.

Keynesian policies are named after John Maynard Keynes the economist who founded modern macroeconomics and whose ideas helped put an end to the Great Depression of the 1930s.

Hopefully, this US government spending will spur economic activity, get the US economy working again at normal speeds, and generate jobs for the 2 million workers who have lost their jobs over the last year in the US.

(See photo of Keynes at the Bretton Woods conference in 1944 that set up the world financial system after World War II)

Protectionist policies and Keynesian policies

The unfortunate reality is that protectionist policies would help make Keynesian policies more effective in stimulating the economy.

Protectionist policies are dangerous because when one country adopts them, other countries adopt them in retaliation (beggar thy neighbor policies).

This is what happened in the 1930s when the US passed the Smoot-Hawley Tariff Act which helped push the world economy into the long and painful  Great Depression. 

Making sure emerging market economies have enough credit for Keynesian policies

Economist Dani Rodrik, the keynote speaker at this year's international symposium at the Bank of Thailand, made some important suggestions in his blog last week on how to prevent the spread of protectionism (Also read VoxEU article on fighting worldwide protectionism).

The right approach is to make sure that all countries, including emerging market countries like China and Thailand, engage in government spending. Luckily this is what Thailand has already started to do.

To increase government spending in emerging market countries like Thailand, special arrangements will be necessary to make sure that there is enough credit available to fund this government spending (See chart of how the credit default risk for Thailand has increased along with other countries recently making it more difficult to borrow).

Here is the article from Dani Rodrik's blog in full:

Some unpleasant Keynesian arithmetic

How much of a boost to economic activity will a fiscal stimulus provide?  For those who believe that we have entered a Keynesian world of shortage of aggregate demand--me included--the answer depends on the Keynesian multiplier.  The size of this multiplier depends in turn on three things in particular, the marginal propensity to consume (c), the marginal tax rate (t), and the marginal propensity to import (m).  If c=0.8, t=0.2, and m=0.2, the Keynesian multiplier is 1.8 (=1/(1-c(1-t)+m)). A $1 trillion fiscal stimulus would increase GDP by $1.8 trillion.


Now suppose that we had a way to raise the multiplier by more than half, from 1.8 to 2.8.  The same fiscal stimulus would now produce an increase in GDP of $2.8 trillion--quite a difference. Nice deal if you can get it.

In fact you can. It is pretty easy to increase the multiplier; just raise import tariffs by enough so that the marginal propensity to import out of income is reduced substantially (to zero if you want the multiplier to go all the way to 2.8).  Yes, yes, import protection is inefficient and not a very neighborly thing to do--but should we really care if the alternative is significantly lower growth and higher unemployment?  More to the point, will Obama and his advisers care?


Being the open economy that it is, I fear that the U.S. will have to confront this dilemma sooner or later. In an environment where the dollar has already appreciated against the Euro and even more significantly against emerging market currencies, fiscal stimulus here [the US] will produce an even larger current account deficit.  If American consumers decide to spend 40 cents of a dollar of additional income on cheap imports from China and other foreign countries, the multiplier will be a mere 1.3.  How long will it take before politicians of all stripes cry foul over the leakage through the trade account and the "gift to foreigners" that this represents? And they will have Keynesian logic on their side. 

All governments must increase spending at the same time

The way out of this dilemma is to get the rest of the world to engage in fiscal expansion at the same time--so that the gift is returned.  The good news here is that China is playing along and hopefully the Europeans will too (if they can convince Germans to get over their weird obsession with fiscal conservatism).    


But most developing nations are constrained by weak fiscal fundamentals.  They cannot play the fiscal stimulus game because their borrowing capacity is limited: external finance is drying up and domestic financial markets cannot absorb the increase in public debt without a sharp rise in interest rates.


So unless we come up with a solution to the credit constraints in the developing world, we are going to either endanger the effectiveness of Keynesian policies in the U.S. and other advanced nations, or risk a sharp increase in protectionism.  Not a pleasant choice.


Two solutions suggest themselves.  One is to enlarge global liquidity by creating new SDR allocations and handing them over to developing nations to increase their spending. The other is to institute a Tobin tax on foreign currency transactions and pass the proceeds on to the developing nations.

Exceptional times, exceptional measures.  


(Source: Dani Rodrik's blog, 08-12-08,  link)

Posted by Jon Fernquest at 05:40 PM | Permalink | Comments (0)