stimulus packages pros and cons

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Economic revival package: Medicine to heel or poison to kill The main purpose of the economic stimulus package was to prevent the re-emergence of the panic that gripped investors in 2008. It also aimed to restore trust in the finance industry by further limiting bonuses for senior executives for companies that received TARP funds. Obama increased spending from the $190 billion plan he proposed in his campaign, after realizing that dramatic and aggressive action is needed to stem the economic crisis. Some components of his campaign plan, such as enacting a foreclosure moratorium, have already been implemented by Fannie Mae. Others, such as eliminating taxes for seniors making up to $50,000, are still part of Obama's economic agenda elsewhere. How Does the Plan Work? Obama's tax rebates encourages consumer spending, although many doubt that it is enough. The stimulus for small businesses helps create jobs. The state aid helps keep them from having to either raise property taxes or cut needed services, which also saves jobs. The public works construction retains or adds 3 million jobs. It also lowers transportation costs for consumers. All incentives should be removed once the danger is over to reduce the deficit and avoid future inflation. In wake of the economic slowdown and the stimulus package announced by the Government, CII conducted a snap poll to analyse the impact of various initiatives, announced as part of the first & second stimulus packages on the Micro, Small & Medium Enterprises (MSMEs). The findings of the snap poll revealed that as part of the First stimulus package, the Reduction in CENVAT by 4%, followed by Interest rate cut of 0.5% for small and 1% for micro enterprises by PSU banks, Export support by interest subvention of 2 %,

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Page 1: Stimulus Packages Pros and Cons

Economic revival package: Medicine to heel or poison to kill

The main purpose of the economic stimulus package was to prevent the re-emergence of the panic that gripped investors in 2008. It also aimed to restore trust in the finance industry by further limiting bonuses for senior executives for companies that received TARP funds. Obama increased spending from the $190 billion plan he proposed in his campaign, after realizing that dramatic and aggressive action is needed to stem the economic crisis. Some components of his campaign plan, such as enacting a foreclosure moratorium, have already been implemented by Fannie Mae. Others, such as eliminating taxes for seniors making up to $50,000, are still part of Obama's economic agenda elsewhere.

How Does the Plan Work?

Obama's tax rebates encourages consumer spending, although many doubt that it is enough. The stimulus for small businesses helps create jobs. The state aid helps keep them from having to either raise property taxes or cut needed services, which also saves jobs. The public works construction retains or adds 3 million jobs. It also lowers transportation costs for consumers. All incentives should be removed once the danger is over to reduce the deficit and avoid future inflation.

In wake of the economic slowdown and the stimulus package announced by the Government, CII conducted a snap poll to analyse the impact of various initiatives, announced as part of the first & second stimulus packages on the Micro, Small & Medium Enterprises (MSMEs).

The findings of the snap poll revealed that as part of the First stimulus package, the Reduction in CENVAT by 4%, followed by Interest rate cut of 0.5% for small and 1% for micro enterprises by PSU banks, Export support by interest subvention of 2 %, Reduction in lock in period under Credit Guarantee scheme from 24 to 18 months and Additional Plan Expenditure of Rs 20,000 crores.

Also as part of the First stimulus package the initiatives such as MSME sector refinance facility of Rs 7,000 crores, PSEs and Government departments to pay promptly to MSMEs, RBI Steps to ease liquidity by reducing repo, reverse repo and CRR, Public sector banks agreed to enhance working capital by 20% payable in one year with six months moratorium and extension of the Credit Guarantee from Rs 50 lacs to Rs 1 crores, would immensely contribute towards easing the liquidity.

The snap pool also revealed that as part of the Second stimulus package, initiatives such as restoration of DEPB rates prior to Nov 2008 till 31 Dec 2009, Duty Drawback benefits for certain products like bicycles, agricultural hand tools, and specified category of yarns with retrospective effect from 01/09/2008, assistance to state Government to purchase buses for their urban transport system and accelerated depreciation of 50% for Commercial Vehicle purchased between January to Jan 31, will  have a beneficial impact for the MSMEs. At the same time, initiatives such as Special Monthly meeting of SLBC to look into the matters between MSMEs

Page 2: Stimulus Packages Pros and Cons

and Banks not resolved within a fortnight, Enhancement in the Guarantee cover under Credit Guarantee scheme from 50% to 85% for loan up to Rs 5 lacs and Rs 5,000 crore RBI credit to EXIM Bank for pre and post shipment credit, would also contribute towards easing the liquidity .

According to Chandrajit Banerjee, Director General, CII, the last few months have witnessed a series of initiatives being announced by the Government of India, Reserve Bank of India (RBI), as part of the stimulus package, and supplemented with announcements by the Indian Banks Association (IBA), for the MSMEs. He added that clearly, the intent is to help the MSMEs with additional liquidity, in the midst of the current economic crisis. However, the impact of these, either to prop up consumer demand or to the economy at large, is limited.

While we believe that the additional 2% Excise Duty cut would be passed onto the consumers, the various sectors that stand to gain from the 2% Service Tax cut, though only in limited capacity, include multiplex / retail, media television, oil and gas, real estate, telecom and commercial vehicles.

While the tax sops may help in stimulating the demand to an extent, the fiscal repercussions can be quite daunting. Already, the government of India anticipates a fiscal deficit of Rs3.27 lakh crore (6% of gross domestic product [GDP]) during FY2009—much higher than the original estimate of Rs1.33 lakh crore (2.5% of the GDP).These measures imply further pressure on tax collections, which are already moderating as economic activity is slowing down.

Owing to the worsening fiscal position S&P has already downgraded its outlook on Republic of India to ‘negative’ from ‘stable’ earlier while affirming BBB- long-term credit rating, the lowest level in the investment grade.

In light of the fresh tax sops, further review of India’s sovereign rating cannot be ruled out. Cement is a heavily taxed commodity and industry was lobbying for a reduction or rebates in taxes.In a move to give relief to the industry impacted by slowdown and help revive the economy, government has announced reduction in the excise duty on bulk cement to 8% or Rs230 per tonne whichever is higher and further extension of 4% reduction in cenvat beyond March, 2009.This move is expected to result in reducing the prices in the bulk cement category to the extent of Rs 60 per tonne. Though cement demand is inelastic to cement prices, but this move, indirectly, is expected to reduce the cost of construction of large-scale infrastructure projects and can have an indirect impact on the cement demand.We continue to maintain our estimates for the companies since benefit of reduction in excise duty is expected to be passed on to the end users.

Tax rebates

What's the plan? Will it work?Whom will it help

most?What's the downside?

Give money directly to consumers, to spend as they wish.For e.g in U.S Under the House-

Depends. If consumers spend it all, it could boost growth by half a percentage point or

Lower-income workers most likely to need the money more for routine

It adds to the budget deficit and the federal debt. And timing is critical. If the economy

Page 3: Stimulus Packages Pros and Cons

What's the plan? Will it work?Whom will it help

most?What's the downside?

approved plan, millions of individuals would get a $600 check; couples filing jointly, $1,200. Certain low-earners would get half as much.

more. But after similar rebates in 2001, many people used the money to pay off debt or boost their savings, which muted the effect.

expenses, and actually spend it. In wealthier hands, the money would benefit the economy less.

has already bottomed out and begun to recover by the time checks go out in May or June, the extra money could drive up inflation.

Tax breaks for business

What's the plan? Will it work?Whom will it help

most?What's the downside?

The House plan includes providing incentives that would increase tax deductions and otherwise offset business expenses.

Unclear. To boost the economy, businesses would have to invest the savings in new equipment or workers. But in a downturn, the demand for goods and services typically falls, leading companies to cut back--not expand.

Small businesses and other companies. It will help consumers in general only if those companies use the savings to invest more and hire new workers, or at least keep the ones they have.

Business incentives take longer to affect the economy than a direct injection of cash to consumers. And like rebates, they add to the deficit.

Interest rate cuts

What's the plan? Will it work?Whom will it help

most?What's the downside?

Interest rate cuts make loans cheaper for businesses and consumers, broadly stimulating the economy. One reason such "monetary policy" is a powerful tool is thatthe Fed can act quickly, without political dickering.

They're often the most effective economic lever the government can pull--unless there's a credit crunch, with banks cutting back on loans for other reasons.

Banks and big institutions that borrow large sums at or near the prime rate, and consumers getting lower rates on mortgages and other loans. Plus, companies with low borrowing costs are more likely to invest and hire new workers.

If rates go too low, spending can shoot up, triggering inflation or fueling another bubble. Remedial rate cuts could also convince investors the Government will bail them out, encouraging riskier behavior.

Government spending

What's the plan? Will it work?Whom will it help

most?What's the downside?

Increased spending on infrastructure projects or goods the government buys

This is no time for New Deal II. Government spending typically takes

Workers employed on infrastructure projects or at

The money ultimately comes from taxpayers, and the

Page 4: Stimulus Packages Pros and Cons

What's the plan? Will it work?Whom will it help

most?What's the downside?

can add to growth, but few policymakers are proposing a spending hike as part of the stimulus plan.

place over years--a period too drawn out to help when a quick, targeted stimulus is needed.

companies that make what the government buys.

government generally spends money less efficiently than consumers:.

Tax cuts

What's the plan?

Will it work? Whom will it help most? What's the downside?

Reduction in Tax rates to increase consumer spending.

Tax cuts that left consumers with a bit more cash in their paycheck would boost spending but not as quickly or effectively as lump-sum rebates to targeted groups of people.

Many consumers would benefit from having extra money in their pockets. But tax cuts tend to favor people with higher incomes, since they pay more taxes, and the cuts take a while to affect the economy.

Some of the most bitter beltway battles erupt over the fairness of tax policy, which makes quick action unlikely. And tax cuts add to the deficit unless offset by spending cuts.

Finally, one of the potential harmful aspects of the stimulus packages is the political rhetoric of its proponents. Franklin Roosevelt said “the only thing we have to fear is fear itself”. For e.g. statements that United States is on the verge of another great depression, damage consumer and investor confidence undermine the economy’s own recuperative power.

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Fiscal stimulus: is it the only solution to regenerate economies

Dillip khuntia

Abani kanta sahu

Mfc-I

Introduction

The world economy bleed heavily in 2007 which resulted in the worst financial crisis since the great depression of 1930.It contributed to the failure of the key business, declining in the consumer health and a significant decline in economic activities. Economics worldwide slowed during this period as credit tighten and international trade declined. For that government of different countries and central banks responded with unprecedented fiscal stimulus, monetary policy expression & institutional bailouts.

As financial turmoil continues to better world economies, triggering the collapse of a number of financial institutions, the bailout packages of different governments globally is nearing the $3 trillion mark about three times the size of Indian’s economy. The US government had moved the hiatoride $700 billion rescue plan in response to the deepening credit crises. Containing a spate of billion dollar rescue plans, countries like UK, India, Russia, European countries have also announced revival packages.

Ambulance Economics:- The Keynesian Approach

Ambulance economics is about the immediate, urgent temporary rescue process. Keynesian theory that was never really called upon in Great Depression of 1930, seems to be the only rescue called upon all over the World from China and Japan to the US and Germany in the after math of global economic meltdown. Thus it is very much important that we should analyze the effect of stimulus packages.

The Keynesian theory states that a fiscal expansion taking the form of expenditure on in fracture, which is financed by the sales of bonds or other forms of public expenditure or reduction in taxation , will lead to budget deficit, which will increase the public debt. The increases expenditure relative to recession situation will give rise to a familiar multiplier process, which will revive domestic output and employment and also consumption.

The theory also states that a country’s fiscal stimulus actually has three parts. The 1 st part is the discretionary stimulus, of which in investment in fracture is an important example. The 2 nd part

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consists of the automatic stabilizers. Here it is important to remember that these stabilizers may actually be financed, they are not financed, and they would fail to stimulate the economy. The 3rd part is government finance provided to rescue or assist the financial sector. This will certainly increase the public debt, but may not directly lead to extra spending and hence may not have an immediate stimulus effect. It will just help in reviving the financial sector and hence the economy.

Benefits

It implemented properly, stimulus packages have may benefits, and they are

1. The cost of complete collapse of a financial system is incalculable for business and for a nation. Thus it is almost lead to stimulate the economy by announcing stimulus packages.

2. The fiscal stimulus leads to financial stability.3. By taking away, the uncertainty about looming mortgage related losses, the stimulus

packages will pave the way for the financial institution to keep lending and get new infusions of private capital. Indeed bailouts are very much crucial at a time when the size of the problem is growing faster then bank’s capacity to handle it.

4. Fiscal stimulus also protects the economy from depression. It can also be said hare that it there would be stimulus packages during the financial crisis in 1930’s it wouldn’t have lead to great depression.

5. Prolonged and severe unemployment lead to loss of human capital in the form of work experience and confidence that goes with it. But by the help of stimulus packages the unemployment problem can be hedged and an important resource that is human capital can be saved.

6. Financial crisis harms the capital market and inefficient capital market obstructs the development of a country. But by the stimulus packages the efficient operation of capital market can be assured and also the economic development.

The Skeptics

Though fiscal stimulus has many advantages, it is not free from critism.The major agreement against fiscal stimuli is

1. If the economy is recovering what is the need for a stimulus packages. Perhaps it would have recovered without the stimulus.The central issue here is the uncertainty of success of stimulus packages.

2. It is also said that the bailout doesn’t address the core problems. It only deals with the difficulties of financial institutions instead of dealing with main causes of meltdown.

3. So far it has failed to restore the flow of lending as per the expectation.4. The bailout package has attached a limited set of restrictions on dividend increase, share

repurchasing and managerial compensation. In spite of these restrictions there is no way to measure whether taxpayer money is being used to boost lending and at the same time there is no obligation to make new loans.

5. If a government borrows to finance a deficit, the wise far seeing taxpayers will anticipate that taxes will have to go up in future to repay this debt. They will then save additionally

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to prepare for this event. Thus the total spending will not change. So the objective of stimulus package that is to stimulate public expenditure will fail.

6. Fiscal expansion will crowd out private investment through raising interest.7. Huge stimulus packages of developed countries may affect adversely the developing and

developed countries.

Conclusion

The arguments against stimulus packages can also be can also be challenged. One can’t say that it is unnecessary to announce stimulus packages when the economy is recovering or investor will not invest because they have to pay more tax in future. Thus it can be concluded that ambulance (stimulus packages) should be called to hedge the drastic and add impact ofcrisis and to catalyze the economic revival and growth.

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Stimulus package: Is the public debt sustainable?

Suresh pidisika

Prafulla kumar Sahoo

With ever increasing bailouts packages and more and more fiscal grants in form of stimulus given to economies throughout the globe , there is a growing concern about the expanding public debt which has mounted up not only in USA and Europe but also in the developing countries like India. The rising debt structure though unavoidable has rasied a question that is the public debt sustainable in long run and will all the economies be able to cope with the mounting fiscal pressure created because of the heavy stimulus packages. Even ardent proponents of the free market find it hard to argue today that globalisation is improving the lives of the majority of the world. A system of inherent crises, which has fuelled historically unprecedented levels of inequality, has collapsed, leaving in its wake a nightmare for many developing countries who find the trade and investment that globalisation has made them dependent on, suddenly drying up. Across the world 40 million jobs are predicted to be lost in 2009.

Against this backdrop, world leaders who profess concern with the fate of the global poor should be asking themselves some soul-searching questions as to why they have stuck behind the dogmatism of free market fundamentalism for so long. Instead, some of the ideas for new funding put forward by Gordon Brown and others could, after an immediate injection of desperately needed cash, mean more of the same policies that have created the mess in the first place. Dominique Strauss-Kahn, Managing Director of the International Monetary Fund (IMF), warned the world’s economic leaders to remain cautious as they examine exit strategies from the various stimulus packages they have implemented in response to the global economic crisis.

“If we exit too late, public debt will be higher,” he said at a panel on the Global Economic Outlook at the World Economic Forum Annual Meeting here.

“But if we exit too early, there is the risk of a double-dip recession. In that case, I don’t know what we can do because we have used all of the tools. The probability is low, but the risk is high.”

He also noted that “Growth is better than expected, but still fragile. In large part, it is still supported by public funding.”

Another problem highlighted by the IMF chief is the uneven pace at which the recovery is taking place around the world, with Asia and some other emerging market countries leading the way, and the United States and Europe lagging behind.

Starting the discussion with USA as it has been leading the chart with economic revival packages After $787 billion in stimulus spending and $700 billion in bank bailouts, 2010 is fast shaping up to be the year of the federal budget diet. The public debt is the amount owed to

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individual investors, including foreign countries, but excluding money the government owes to its own trust funds. It has soared from $5.8 trillion to $7.6 trillion this year alone — and is more than half the size of the nation's economy for the first time since 1956.

As predicted by many economist The United States and the United Kingdom stand on the brink of bankruptcy. Former prime minister and treasurer Paul Keating says fiscal stimulus is reaching its limits and even advanced nations are at risk of debt default if they continue to amass huge budget deficits and borrowings to rescue their economies.

"There is a limit to what fiscal policy can do simply because there is a limit to fiscal policy," Mr Keating told a Lowy Institute gathering in Sydney on Thursday.

"Is this sustainable? Who is going to buy the bonds?"

He cited in particular the huge bill the United States was running up in an effort to counter the recession and to bail out its banking system and strategic companies such as the insurer AIG.

"Is America going to default on its debt or be able to issue bonds?" he asked.

Governments across the globe will seek to borrow between $US3 trillion and $US4 trillion on bond markets in the coming year to fund stimulus packages and rescue packages for ailing banks and other financial institutions.

While both governments experiment with quantitative easing, bad banks to absorb non-performing loans, and state guarantees to restart bank lending, the only real way out is some combination of widespread corporate default, debt write-downs and inflation to reduce the burden of debt to more manageable levels. Everything else is window-dressing. The widespread policies being pursued to kick start the economy whether by providing bailouts or by stimulus packages has resulted in a severe mounting of debt. n particular, having governments buy distressed assets from the banks, or provide loan guarantees, is not an effective solution. It does not reduce the volume of debt, or force recognition of losses. It merely re-denominates private sector obligations to be met by households and firms as public ones to be met by the taxpayer.

This type of debt swap would make sense if the problem was liquidity rather than solvency. But in current circumstances, taxpayers are being asked to shoulder some or all of the cost of defaults, rather than provide a temporarily liquidity bridge.

In some ways, government is better placed to absorb losses than individual banks and investors, because it can spread them across a larger base of taxpayers. But in the current crisis, the volume of debts that potentially need to be refinanced is so large it will stretch even the tax and debt-raising resources of the state, and risks crowding out other spending.

The financial crisis and economic downturn has left a hole in the public accounts of EU Member States. Governments across the EU have taken unprecedented measures, assuming important liabilities for years to come.

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With EU government deficits expected to rise to an average of 7.5% of GDP in 2010 and public debt projected to steadily increase during the next decade, the fiscal impact of the crisis across EU member states has been severe. Marco Buti, the European Commission’s Director General for Economic and Financial Affairs, focused on the different challenges facing European governments. In the short-term, automatic stabilisers and discretionary policies in response to the crisis have led to a rapid enlargement of budget deficits. All Member States – except Bulgaria – are expected to be put under ‘excessive deficit procedures’, triggered when government deficits no longer meet the 3% ceiling set by the Stability and Growth Pact. The crisis has also had an impact on the European gross debt, which is rising on average from 68% in 2007 to 84% in 2011.

Looking at past crises, large fiscal deficits have contributed to an average increase of public debt of around 20% of GDP. The impact on public debt has typically taken a long-time to reverse. In the medium term, average debt in the EU is expected to reach 120% of GDP by 2020, if no fiscal consolidation measures are taken. In addition, many Member States have already been facing high ‘starting points’ and will face significant challenges in responding to an aging population. Turning to the question of fiscal exit strategies, Marco Buti stressed the importance of a coordinated approach between consolidation, starting in 2011, and economic recovery, whenever it takes place. However, withdrawing fiscal stimulus alone will not be sufficient to ensure long-term sustainable public finances. Member States will need to look at reducing public deficits and/or age-related spending. Consolidation based on expenditure cuts tends to take longer time, although tax-based consolidation will also be an important tool for some governments. Gradual adjustments are generally more effective, particularly if accompanied by structural reform and action to tackle public sector pensions.

Responding to a reported quote by an official at the Bank for International Settlements describing financial regulators ‘driving while just looking in the rear-view mirror’, the presentation by Ad van Riet, Head of Fiscal Policies Division at the European Central Bank, looked at some of the substantial risks lying ahead. Assessing the fiscal costs of the crisis for the Eurozone, Ad van Riet agreed that, given the impact of automatic stabilisers and various fiscal stimulus packages, this crisis has come at a very high cost for public finances across the EU. In addition, there remain a number of significant fiscal risks from the crisis. Primary balances could be affected by several factors, including prolonged or expanded fiscal stimulus measures, ongoing costs associated with automatic stabilisers and a trend towards growing government spending. Member States might also try to downplay or reduce the size of their fiscal deficits by engaging in window dressing or creative accounting. Economic growth is key: if economic growth is permanently lower, a higher primary surplus will be needed to reverse the rise in public debt ratios. A further fiscal risk is linked to probable changes in interest payments – as interest rates rise once financial conditions normalise – and monetary conditions.

Coming to the developing countries while some major emerging economies like China and India escaped the negative impact of the financial meltdown on their banking sector, any hopes that their real economies have decoupled from the developed market economies have been quickly belied. These economies are now experiencing a sharp downturn in their GDP growth rates. The IMF in January 2009 lowered its projections of GDP growth in 2009 for both India and China to

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5.1 and 6.7 per cent respectively. This is a sharp slowdown in GDP growth for both these giant emerging economies compared to the past five years. Quite expectedly, the sequencing of the crisis and the transmission mechanism are different in developed and developing economies. In the developed world the crisis originated in the financial sector and then impacted the real economy. The Swedish and Norwegian crises of the nineties and the present crisis in the US followed this sequence. For developing economies in the current crisis the causality and sequencing generally runs the other way, with the real sector being hit first and the financial sector thereafter. The pattern was of course different in the Asian financial crisis of the later nineties when the crisis also originated in the financial sectors of Asian economies. In line with this trend, in each of the cases of external shock, the real sector of the Indian economy has been initially impacted by the crisis as its banks are considered safe and robust4. Exports and foreign trade overall have been the first to be impacted and act as the channel for the external crisis to be transmitted to the Indian economy.

In order to preserve the economic growth during the time of worst recession, Federal authorities in India have announced the stimulus packages to prop-up the economic growth. To finance the stimulus packages, Indian Government has raised over $100 billion over the last four quarters in a way to finance the stimulus package. Country’s Public debt, according to the latest data has zoomed to over 50% of Going forward, India will see sharp rise in supply side inflation, after the effect of large government borrowings, printing of new currency notes, rise in food prices due to huge gap in demand-supply. Interest rates will also expected to rise awkward, as the central bank will take precautionary measure to contain inflation rate and expanding money supply. The total GDP and India’s Central bank, Reserve Bank of India has started printing new currency notes.

In the wake of rising inflation and the increasing deflicit Finance Minister Pranab Mukherjee today said the country’s GDP growth might exceed 6 per cent in the current financial year, but a rising fiscal deficit was not sustainable in the long term.

“The government has stepped up its development outlay to the extent of 39 per cent, and we had to finance not through our own resources but through borrowed resources. But this level of deficit is not sustainable in the long run,” at some point the deficit will have to be eliminated and when that happens, it might be a drag on growth. In India's case, it could lead to lower interest rates and higher investment and consumption.

There is no fundamental reason why fiscal deficit is necessary to support demand. So it's probable, except in these exceptional circumstances when structural fiscal deficit crowds out private spending. It would be better to have a smaller deficit and more private spending.

How long can India tolerate such a deflicit

India's GDP grows at 10% and fiscal deficit is 10% then, roughly speaking, debt over GDP stabilises when debt is at 100% of GDP -- that's not bad. So, if nominal GDP grows at 10% and deficit is 10%, it's sustainable. I regard the fiscal deficit problem in India as one of a misallocation of resources and not a macroeconomic one.

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Solution: Bankruptcy or Inflation

The solution must be some combination of policies to reduce the level of debt or raise nominal GDP. The simplest way to reduce debt is through bankruptcy, in which some or all of debts are deemed unrecoverable and are simply extinguished, ceasing to exist.

Bankruptcy would ensure the cost of resolving the debt crisis falls where it belongs. Investor portfolios and pension funds would take a severe but one-time hit. Healthy businesses would survive, minus the encumbrance of debt.

But widespread bankruptcies are probably socially and politically unacceptable. The alternative is some mechanism for refinancing debt on terms which are more favorable to borrowers (replacing short term debt at higher rates with longer-dated paper at lower ones).

The final option is to raise nominal GDP so it becomes easier to finance debt payments from augmented cash flow. But counter-cyclical policies to sustain GDP will not be enough. Governments in both the United States and the United Kingdom need to raise nominal GDP and debt-service capacity, not simply sustain it.

There is not much government can do to accelerate the real rate of growth. The remaining option is to tolerate, even encourage, a faster rate of inflation to improve debt-service capacity. Even more than debt nationalisation, inflation is the ultimate way to spread the costs of debt workout across widest possible section of the population.

The need to work down real debt and boost cash flow provides the motive, while the massive liquidity injections into the financial system provide the means. The stage is set for a long period of slow growth as debts are worked down and a rise in inflation in the medium term.

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Iceland crises: what stimulus package can do when the entire economy falls?

Bipin Bihari SamalDeba Prasanan Dash

That’s an amazing sentence: Iceland goes bankrupt. But that’s exactly what happened. That’s a clear sign that the global financial crisis is entering a new and vastly more dangerous phase, where we are paying the price of the lack of a global financial regulator and global central bank.

What ‘bankrupt’ means is just that: The country cannot pay back its external debts, and the Icelandic currency, the krona, has become essentially valueless in the rest of the world. That means the country can no longer pay for imports. There can be little doubt that Iceland was the greatest casualty of the global financial crisis of 2008-09. There was a run on the nation’s banks, which caused all three of them to go bankrupt. Unemployment has skyrocketed and inflation has risen sharply because of a plunge in the value of the currency. McDonald’s has closed its three restaurants on the island because of the high cost of importing food supplies.

The crisis has also left a legacy of debt. The European Union wants Reykjavik to repay retail depositors in the UK and the Netherlands for $5.6bn (£3.4bn, €4bn) they had deposited in Icelandic banks. As Iceland is trying to join the European Union its parliament agreed to pay , but the president vetoed the bill because of public anger. Sixty thousand people signed a petition against repaying the deposits with government money. They feared such a large debt because gross domestic product is only $12bn.

Now the aftermath of the crises the Iceland government has already used the tools used by other Euro nations. Iceland proposed a record high budget deficit of up to 170 billion Iceland crowns ($1.5 billion) for next year to finance the bailouts of its top banks and a vast public works programme to help the ailing economy.

The proposals, made by the government, include a 1 percentage point rise in the income tax rate to 23.75 percent and cuts in spending in non-priority areas to limit the bulging deficit. Public works programmes are seen costing 41 billion crowns next year, also a record high, even though some road projects have been shelved to save money.

"We are not at the end of the road yet, this is one step of many," Prime Minister Geir Haarde told reporters.

Iceland faces a 10 percent contraction of its economy in 2009, with unemployment set to soar after access to the cheap foreign funding that fuelled the island's growth dried up. Trying to stabilise its currency and banking system, Reykjavik has secured $10 billion in foreign assistance, including a $2 billion lifeline from the IMF.

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The government said revenues would be considerably lower in 2009 than anticipated due to lower tax revenues and increased costs, as inflation surged following a sharp crown devaluation.

The government said it aimed to protect the social safety net, education, health and law enforcement, while pushing through cost cuts in ministries and state institutions.

The entire model of the debt based market has been shattered to grounds with the fall of the wall street and with the subsequent fall of several economies. Somewhere or the other the entire model of rescuing the economies by undergoing significant fiscal grant is again based on the same debt model. When we have no choice but to give stimulus package, in short run the measure can seem to be a solution but it is fuelling the ground for next debt crises where the governments will suffer because of the unprecedented fiscal debt and mismanagement. The very basic crises and its management somewhere or the other is not able to come out of debt trap. The question before us is are we ready for a next debt crisis?

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Fiscal deficit, the biggest challenge

Borrowing from the RBI has its risks; it will increase money supply and stoke inflation

It is not just the size of the budgeted fiscal deficit — at 6.8 per cent of the GDP — but the high probability of not being able to check it even over the next two years that is causing concern.

With both government and RBI using fiscal tools to fuel economic growth and with subsequent announcement of stimulus packages to kick start the economy Arguably the biggest challenge before the Finance Minister, and almost certainly his successors as well, will lie in the area of containing the government’s fiscal deficit. The announcement of a 6.8 per cent fiscal deficit has made headlines and has, along with other factors, caused a stock market decline which continued well into the following week. If the deficits of the States and off-budget liabilities (such as petroleum and fertilizer bonds) are taken into account, the combined fiscal deficit will be almost 11 per cent of the GDP.

An immediate consequence of the large deficit will be a big jump in government borrowing. In fact, fiscal deficit is really government’s net borrowing needs. A 6.8 per cent Central government deficit translates into Rs. 400,000 crore of borrowing during 2009-10. That will be roughly four times the amount envisaged in the 2008-09 budget. The States may have to borrow around Rs. 15, 000 crore.

A public borrowing programme of such magnitude will definitely crowd out private investment and push up interest rates.

A big gamble

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There can be no doubt that Finance Minister Pranab Mukherjee has chosen a huge gamble. From the government’s point of view, the only way a calculated risk of this magnitude can pay off, and restore fiscal balance, will be for economic growth to accelerate to its earlier 8.5 per cent to 9 per cent levels, so that tax revenues increase substantially. At the same time, unproductive expenditure will have to be pared down and the heavy social sector spending better targeted.

Governments around the world have incurred deficits to finance their contra cyclical stimulus packages. Some, like the U.K and the U.S., have incurred much larger deficits and consequently borrowed more. Everywhere the expectation is that growth, so badly affected by the global economic crisis, will resume. However, there is a qualitative difference between India’s economic story and that of developed and most other developing countries except China.

India and China are among the few that are forecast to post positive growth while most others will witness a contraction in their economies. China’s economy grew by 7.9 per cent in the second quarter this year, due to an ambitious stimulus package and aggressive bank lending.

The stimulus packages and the policy measures enabled the economy to avert a crisis. While the country’s GDP growth slowed down from 9% in 2007-08 to 6.7% in 2008-09 and around 7% in the first half of 2009-10, the economy has achieved a growth rate — despite a steep decline in exports — which is among the highest growth rates in the world during these periods.

The stimulus packages have not only enabled the Indian economy to avert a severe impact of the global economic crisis but also sustained a high rate of growth during this period. The industrial production has gathered momentum, othe services sector is recovering, Corporate profitability has improved quarter-on-quarter since Q3 of 2008-09. There is an expectation that exports would return to positive growth by April 2010.

The real challenge

The government treasury runs at a substantial fiscal cost; an unsustainably-high fiscal deficit resulting in a departure from FRBM targets and fiscal consolidation. The estimated fiscal deficit of 6% of GDP in 2008-09 and 6.8% of GDP in 2009-10 is way above the target of restricting the fiscal deficit to 3% of GDP by 2008-09. The fiscal deficit in 2010-11 is also likely to remain high as revenue collection may miss the target. Between 2007-08 and 2009-10, revenue deficit has gone up more than four times from 1.1 per cent to 4.8 per cent of the GDP and .fiscal deficit from 2.7 per cent to 6.8 per cent. Revenue expenditure has increased by more than Rs. 300,000 crore while tax revenues have risen by just Rs. 35,000 crore. The massive increase is due to interest payments, defence, subsidies, salaries as well as major social programmes such as the NREGA and Bharat Nirman.

Replying to the budget debate, the Finance Minister laid stress on economic reforms and promised action on public sector disinvestment. The fiscal deficit will be brought down to 5.5 per cent by 2010-11 and to 4 per cent by 2011-12, as stated in the Medium Term Policy Statement.

Flawed assumption

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There are sceptics who feel that the government is being overambitious in aiming for a 2.8 per cent reduction in fiscal deficit from the budgeted 6.8 per cent (2009-10) to 4 per cent of the GDP by 2011-12.They have argued that such a large improvement in government finances over a short time has never occurred before in India.

Implicit in the government’s calculations is the assumption that buoyant tax collections will make up for half of the 2.8 per cent fiscal correction. But tax revenues depend on economic growth and India’s growth rate, though impressive in comparison with most other countries, will not be that robust to deliver outsized tax revenues.

Subsequent withdrawal:

Though the fiscal stimulus has helped our economy to avert a crises as severe as USA but the reality remains that there has to be a subsequent withdrawal of the revival packages so as to keep a fiscal balance and to avert a debt crises in future. The time has come for fiscal prudence and discipline. It is time to review and arrive at a plan for withdrawal of fiscal stimulus packages. The right course of action would be to consider a gradual withdrawal. A sudden and comprehensive withdrawal could jeopardise the economic recovery that is gathering strength.

In the short run, it will surely hurt. But keeping in mind the difficult task of sustaining a combination of high fiscal deficit, strong growth and controlled inflation, it has to be done. The adverse impact could be offset by appropriate increase in investment, both industrial as well as infrastructural.

A priority in that case would be to create enabling policy framework to escalate investment . The most appropriate time to begin the process of phased withdrawal of stimulus packages would be around July 2010, by when corporate performance during 2009-10 would be known and reliable information on the status of global economic recovery would be available.

Conclusion

India will also face the head wind of drop in future savings rate as government turns from saver to spender. It also needs to keep in mind that FY09 growth to some extent is front-ended by its stimulative policy aka high fiscal deficit. The back-ended price for the same needs to be kept in mind.

The government needs to focus on execution and efficiency. It needs to get bigger bang out of every buck that it is spending. Instead of spending money it needs to invest money wisely. Building check dams improves water level and helps in improving agriculture yield. The withdrawal of stimulus packages is inevitable, given the need for fiscal consolidation. Under the circumstances, continued spending by the state and central governments in creating infrastructure is likely to remain a key engine of economic growth and the extent and phase of resurgence of private investment activity is likely to play a critical role in shaping the trajectory of economic growth.

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Below is some helpful advice on how to best help the US economy by spending your stimulus check wisely:

If you spend that money at Wal-Mart, all the money will go to China .

If you spend it on gasoline, it will go to the Arabs.

If you purchase a computer, it will go to India.

If you purchase fruit and vegetables, it will go to Mexico, Honduras, and Guatemala (unless you buy organic).

If you buy a car, it will go to Japan .

If you purchase useless crap, it will go to Taiwan .

And none of it will help the American economy.If you need to keep that money here in America. You can keep the money in America by spending it at

yard sales, going to a baseball game, beer (domestic ONLY), or tattoos, since those are the only businesses still in the US.

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Sleep well America. Your financial future is finally secure.