Lessons from Previous Experience  The current crisis represents a rare event, and caution is needed when applying the lessons from past experience to the present situation.  Nevertheless, previous experience suggests that the following issues should be considered carefully when designing potential fiscal responses by developing countries to the current crisis.

Recommendations  Any fiscal response should be commensurate to the shock experienced by the country.  The effect of growth slowdowns in rich countries on developing economies differs considerably across countries, depending on the strength of their links with rich countries through trade, capital flows, and remittances.  Past experience suggests that the adverse effects of growth slowdowns in rich countries have been modest for many developing countries.

Recommendations  Consideration needs to be given to the scope for monetary as well as fiscal policy responses, as both entail risks.  Policymakers need to consider the scope for coordinated monetary and fiscal interventions, given the uncertain effects of the latter.  In many developing countries the central bank’s policy interest rates are still high and inflation is modest, suggesting that there may be scope for traditional easing measures. However, Monetary response entails risks, including: (i) downward pressures on exchange rates. (ii) a loss of hard-won anti-inflationary credibility in countries with past histories of reckless monetary policy and accompanying high inflation.

Recommendations  Fiscal expansions need to be credibly and sustainably financed.  Lack of access to external finance has been an important impediment to expansionary fiscal policy during downturns in developing countries. This problem is likely to be acute during the crisis, with its accompanying paralysis in international credit markets.  Many developing countries have limited capacity for domestic borrowing to finance increased spending, and monetizing fiscal deficits is potentially very risky.

Recommendations  Moreover, a fiscal expansion with weak investor confidence in the sustainability of public finances can be self-defeating.  All this suggests that only those developing countries with strong fiscal positions and large reserve stocks can afford to finance a fiscal expansion.

Recommendations  The fiscal expansion must be timely but not rushed.  Fiscal interventions need to be timely in order to be effective, and that mistimed interventions can be counter-productive.  This has been a challenge in developed countries, and is even more so in developing countries, where data quality (to identify downturns and recoveries in real time) and fiscal institutions (to design and implement any proposed spending increases) are weak.

Recommendations  There are serious risks to rushing ahead to expand public spending when adequate oversight institutions and capacity to appraise new projects are not in place – as is the case in many developing countries.  Policymakers should first carefully consider the scope for expanding tested and well-functioning existing projects and financing pre-appraised and 'shovel-ready' new projects before embarking on completely new and untried public spending projects.

Recommendations  The balance of tax cuts versus spending increases needs to be tailored to country circumstances.  Assuming that there is a role for discretionary expansionary fiscal policy that can be sustainably financed, conventional wisdom is that spending increases are more effective at stimulating aggregate demand, since households might simply save tax cuts or direct transfers. However, this tradeoff is complicated by two factors in many developing countries.

Recommendations 1- On the one hand, in countries with weak fiscal and oversight institutions the risk is greater that large new public spending programs will be wasteful, captured, and hard to reverse. 2- On the other hand, tax cuts and/or social insurance transfers will not reach many of the poorest households and firms in the informal sector. In fact, there is a risk that such biased automatic stabilizers might aggravate inequality during the downturn.

Recommendations  To prevent a weakening of public finances, spending increases should concentrate on areas where the expenditures are either reversible or likely to increase growth in the future.  This is crucial to ensure that long-run fiscal and debt sustainability is not jeopardized by the countercyclical spending increase.  Concretely, this can be done by focusing spending on projects that act as automatic stabilizers. For example, expansion of social benefit programs will naturally occur and should be financed during downturn and will reverse as the economy recovers.

Recommendations  Similarly, workfare programs with a clearly below-market wage offer will attract participants in downturns but will not be appealing once the economy recovers.  The risks of unsustainable public debt accumulation are also reduced to the extent that increases in spending fall in areas such as infrastructure, where there are reasonably expectations of longer-term growth benefits as well as direct cost-recovery through future user fees.  Moreover, aside from this long-run growth contribution, infrastructure projects can also provide the basis for employment programs that reach poor workers.

Conclusion  Historical experience suggests that expansionary fiscal policy has not been an effective tool for most developing countries in responding to economic downturns. But this does not mean that fiscal policy can play no role in mitigating the effects of the current crisis; rather, it implies that recommendations for countercyclical fiscal measures should take into account lessons from past experience.

Conclusion  Developing countries should consider two priorities in the use of the limited scope they may have for expansionary fiscal policy – to ensure that short-term crisis alleviation is aligned with long-run development:  First, strengthening social safety nets is key in order to help the most vulnerable and those most affected by the crisis to cope.  Second, spending increases should concentrate in areas such as infrastructure to contribute to growth in the long term. However there are obvious risks to proceeding quickly with new infrastructure spending, and expansions in this area could best be used to finance "shovel-ready" projects that have already been appraised and found viable.