In its relations with its most powerful clients, the International Monetary Fund possesses “the right to be consulted, the right to encourage and the right to warn”. Walter Bagehot, the great Victorian economic journalist, gave this description of the role of the British monarch in the 19th century. I applied this phrase to the role of the fund in a paper I submitted to its 2011 triennial surveillance review. At the annual meetings in Tokyo, the fund fulfilled precisely this role. What matters, however, is that its members, above all, the US and Germany, act upon the warnings and encouragement they have received.
The warning provided by the IMF’s World Economic Outlook was that: “The recovery continues, but it has weakened. In advanced countries, growth is now too low to make a substantial dent in unemployment. And in major emerging market economies, growth that had been strong earlier has also decreased.” The IMF revised its forecast for 2013 growth in advanced economies from the 2.0 per cent it forecast in April to 1.5 per cent. For developing countries, it cut its forecast from April’s prediction of 6.0 per cent to 5.6 per cent. The performance of the US, with forecast growth of 2.1 per cent next year (just 0.1 percentage points lower than forecast in July), is expected to be far better than that of the eurozone, where growth is forecast at 0.2 per cent next year (0.5 percentage points lower than forecast in July), after -0.4 per cent in 2012. Even Germany’s economy is forecast to grow by a mere 0.9 per cent in 2012 and 2013. Spain’s is forecast to shrink by 1.5 per cent and then 1.3 per cent. The eurozone is a cage for masochists.
It is no secret why growth is slowing in high-income countries: this is due to fiscal tightening, weak financial systems and powerful uncertainty. This toxic combination is particularly threatening inside the eurozone, where, again no surprise, countries reliant on exports are affected by the shrinking economies of big trading partners. As the latest Global Financial Stability Report shows, cumulative capital flight from peripheral eurozone economies is more than 10 per cent of gross domestic product. Indeed, without support, principally from the European Central Bank, peripheral economies would have had to impose exchange controls. They might even have left the eurozone. The fear of break-up remains pervasive: it is always hard to make masochism a credible strategy.
So far, so bad. But even these depressing forecasts make two possibly optimistic assumptions. The first is that the US avoids the “fiscal cliff” created by its quarrelling legislators. If not avoided, this would impose a tightening of 4 per cent of GDP. Sane people know the result: a deep recession and, possibly, outright deflation. Can US legislators be that stupid? One must assume not. The second optimistic assumption is that “European policy makers take additional action to advance adjustment at national levels and integration at the euro area level. As a result, policy credibility and confidence improve gradually.” Will European policy makers be that effective? One wonders, even if they have been more decisive recently.
So much for the warnings. What about the encouragement? The IMF argues, boldly and controversially, that fiscal multipliers have been far greater than normal in the Great Recession. This would hardly be surprising, since the Keynesian conditions of interest rates close to zero and tight constraints on credit now apply. Its conclusion is that multipliers have been in the range of 0.9 to 1.7, instead of the standard assumption of 0.5. This means that a tightening of, say, 5 per cent of GDP, roughly the cyclically-adjusted tightening expected of Spain between 2009 and 2013, would lower GDP by between 5 and 9 per cent, other things being equal. If anything close to this were true, even the fiscal deficit would fail to improve, as revenue fell and spending rose.
Overly rapid fiscal tightening is likely to be hugely damaging. In a sensible world, policy makers would apply strong fiscal support to the economy and robust efforts to heal weak and over-indebted private sectors, in the short run. They would also make strong efforts at structural consolidation, in the long run. Moreover, they would set fiscal goals in structural, not nominal, terms.
Beyond that, what encouragement does the IMF offer? The main answer is to cut off the “tail risks”.
For the US, that means eliminating the fiscal cliff, together with a plan for short-term fiscal support and structural fiscal improvement. This combination could well deliver surprisingly strong growth, since the housing market has stabilised, deleveraging of the private sector has gone a long way and the Federal Reserve has promised sustained support for recovery. The next presidential election is one to win.
In the eurozone, I see three steps.
The first is to proceed with long-term reforms, of which the most important is the “banking union” – the effort to cut links between weak sovereigns and banks.
The second step is to agree a programme with Spain in the very near future. The ECB should then use its new policy of “outright monetary transactions” to lower interest rates on government debt to some 3 per cent. At present, Germany seems to be making Spain hostage to progress on Greece. This is the wrong way round. The eurozone will only be able to deal with Greece when it has reinforced its defences for other countries, particularly important ones. On Greece itself, another large debt restructuring is needed. This time, that must include restructuring of official loans. The IMF should not proceed with a new programme for Greece that does not deliver a sustainable debt profile. Without it, no private investment will occur.
The last step has to be adjustment and growth. An important figure in the WEO shows that the current account imbalances of deficit countries are forecast to disappear as their economies shrink (see chart). But the surpluses of creditor countries are not forecast to fall. This is a beggar-my-neighbour combination for the world. It is also unconscionable. It is essential for the eurozone and the world that it sustains a healthy level of demand.
The IMF has, as it should, warned and encouraged. The warning is that the world economy is weak and could get weaker if proper action is not taken. The encouragement is the belief that it can be strengthened if those with clout act. Responsibility is the burden of power. So act now.
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