With the IMFs recent change of heart on austerity, Greame O’Meara looks at the impact this will have on Ireland, Europe and the world
The IMF last week issued a fresh update on the global economy in its latest World Economic Outlook; it is most appropriately subtitled ‘Coping with High Debt and Sluggish Growth.’ In the forward, chief economist Oliver Blanchard relayed the key forces constraining the global recovery: fiscal consolidation (admitting here the effect of austerity on demand and the potential fiscal multipliers could have), a fragile financial system, and widespread uncertainty regarding US policymakers and the ongoing debt crisis in Europe. The sluggish economic activity within advanced economies is also spilling over to emerging economies via trade channels and capital flows. Prof. Blanchard ends optimistically in the hope that through continued reform and a revamped architecture for the EMU, his forecasts will turn out to be inaccurate and overly pessimistic.
The report downgraded its April 2012 forecasts for global growth next year and provided ammunition to critics of austerity, concluding that governments had systematically underestimated the adverse effects of fiscal tightening. Assuming the US congress avoid the January 1st ‘fiscal cliff’ (comprising tax hikes and spending cuts to the tune of $600bn) and the ECB buys up Spanish sovereign debt through the €440bn bailout fund, global output is set to expand by 3.6% in 2013, down from its earlier estimate of 3.9%. The fiscal cliff will of course be entirely dependent on the reshaping of the US political climate in November; should Romney take office, we can be sure to see these hikes and cuts materialise, especially given that the US Treasury is now close to its debt ceiling of $16.4 trillion.
The Fund unleashed new analysis showing that governments’ assumptions regarding the trade-off between fiscal squeezing and growth had been too optimistic, and that cutbacks would do more damage to output than their previous forecasts had envisioned. New evidence from 28 countries shows that fiscal multipliers, the ripple effect of alternating fiscal policy on growth, had underestimated the damage to the economy; smaller multipliers imply fiscal consolidation is less costly. Analysis of policy documents indicated that governments were using fiscal multiplier estimates of 50c in the dollar; this means that for every $1 cut in public expenditure (or tax increase), the loss of output in the economy was 50c. In reality, the evidence shows the loss to be between 90c and $1.70 since the great recession. In addition, the effect of austerity has not been offset by loose monetary policy, given that we are now seeing a liquidity trap in most if not all western economies.
This has influenced the Fund’s policy prescriptions for countries under IMF programmes, such as Portugal. The Troika has recently relaxed Portugal’s deficit target for 2013 from 4.5% to 3% of GDP until we reach a more accommodative economic climate. IMF managing director Christine Lagarde cautioned against countries front-loading spending cuts and tax increases. “It’s sometimes better to have a bit more time,” she said at the annual meetings of the IMF and the World Bank last Thursday.
What will policymakers do with this newfound revelation of Eureka proportions? As mentioned, for the US that will depend on the impending election, while in Europe, Italy and Greece are advised by the IMF to ease austerity and Spain is implored to comply to a bond buying programme with the ECB. For Ireland, the IMF’s latest report plays up the role of fiscal squeezing in allowing Ireland’s return to international capital markets through the €4.6bn raised in July as a result. The general (total) government debt is predicted to hit just under 120% of GDP by 2013; a 1.6% upward revision in their April 2012 outlook. With regards to austerity, the Fiscal Advisory Council is unlikely to heed the IMF’s advice; speaking at the Dublin Economics Workshop in Galway over the weekend, Prof John McHale said: “We certainly will be looking at the IMF findings … but the findings don’t seem to be particularly strong … in the Irish case …We will be looking at it and looking at it carefully, but at this point my sense would be that it mightn’t change our advice.” The Council’s focus is heavily skewed toward market creditworthiness (one of the reasons the recent AIB bonds were repaid in full) and access to funding in financial markets. So Budget 2013 is unlikely to show signs of reduced austerity.
It is amusing that the IMF is only copping on to this now. They have used up to date evidence since the onslaught of the global downturn, as opposed to looking at historical trends. Around 2010, particularly after Obama tried a fiscal stimulus in 2009, when advanced economies pivoted toward austerity, the relevant economic theory broke into three schools of thought. The expansionary fiscal policy types and those against it, those who looked at history and formed a biased opinion that austerity would have a very negligible impact on economic activity and finally, those who argued that when countries with flexible exchange rates were nowhere near a liquidity trap pursued austerity the impact was negligible. For example, Canada and Finland imposed sharp fiscal contraction during the 1990s, but the effect on economic activity was minor because it was amidst an environment of booming exports and loose monetary policy, thus counteracting the fall in aggregate demand. However, now things are different, we are near a liquidity trap and we don’t all have flexible exchange rates (eh, Europe), and thus austerity is taking its toll. Perhaps there is a first year undergraduate economics textbook lurking around IMF offices. No doubt Paul Krugman is feeling a bit smug right now and rightly so.