Pragmatic retreats into reality by the IMF will be ephemeral

On June 26, 2016, the Bank of International Settlements (BIS) published its – 86th Annual Report, 2015/16 – claimed that “there is an urgent need to rebalance policy in order to shift to a more robust and sustainable global expansion and address accumulated vulnerabilities”. Yesterday (October 5, 2106), the IMF issued its latest – Fiscal Monitor – Debt: Use it Wisely – which as the title might suggest focuses on what it sees as a dangerous exposure to global debt, which it currently estimates to be “at 225 percent of world GDP … currently at an all-time high.” Needless to say, this latest offering from the IMF has attracted news headlines with dire warnings about impending catastrophes. Some of this emphasis is justified but overall the IMF is erring, once again, in the opposite direction to its pre-GFC prediction errors. The context is obvious – mass unemployment continues as economic growth is stalling (or modest at best) because of a combination of non-government sector spending caution and the government obsession with fiscal austerity. The latter obsession has been stoked for years by the likes of the BIS and the IMF and while they do not explicitly recognise that in these latest documents, their stilted support for more fiscal action now, amounts to an admission of prior failures driven by the neo-liberal Groupthink that pervades these institutions.

The BIS wrote in its Annual Report that:

Less comforting is the longer-term context – a “risky trinity” of conditions: productivity growth that is unusually low, global debt levels that are historically high, and room for policy manoeuvre that is remarkably narrow.

Their cures:

1. “It is essential to relieve monetary policy, which has been overburdened for far too long”. And they might have added – relatively ineffective for the tasks given to it. The reliance has been driven by a hangover from Monetarist ideology which eschewed the use of fiscal policy.

2. “completing financial reforms” – but still allowing banks to be casino players and allowing investment bankers to shunt massive amounts around the world across borders with no regard for the real consequences for workers.

3. “judiciously using the available fiscal space while ensuring long-term sustainability” – continuing to use the neo-liberal framing of ‘fiscal space’ in financial terms for currency-issuing governments when the only appropriate way to think about that concept is to relate the unlimited capacity of such a government to purchase anything that is available for sale in the currency of issue to the available (idle) real resources.

4. “above all, this means stepping up structural reforms” – which is code for further deregulation of labour markets, further retrenchments of worker safeguards, attacks on public pension entitlements, and wage suppression.

The latest IMF Fiscal Monitor continues the theme set out in the BIS Annual Report.

Go back to 2006 when all the true, neo-liberal believers were smugly declaring that the business cycle was dead and that more financial deregulation was required, apparently to enrich us all, whereas in reality, income inequality had been rising at rather stunning rate, such that the enrichment was being concentrated at the top-end-of-town.

In its April 2006 – Global Financial Stability Report – which is a sister publication to the Fiscal Monitor, the IMF waxed lyrical about the strength of the “global financial system”.

We learned that:

… globalization and financial innovations have advanced the scope for capital markets to channel credit to various users in the economy. In particular, the emergence of numerous, and often very large, institutional investors and the rapid growth of credit risk transfer instruments have enabled banks to manage their credit risk more actively and to outsource the warehous- ing of credit risk to a diverse range of investors. A wider dispersion of credit risk has “derisked” the banking sector, which still occupies a strategically important role in the economy, in part because of its role in the payments system. It is widely acknowledged, meanwhile, that holding of credit risk by a diverse multitude of investors increases the ability of the financial system as a whole to absorb potential shocks.

Okay, the rest of the world now knows that this assessment was ridiculous given the circumstances that had emerged after two decades or so of financial market deregulation.

We now know that the financial sector was out of control by 2006 and on the verge of collapse. We now know that only massive government intervention – that is, the use of the currency-issuing capacity of the government and its central banks – saved the world from a financial meltdown.

When the IMF wrote:

Beyond risk diversification, the unbundling and active trading of risk, including through credit derivative markets, seem to have created an efficient, timely, and transparent price discovery process for credit risk.

We now know that the IMF didn’t have a clue what it was talking about.

When the IMF wrote that:

Balance sheets of the household sector in major countries have also improved since 2001, because of the rise in house prices and the recovery of international equity markets.

We now know that the estimates of rising household net worth was predicated on the asset-price bubbles created by the credit binge that followed the rise of the financial engineer through deregulation and the corrupt and unethical and criminal behaviour of the increasingly unfettered financial sector.

We now know that a substantial portion of this rising household net worth was illusory and households found that out the hard way, especially in the US, as housing prices crashed.

When the IMF wrote that:

There are several reasons to suggest why concerns of an impending recession in the United States may be overstated …

We now know what followed 18 months later. The real collapse of the US economy which then resonated throughout the world in one way or another had been predicted by some economists (including all the original Modern Monetary Theory (MMT) authors) for at least a decade prior to the GFC.

The IMF was trying to claim that financial markets were working efficiently to resolve any so-called “”mismatches’ between the duration of their assets and liabilities” – that is, the exposure of banks to increasingly risky portfolio positions.

Finally, in 2006, the IMF was claiming that there was a need to:

… rein in fiscal deficits and public debt … strong policy efforts to contain these trends are needed less these countries face increase market scrutiny when the environment turns less friendly.

The IMF claimed that “sound macroeconomic policy, especially prudent fiscal policy … is essential to reduce vulnerabilities”. That is, they were rehearsing the standard neo-liberal line at the time that fiscal surpluses were a necessary part of a low risk environment for countries.

They never once during this period, leading up to the GFC, acknowledged any understanding of the national account relationships that tell us that a government surplus (deficit) is exactly equal to a non-government deficit (surplus).

And they never once acknowledged an understanding that if the non-government sector is running a continual deficit, then after the exhaustion of savings and asset sales, the only other thing we would observe is rising non-government indebtedness.

This rising indebtedness clearly exposes the non-government sector to increased risk such that fluctuations in asset price and/or incomes can bring the whole house of cards crashing down.

That is exactly what happened in 2008.

It is important to reflect on what might be characterised as the standard narrative at the time propagated by the likes of the IMF, the BIS, and the OECD.

These institutions massively failed to understand what was going on over the last 3 decades or so, and, once the crash occurred, advocated policy interventions that made the consequences much worse than otherwise might have been the case,

Now their narrative is being nuanced in an attempt to restore their external credibility.

They all should be abolished – please read my blogs:

1. Reforming the international institutional framework – Part 1.

2. Reforming the international institutional framework – Part 2.

While all these interventions from the IMF and the BIS are heading in the same direction – which is that a greater reliance on fiscal policy is essential – they still refuse to countenance basic accounting relationships between the government and the non-government sector and what these mean in a behavioural sense for sustainable macroeconomic policy.

In case I’m sounding like a typical IMF report here – full of platitudes and generalisations – let me be clear.

Most governments around the world have to run continuous fiscal deficits to provide the conditions where desired private saving targets can be met without deflationary (recessionary) consequences.

But we need to go further than that. To really grapple with the out-of-control and largely unproductive financial sector several new initiatives have to be undertaken by the government.

In the latest Fiscal Monitor, the IMF notes that of the record levels of debt:

Two-thirds, amounting to about $100 trillion, consists of liabilities of the private sector which, as documented in an extensive literature, can carry great risks when they reach excessive levels.

The risk they highlight:

… the sheer size of debt could set the stage for an unprecedented private deleveraging process that could thwart the fragile economic recovery.

In fact, we need a large deleveraging process to clear the “debt overhang” and only fiscal policy can help ensure that doesn’t kill economies as it occurs.

Remember back to 2009 – I wrote this blog – Balance sheet recessions and democracy.

It distinguished between a normal recession, where the fluctuation in spending comes mostly from private investment as a result of growing negative sentiment.

While the downturn can be extremely costly in terms of lost incomes and jobs, the length of this adjustment process is relatively short and typically, V-shaped, because government intervention via fiscal stimulus can quickly restore optimism in the non-government sector.

However, a balance sheet recession is a different thing altogether. Its origins are found in the expansion of private credit and indebtedness, which underwrites the expansion of private spending, and, ultimately, the increased precariousness of private balance sheets.

Once the precariousness fractures, and this could be because of small changes in economic parameters (for example, employment levels) that would normally not precipitate a crisis, the debt exposure of the non-government sector becomes un-sustainable.

The problem then is twofold. The non-government sector cuts its spending growth in an effort to reduce its debt exposure.

The reaction to this credit binge is that the private sector starts to save more and will not borrow even though interest rates are low. So monetary policy will not stimulate investment.

The government sector then has to increase its net spending (that is, fiscal deficit) to provide the fiscal support to economic growth to maintain growth in national income, which provides the increased savings capacity for the non-government sector.

But unlike the V-shaped downturn and recovery profile, a balance sheet recession takes a long time to exit from whereupon the normal parameters are restored.

By that I mean that the elevated fiscal deficits has to be maintained for probably a decade or more before they can fall to more normal levels because the increased spending support is required while the non-government sector is restoring the viability of its balance sheet.

That process – of paying down debt etc – takes a considerable period of time.

So while there was elevated fiscal support in 2008 and 2009 in many countries, the neo-liberal ideologues, fanned by IMF scaremongering, placed political pressure on governments to engage in more or less rapid fiscal consolidation (their term, which just meant hacking into that government spending).

The upshot has been that the recovery has been tepid at best in many countries and seems to be teetering on the edge of expiry.

The second consequence has been that the non-government sector has not had sufficient fiscal support to make any meaningful dent into their precarious debt exposure.

So while it is reasonable for the IMF to highlight the massive “private debt overhang” in the latest Fiscal Monitor and talk about the “role fiscal policy can play in facilitating the adjustment”, there is no real comprehension displayed in the Report of how private and public debt, under current institutional arrangements, are intrinsically related and that austerity was a disastrous option to advocate.

The fiscal austerity has created an environment of sluggish growth, deflation or low inflation, entrenched unemployment, and low incentives to invest in productive capacity building (which is retarding potential growth and productivity).

The reliance on monetary policy with very low interest rates has created an environment where savings are punished and there is less incentive to deal with the outstanding private debt levels.

Central banks know that if they start hiking rates any time soon there will be a swathe of bankruptcies as the elevated private debt exposure comes back into play with higher debt servicing costs and stagnant income growth.

The IMF now believes that fiscal policy must come forward in the policy mix “to facilitate the deleveraging process”. This requires both “macroeconomic deleveraging” (stronger growth) and “balance sheet deleveraging” (cleaning up private debt).

The IMF recommend:

1. “strong growth in those countries mired in a debt overhang” using fiscal policy to support demand.

2. “decisive and prompt action to repair the balance sheets of banks” – the preferred option not mentioned by the IMF is, of course, to nationalise the banking sector or create a national bank and drive the bad private banks out of business using the public bank as the lure for customers.

3. “government-sponsored programs to restructure private debt-which can include measures such as subsidies for creditors to lengthen maturities, guarantees, direct lending, and asset management companies-can create incentives for the cleanup to take place” – in other words, more corporate welfare from the fiscal authority.

I would oppose any such measures. The bad private debt should take its usual ‘market’ course and the public sector should concentrate on policies that will increase employment and divert resources away from these unproductive and crisis-riddled activities.

However, the IMF thinks that fiscal interventions should be complemented by “Structural policies” which “prevent excessive leverage from building up in the first place”.

The appropriate structural policies in this regard (even though the IMF doesn’t discuss them) would be to force banks to once again become simple banks rather than speculative enterprises.

Please read the following blogs – Operational design arising from modern monetary theory and Asset bubbles and the conduct of banks for further discussion.

But there is one other major structural reform that the IMF doesn’t mention and that is related to the way the distributional process operates in the labour market.

As I’ve noted previously – see The origins of the economic crisis – the neo-liberal era has been characterised by a widening gap between productivity growth and real wage growth such that in some countries real wages have barely grown it all over the last 20 to 30 years whereas productivity growth has forged ahead.

Historically, these two growth rates were proportional with each other, which made sense, because as the economy increased its productive capacity (per unit of input), it also increased the purchasing power in real terms of workers.

Given that consumption expenditure is the major source of aggregate spending, this proportionality was important because it prevented the system from entering so-called ‘realisation’ crises, where the productive capacity outstripped the spending capacity.

As governments, acting as agents for capital, introduced repressive legislation designed to suppress the capacity of trade unions to realise real wages growth for their members, the gap between productivity and real wages growth began to grow – around the mid-1980s.

The only way that the system could continue to grow as the purchasing power of workers lagged behind the capacity of the system to produce more and more output was to foist increasing levels of credit onto the workers.

The labour market deregulation that suppressed real wages growth was accompanied by the financial market deregulation which opened the floodgates for the financial engineers who took advantage of the lax conditions relating to credit and the credit binge began in earnest.

The single most important policy change in this regard has to be to force real wages to grow in line with productivity growth so that workers can enjoy real consumption growth without the need for expanding credit and hence indebtedness.

The IMF, of course, is silent on this issue.

Finally, while the IMF is now advocating some renewed fiscal policy activism, it continues to perpetuate neo-liberal myths.

They claim that:

In particular, entering a financial crisis with a weak fiscal position exacerbates the depth and duration of the ensuing recession. The reason is that the absence of fiscal buffers prior to the crisis significantly curtails the ability to conduct countercyclical fiscal policy …

This is arrant nonsense – neo-liberal Groupthink nonsense.

A currency-issuing government does not reduce its capacity to purchase whatever is for sale in its own currency at any time by dint of running continuous fiscal deficits in the past. Fiscal surpluses in the past do not provide any extra capacity for such a government to spend in the future.

To say otherwise is a lie.

The IMF thinks that bond markets will not allow a government to spend during a crisis if it already has ‘high’ levels of outstanding debt liabilities.

They might use Greece as an example, which would compound the error of their reasoning.

Greece is a non-currency-issuing nation – it uses a foreign currency and has to borrow to cover spending beyond its taxation revenue.

Non-Eurozone governments such as Japan, the US, the UK, Australia and hundreds more do not use foreign currencies. The bond markets in those countries can never restrict the government’s capacity to spend and, for example, buy up all idle labour (the unemployed).

The bond markets can refuse to buy the debt being offered by such a government, whereupon an E-mail or a SMS message gets sent to the central bank telling them to keep crediting bank accounts on behalf of the treasury irrespective.

If rules and regulations have to be altered to accomplish that – that is, a relaxation of voluntary constraints the government has in place to regulate spending behaviour – then those changes will follow pretty quickly.

Conclusion

It is interesting to see how the internal tensions within these multilateral institutions, who were so categorically found to be incompetent with the onset of the GFC, are forcing them to advocate policies that they had previously eschewed.

But I wouldn’t be so hopeful that these institutions are undergoing fundamental ideological changes.

They still represent call neo-liberal values and these pragmatic retreats into reality will be ephemeral.

That is enough for today!

(c) Copyright 2016 William Mitchell. All Rights Reserved.