I read an article in the Financial Times earlier this week (September 23, 2023) -…
Today I was in Sydney for some meetings and also I attended the first sessions of the Society of Heterodox Economists conference. I took some papers with me to read on the train coming back to Newcastle. Sitting on the train for 3 hours presents a good opportunity to catch up on back-reading. While I would have been better off reading the Phantom comic that I had in my bag, I chose, instead, to read the latest fiscal analysis provided by the IMF. The paper I discuss here is typical of the whole debate at present. It cannot provide any evidence to advance its scary “deficit and public debt” vision, but it doesn’t let the facts get in the way of presenting it anyway. My professional assessment. These guys should get a real job.
The IMF has released a new series which they are calling Staff Position Notes which they say are intended to:
… showcase new policy-related analysis and research by IMF departments. These papers are generally brief and written in nontechnical language, and are aimed at a broad audience interested in economic policy issues.
So you would hope that they would at least canvas the wider debate rather than just push the IMF line. Your hopes would be in vain. I was reading some of these papers coming back from Sydney today. I had some meetings down there one of which involved talking to The Greens about their neo-liberal macroeconomic tendencies.
If I guage the sentiment expressed to me correctly then there is an internal struggle going on between the neo-liberal forces and others within the party who understand that you cannot aim to balance the budget over the business cycle as a matter of policy if the country is running a current account deficit and the private domestic sector is wanting to net save.
The Greens are going to organise some sort of workshop in the early new year to thrash these issues out. I agreed to participate.
Anyway, one such Staff Position Paper (09/22) by IMF researchers Carlo Cottarelli and Jose Viñals was entitled A Strategy for Renormalizing Fiscal and Monetary Policies in Advanced Economies, was representative of the quality (not) of the arguments that the IMF is now pushing as the crisis bottoms out (at this stage).
The IMF paper starts with its introductory proposition
It is too soon to exit from crisis-response policies – prospects remain highly uncertain – and, indeed, further stimulus may be needed. But it is not too soon to clarify the strategy that governments and central banks intend to adopt to return their budgetary and monetary positions to normalcy when the moment comes. Failure to do so would destabilize expectations and weaken the effect of the fiscal and monetary support now being provided.
So crucial to the discussion is some concept of budgetary and monetary normalcy. Further, the IMF is leading the charge in trying to concoct contraction plans even though they know that we will not know how much discretionary fiscal stimulus is needed once the automatic stabilisers reflect their true full employment levels.
Note that anything these agencies (IMF, World Bank, OECD, Treasuries, Central Banks) say about the “normal” levels of the automatic stabilisers will be biased towards excessive contraction of fiscal policy because they will be based on flawed NAIRU estimates (to derive potential GDP estimates) which will be well above the true level of labour underutilisation that would coincide with full employment (frictional unemployment only; zero underemployment and zero hidden unemployment). Please read my blog – Structural deficits and automatic stabilisers – for more discussion on this point.
The other problem that you immediately see emerging in the public debate is that these so-called informed interventions help to condition expectations. The more crackpot articles you read from these institutions that say the deficits are too large and public debt levels are dangerously high the more people start to believe it and the narrative inherits self-fullfilling properties.
In that sense, these characters should be called to account for spreading nonsense that they deliberately use to condition the debate such that their ideological preferences are advanced.
To frame the paper, the IMF authors say:
In sum, the crisis has weakened in a major way the fiscal accounts of advanced economies, at a time when they were targeted to improve to prepare for the demographic shock. What are the risks, if no adjustment takes place? At best, assuming that market confidence in fiscal solvency is not shaken, this will cause higher real interest rates and crowding out (as the economy recovers). At worst, this could lead to concerns that the debt will be “inflated away” or that default is inevitable. If so, debt maturities would shorten, risk premia rise and, ultimately, refinancing crises could emerge. Thus, while the current crisis is rooted in the private sector, the next could be fiscal and, arguably, more severe as no entity would be available to bail out the public sector.
True, default has not occurred in advanced economies since the 1930s. But the fiscal challenge is unprecedented. And while inflation expectations and interest rates on government paper remain low at the moment, recent experience has shown that markets often react late and suddenly to persistent disequilibria.
So the only advanced sovereign default occurred during the convertible currency system of the 1930s at a time of deep crisis. You get this uneasy feeling when you read this sort of rhetoric – sort of like this – there hasn’t been a default under the fiat monetary system; inflation is low; interest rates are low; capacity utilisation rates are low; labour underutilisation rates are high; but we cannot let that get in the way of our religious belief that a second coming is near – even though all the signals would not allow a reasonable person to conclude that. And, true, we cannot really outline a situation where a sovereign government would default.
But we have our story and we are going to stick to it. You have to feel sorry for the economists who tout this nonsense. If they were to open their eyes and recognise the reality in front of them then they wouldn’t have anything to say.
The paper is full of these double-takes – the evidence implies benign outcomes but you better be scared anyway because our flawed theory asserts you should be.
For example, on page 7 they say that “Inflation will likely become an issue only once economies are well on the road to recovery, so monetary tightening is not an immediate concern in the advanced economies. This said, it cannot be ruled out that inflation could reemerge while the economy is still weak”.
Sure, the sky might fall in. But a behavioural and structural understanding of inflationary processes would say that it is highly unlikely that inflation will re-emerge in the present recessed states that the advanced world finds itself stuck in. So they just have to say the danger “cannot be ruled out” because they have to keep the reader on their guards – the neo-liberal way.
There was a footnote attached to the last quote that amused me. It said:
It is sometimes argued that the risk of a fiscal crisis in advanced economies should not be taken too seriously because investors do not have many alternatives on how to store their wealth (other than, say, gold). However, a flight out of advanced economies into emerging markets with better fundamentals is not inconceivable. In any event, shifts in investments across advanced economies (say, between euro and dollar assets) could disrupt financial markets and exacerbate the refinancing problems of advanced economies experiencing a depreciation.
So exactly how will a flight of “what” out of advanced economies occur even though it is only asserted as being “not inconceivable”? The language throughout the paper is always … there is nothing to suggest it will happen but if it does the sky will fall in!
Further, which refinancing problems are we talking about here? And what about the positive real adjustments that typically accompany an exchange rate depreciation?
The IMF authors also claim that there is a “tail risk that the enormous and ongoing increase in public debt” will push central banks to “provide easier lending terms” which will be … ultimately be inflationary. Okay, so the treasury is going to bully the central bank board into lowering interest rates to make the debt servicing cheaper … that would actually be a good idea – that is, bringing monetary and fiscal policy into concert.
There is no evidence that low interest rates generate more inflation than higher interest rates. And further fiscal policy has the capacity to discipline the inflation process should that problem arise.
The IMF further argues that central banks face losses following their balance sheet expansions and this will increase pressure on them to be brought back into government. However, they claim that now more than ever central banks have to focus on inflation targetting. Please read my blog – Inflation targeting spells bad fiscal policy to see why we should abandon this modern obsession with inflation targetting. There is no evidence that countries that adoped inflation targetting have enjoyed lower or less variable inflation trajectories.
On Page 8, the IMF paper begins to focus on “Returning to Fiscal Normalcy: What Does It Mean and How Can It Be Done?” – which is the main reason I was interested in reading the paper in the first place.
They introduce what they posit is the legitimate goal of fiscal policy. Any reasonable person would agree that the goal of fiscal policy – the primary tool of our elected governments – is to act in our best interests to ensure aggregate demand is sufficient to fully employ the available capital and labour resources and to pursue the political mandate we have vested in it to achieve an agreed balance between the public and private allocations of resources.
While that is the way an economist would express it, it could easily be translated for public consumption to mean the government should ensure there are enough jobs for all those who want them and that they provide high quality public services and regulation of private activity along the lines that they indicated when they sought our vote at the last election. Pretty simple really.
Well apparently not so simple when it comes to the IMF. Their boffins say that instead we have to ask:
What should be the goal of a fiscal strategy aimed at ensuring that markets remain confident in the solvency of the fiscal accounts?
Where do you start with that? First, the irrational belief fostered by the vested interests of capital and its media hounds that a sovereign state faces a solvency risk is elevated to prominence, despite the IMFs own admission that we haven’t seen any sovereign default since the 1930s when currencies were convertible.
Second, exactly which markets are we talking about? Presumably, the institutions that add very little if anything to real income and employment and conspired to bring about this financial then real economic mess in the first place. The sort of nonsense behaviour that the IMF fears should be regulated into illegality, if the governments of the World had any stamina.
The IMF then suggest there are three approaches to this question.
The first would be to stabilize public debt ratios at whatever level has been reached as a result of the crisis. Is living with high debt an option? In principle, yes. Countries such as Italy and Japan, with debt ratios in excess of 100 percent for many years, have so far not experienced a full-blown debt crisis. But they have also grown slowly over the past two decades. While we do not know for sure whether their weak growth was caused in part by high debt, their experience, as well as the case of emerging economies where an extensive literature has found evidence of “debt overhang” effects, suggests that this may be the case.
You see again they want to push a line that high levels of public debt are bad but cannot really find examples to substantiate it. The known “bad-guys” (Italy and Japan) have not defaulted and have not been crippled by their public debt levels. There growth rates have been at the lower end of the spectrum although there are several advanced economies that are in the same camp as them. There is very little correlation between growth performance and public debt levels across the entire OECD bloc.
Further, the extensive literature on “debt overhang” mostly fails to construct the problem correctly. Many emerging economies have been crippled with conditions imposed on them by the IMF which accompanied loans to their governments. The whole development ideology has been biased towards the view that subsistence activity is to be eliminated in favour of export-oriented growth.
World bank and IMF programs have wrecked the sustainable economic fabric of many developing countries and forced them to carry high public debt in order to “restructure their traded-goods sector. Then when world markets punish these countries for oversupply (falling prices) and/or crop failure/drought etc brings the strategy, the IMF has stepped in to extend even more credit. Each time it offers these structural adjustment programs the IMF imposes increasing austerity on the ability of the country to conduct fiscal policy and offer improving public services (health, education etc). This makes it even more difficult for the nation to grow quickly.
So it is hard (and unbelievably “rich”) to argue that the rising public debt is the causa causus of the stagnant growth. What would have these nations been able to achieve if the IMF had not have put these nations into a fiscal straitjacket? None of the studies that I have read in detail (and I am aware of all the important research efforts in this area) have taken that into account.
Finally, upon what basis would any consensus about a “correct” public debt ratio (debt to GDP) be achieved? No macroeconomist can derive any percentage that has qualities that are “better” than any other ratio. What is the difference between 20 per cent, 30 per cent, 40 per cent, 100 per cent, etc? There is no economic theory that can offer any advice on this.
So when you read or hear mainstream economists talk about high debt ratios you should ask them – in relation to what? Is 20 per cent high? Obviously, 20 per cent is 4 times lower than 80 per cent, but what is so magic about the factor of 4 in this context.
If there is no solvency risk then the only question is to consider how the interest servicing payments impact on aggregate demand. They clearly provide incomes to the non-government sector so a higher volume of payments would seem to be a good thing.
If they add to much to aggregate demand growth relative to the real capacity of the economy to absorb the demand – meaning inflation becomes the issue – then the government has plenty of options. For example, it might decide that the private sector has to much purchasing power and can attenuate that by increasing taxes. It can also target the increase tax take to ensure equity principles are maintained while draining aggregate demand.
It can also cut other public spending if that is deemed appropriate. For example, at the level of economic activity that we are considering, real income growth, profits and employment levels would be high and a major retrenchment of corporate welfare measures would be clearly possible. But whatever is targetted the fact remains that the government has the capacity to manage the situation without precipitating a major decline in activity.
We should always understand that in a modern monetary economy the only risk in this context is inflation – never insolvency.
The IMF then resume their “there is no known risk” but “we will say there is anyway” approach. They say:
Two other considerations indicate that stabilizing debt at high levels is not a good idea. First, the effects on the world economy, including on real interest rates, of having many advanced economies running 100 percent debt ratios are unknown. The relatively benign experience of just two countries, Italy and Japan, cannot be extrapolated to the whole group. Second, stabilizing debt at high levels would reduce the flexibility of fiscal policy to respond to future shocks. Indeed, Italy’s response to the recent crisis was constrained by its high debt.
First, Italy’s response to the recent crisis was not constrained by its high debt. It was constrained because it held high levels of public debt within a ridiculous and voluntarily-imposed straitjacket called the EMU. The problems relate to the way in which the Maastricht Treaty imposed the ideologically-driven Stability and Growth Pact on the states that decided (stupidly) to join up. If Italy had have remained a sovereign nation in the Lira it would have been able to respond to the current crisis in a totally different way.
If I had have been the Italian PM under conditions of fiscal sovereignty, the policy response that I would have implemented would have allowed the country to avoid the worst impacts of the global downturn – public debt ratios notwithstanding. However, perhaps the call girl industry might have been less bouyant.
Second, the IMF admit they do not have any basis to assert anything about the impacts of public debt ratios on the world economy. So how can they suggest it is a “bad idea”? Obviously, this is just the opinion of the IMF bosses and the apparatchiks who write these papers and holding out that they are evidence-based and actually worth something just follow suit. Imagine their plight – they have to conclude that public debt ratios are bad but they have no evidence to support that claim and so they have to sit at their desks – trying to come up with a form of words that their bosses will approve of which maintain an air of seriousness.
I just read this stuff as comedy – and it would be if it wasn’t so influential and destructive of the life potential of millions of less advantaged people around the World.
Third, high debt levels do not reduce the flexibility of fiscal policy. What does that mean anyway? That governments cannot spend freely? Sovereign governments can spent whenever there is goods and services available for sale. A sovereign government has no greater or lesser ability to spend today, if it carries a deficit or surplus from the previous period. This capacity is also not diminished or enhanced if the public debt ratio is higher or lower than some other country.
Sure, the interest service payments have to be made and add to aggregate demand. They can clearly be moderated by interest rate policy. But irregardless of the conduct of monetary policy the only issue that the fiscal authority has to be aware of is – as explained above – the need to balance nominal demand growth with the real capacity of the economy to absorb it – and to ensure that the mix of goods and services in final output satisifies their political agenda (with rspect to public/private composition and other equity matters).
As I noted above, a sovereign government has the capacity to make these adjustments whenever it likes, although that is not the same thing as saying that it can politically always operate in an unconstrained manner
The IMF then examine the second approach to fiscal normalcy which would involve:
… targeting a return to pre-crisis public debt levels. After all, if the problem was created by the crisis, a return to pre-crisis levels should be regarded as a reasonable goal. This approach is appealing and is a minimum requirement of any viable strategy. This said, even before the crisis, debt ratios in some advanced economies were too high. And debt dynamics was unsustainable in most of them because of demographic trends. Therefore-now that the crisis has further exposed fiscal vulnerabilities and with the demographic shock approaching-a preferable strategy should aim at placing the fiscal accounts on a sustainable path, one that is indeed stronger than before the crisis, and that ensures the resilience of the fiscal accounts to the demographic shock. Thus, the goal should be to announce a comprehensive and credible strategy aimed at lowering over time public debt to levels regarded as prudent for advanced economies-at least pre-crisis level for countries without excessive debt-and to keep them there during the following decades.
First, the problem is just asserted based on the simpleton notion that any public debt is bad so higher public debt is worse. As noted above, there is no robust framework within any economic theory (credible or otherwise) that can substantiate that proposition. It is a religious statement which is backed up by spurious analysis that uses the flawed government budget constraint approach.
Second, upon what basis do they conclude that “debt ratios in some advanced economies were too high”? There is no robust basis for concluding that. Another religious statement.
Third, once again the mainstream is going to (mis)-use the intergenerational issue to push the “public debt is bad” barrow. I have examined the demographic debate several times in past blogs. For starters, please read my blog – The myths of the ageing society debate – for more discussion on this point.
The conclusion that you reach once you understand the problem properly is that it is not a financial problem for government. It may be a major political headache dealing with the changing public service requirements of an ageing population. Whether the older cohorts get the access to public spending that they desire will be determined via the political process. As long as there are real resources available the national government will be able to command them via spending. It is simply untrue to conclude otherwise.
The real danger is that governments, driven by these mythical “prudent debt level” aspirations, will impose unnecessarily harsh restrictions on fiscal policy which will dampen income growth and reduce the capacity of the non-government sector to save. In turn, the lack of private saving will impose greater demands on public services in the future which will mean that the political challenge will be that much greater.
After admitting that in “the past, many countries succeeded in lowering debt from very high levels in an orderly way” (by ensuring GDP growth was robust enough), the IMF authors then introduce their next scare argument:
It is thus critical to avoid that concerns about high deficits and debt cause a surge in interest rates, as this would lead to snowballing effects. Indeed, there is significant evidence that the effect of high deficits and debt on interest rates is especially pronounced when high deficits lead to a perception of “regime change,” that is, of a more relaxed attitude toward fiscal solvency. This is why it is crucial that countries clarify their strategy to ensure fiscal solvency. What should be the features of such a strategy?
The central bank sets the short-term interest rate. It can if it wants to influence the long-maturity interest rates by appropriate temporal shaping of its public debt issuance.
Further, there is no acceptable empirical evidence that budget deficits and public debt ratios “cause” higher interest rates. We know that budget deficits place downward pressure on short-term interest rates and the central bank has to issue public debt to drain the excess reserves to ensure the overnight interest rate is consistent with its monetary policy target rate.
I have also never seen any acceptable research to pin down this “throw away” proposition that there is a “regime change” in markets toward “fiscal solvency”. That is just a made up claim.
I will spare you the agony of going through all there proposals, predictable though they are. For example, they claim “strengthening institutional arrangements such as medium-term fiscal frameworks, fiscal responsibility laws, fiscal rules, and fiscal councils would be important.” Please read my blog – Fiscal rules going mad … – for an analysis of the use of fiscal rules. These rules are always expressed in terms of some arbitrary deficit/GDP ratio (or similar) and ignore the reality that the fiscal balance is endogenous and determined by the spending preferences of the non-government sector.
There is no pre-determined fiscal balance that can be specified. The final fiscal outcome should just be an expression of the government’s policy design aiming to maintain high levels of employment. Whatever the fiscal position that emerges after that goal is achieved will be an expression of the trade position of the nation and the saving desire of the private domestic sector.
All funding to the IMF should be withdrawn and the staff released to pursue more productive employment.