Sunday, October 18, 2020

More on the IMF's recanting austerity

In a recent post, I wrote about the IMF discarding its austerity mantra in its latest World Economic Outlook Report. The FT has a detailed article on the about-turn. The author writes:

Carmen Reinhart, the eminent economic historian who is now chief economist at the World Bank, recommended countries should borrow heavily during the pandemic. “While the disease is raging, what else are you going to do?” she asks. “First you worry about fighting the war, then you figure out how to pay for it.” Ms Reinhart was a leading advocate of austerity a decade ago after publishing a research paper which concluded that at a similar stage in the 2008-09 financial crisis — to where we are now — high levels of public debt undermined economic performance. It concluded that, “traditional debt management issues should be at the forefront of public policy concerns”.

The author mentions three reasons for the change in the IMF stance. One, the experience post the global financial crisis when fiscal policies  remained relatively restrained while monetary policy was assigned the task of restoring normalcy. It didn't quite work. Now, central bankers urge that monetary policy must work in tandem with fiscal stimulus.

Two, interest rates have fallen steeply over the years and this makes a higher level of borrowing feasible. One wonders whether the fiscal deficit target of 3 per cent  of GDP under the Maastricht Treaty and the notion that debt to GDP in the advanced economies should be under 90 per cent hold water any more. We need to consider alternative indicators: say, the interest to GDP ratio or the ratio of interest to total government income. Better still we have to take a view on (r-g), the differential between the interest rate and  the GDP growth rate. If the interest rate has fallen more than the GDP rate of, say, two decades ago, then the old rules for fiscal policy no longer apply. There is, of course, the interesting question of why interest rates have fallen in the advanced world despite rising public debt and a huge expansion in liquidity- on that, more in a future post.

Three, there is little public appetite for austerity now after the havoc visited on jobs post the global financial crisis. The article notes that even conservative Germany takes pride in the fiscal stimulus it provided post the pandemic.

Carmen Reinhart's prescription, however, may not enthuse Kenneth Rogoff, Reinhart's co-author of the famous book on debt crises, This time is different. In an article in the Guardian written last December, Rogoff gives three reasons, not all of them persuasive. why one must be wary of assuming higher debt given low interest rates.

First, governments may be able to service higher market debt but they may be jeopardising their obligations under social security systems. Well, I guess the measurement issue can be addressed by including contingent liabilities, such as pensions, in government's debt obligations. Let’s monitor the total, public debt plus pension liabilities.

Secondly, the next crisis may be very different in character, say, global climate change or a cyber war, with unpredictable implications for growth and interest rates. This strikes one as something of a bogey. One is not saying the interest burden on government should rise. Let the interest burden in normal times remain the same as before after adjusting for lower interest rates. That means we are at the same level of risk as before in confronting unpredictable crises of the sort Rogoff talks about. Again, the debt level is the wrong indicator to target.

Thirdly, Rogoff argues that "aggressive experimentation with much higher debt might cause a corresponding shift in market sentiment – an example of the Nobel laureate economist Robert Lucas’s critique that big shifts in policy can backfire owing to big shifts in expectations." Well, such a shift has not happened  for well over a decade post the crisis. Markets are not factoring in higher inflation and interest rates consequent to the shift in policy. If it does, policy makers have room to adjust. 

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