Thursday, October 15, 2020

No, we don't need austerity, says IMF!

 The IMF does not prescribe austerity any more- at least not for the advanced economies.

The advanced economies have resorted to a large fiscal stimulus in response to the pandemic. The IMF World Economic Outlook, October 2020, estimates that discretionary stimulus amounts to 9 per cent of GDP in advanced economies (compared to 3.5 per cent of GDP in emerging economies). 

Public debt in advanced economies is poised to rise by a full 20 percentage points to 125 per cent of GDP by the end of 2021 (in emerging economies, the figure will be 65 per cent of GDP). Yet, the IMF thinks the rise in debt will not be a big deal for the advanced economies.

Why? Because interest rates have fallen to close to zero in the advanced world, so more debt does not translate into an unsustainable interest burden. There's more debt but it's cheaper now. As a result, by 2025, overall deficits will be back to pre-pandemic levels without any cuts in public spending, according to a report in the FT:

Most advanced economies that can borrow freely will not need to plan for austerity to restore the health of their public finances after the coronavirus pandemic, the IMF has said in a reversal of its advice a decade ago. Countries that have the choice to keep borrowing are likely to be able to stabilise their public debt by the middle of the decade, Vitor Gaspar, head of fiscal policy at the fund, told the Financial Times. That would mean they would not have to raise taxes or cut public spending plans.

As the report notes, this is a change in the IMF's position with respect to what it had advocated after the global financial crisis.

The IMF is now urging advanced economies to spend their way out of trouble. Growth will take care of debt sustainability because the growth factor 'g' will outweigh the interest rate factor 'r'. 

But the point is that this - the positive gap between growth and interest rate- is not happening by accident. It is happening because central banks are intervening in the debt markets to make it happen. Central banks first allowed the policy rate to drop to close to zero at the lower end of the yield curve. Then, they resorted to Quantitative Easing which is the purchase of a defined amount of government bonds from investors. They have followed this up with Yield Curve Control, which is defining the interest rate they want to see at the higher end of the yield curve.

If central banks elsewhere can make it easier for governments to borrow, why is it a problem if the RBI does the same here? Why is the management of interest rates to facilitate more government borrowing and spending such an issue here? Why the criticism that fiscal dominance dictates monetary policy?

There is merit in what the proponents of Modern Monetary Theory are saying. They say that it's not true that government borrowing drives up interest rates because there is a limited pool of savings to finance it. When the government spends, the interest rate falls, it does not rise. There is an accretion to bank reserves at the central bank. This causes the inter-bank rate, which is the anchor rate in advanced economies, to fall, thereby facilitating more government borrowing and spending.

There is only one constraint in central banks allowing interest rates to fall: the fall in interest rates must not spell higher inflation. This is a constraint in India at the moment, given that inflation has been at over 6 per cent in recent months, that is, beyond the upper bound of the the inflation target framework. However, once the inflation rate falls, there is nothing that stands in the way of a cut in the policy rate. And until then, managing yields at the higher end of the curve is par for the course.

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