The collapsing intellectual case for the government’s economic strategy
The IMF’s Chief Economist Olivier Blanchard wrote a blog post yesterday that I can’t recommend highly enough. He considers why 2011 has been an extremely difficult year for the global economy and draws four lessons for the future. The third of which is so important that’s it worth quoting in full:
Third, financial investors are schizophrenic about fiscal consolidation
They react positively to news of fiscal consolidation, but then react negatively later, when consolidation leads to lower growth—which it often does. Some preliminary estimates that the IMF is working on suggest that it does not take large multipliers for the joint effects of fiscal consolidation and the implied lower growth to lead in the end to an increase, not a decrease, in risk spreads on government bonds. To the extent that governments feel they have to respond to markets, they may be induced to consolidate too fast, even from the narrow point of view of debt sustainability.
I should be clear here. Substantial fiscal consolidation is needed, and debt levels must decrease. But it should be, in the words of Angela Merkel, a marathon rather than a sprint. It will take more than two decades to return to prudent levels of debt. There is a proverb that actually applies here too: “slow and steady wins the race.”
If I have this right, Olivier is suggesting that harsh austerity programs may be literally self-defeating, hurting the economy so much that they worsen fiscal prospects.
Brad DeLong goes further and outlines a simple model of how cutting government spending (during times when the economy is depressed and interest rates are near the zero-bound (as currently) can easily lead to a deterioration in the fiscal position. In simple terms – cutting government spending too quickly when the economy is weak can lead to a larger not a smaller deficit.
This is, I would argue, reasonably well know. As I wrote yesterday the latest independent economic forecasts show exactly this effect – growth lower, unemployment higher and a larger deficit.
The real bombshell though is Blanchard’s almost throwaway line:
Some preliminary estimates that the IMF is working on suggest that it does not take large multipliers for the joint effects of fiscal consolidation and the implied lower growth to lead in the end to an increase, not a decrease, in risk spreads on government bonds.
This is of huge importance. The IMF are suggesting that in certain cases (presumably like those we currently find ourselves in, with weak growth, very low central bank interest rates and depressed demand) that cutting government spending can mean the yield on government bonds rises rather than falls.
This makes intuitive sense. If cutting government spending means weaker growth and a higher deficit then it would be perfectly rational to demand a higher interest rate in return for holding government debt.
This is potentially something of a ‘game-changer’ in terms of economic analysis – all the more so because it is coming from the IMF rather than one of the ‘usual suspects’
Nicola has argued that the OBR’s own analysis shows both the room for a temporary fiscal expansion and the fact that higher bond yield’s won’t have a significant impact on the UK’s overall debt position. I have argued that it is unlikely that a temporary, timely and targeted fiscal stimulus would lead to any sort of panic in the bond market.
But the IMF is going a step further and suggesting the government’s current strategy might actually be leading to higher yields than would be the case with a stimulus.
To understand the whole significance of this one has to look back on Osborne’s justifications for his policy.
So a credible fiscal consolidation plan will have a positive impact through greater certainty and confidence about the future. Businesses can expand safer in the knowledge that an out of control budget is not going to lead to ever higher taxes. Consumers can spend safer in the knowledge that mortgage rates will remain lower for longer
The experience of the past 18 months has proved ‘expansionary fiscal contraction’ to be a myth. Cutting government spending during a downturn does indeed lead to weaker rather than stronger growth.
The Chancellor has therefore switched his arguments but not his policies. He now argues that cutting government spending does have an impact on growth but he has no choice
but to do this or interest rates will rise.
And people know that promises of quick fixes and more spending this country can’t afford, at times like this, are like the promises of a quack doctor selling a miracle cure. We do not offer that today. What we offer is a Government that has a plan to deal with our nation’s debts to keep rates low
The IMF is now casting doubt on this notion, arguing that cutting can lead to higher, not lower, yields on government debt.
Empirically the Chancellor’s strategy has failed, the whole intellectual edifice behind it now risks crashing down too. I for one am eagerly awaiting this promised new analysis from the IMF.