More on the IMF and fiscal policy and Blanchard's rethinking of macroeconomics

I wrote a few days ago on the IMF's persistent views on fiscal policy, and how these views are rooted in an unchanged perception of how the macroeconomy works.  The new Fiscal Monitor tends to support my previous position. The policy recommendations, in the case of advanced economies, suggest that:

"Fiscal efforts in the last five years have stabilized the average debt-to-GDP ratio. Nevertheless, it is still expected to exceed 100 percent of GDP at the end of the decade. It is important to continue to reduce debt to safer levels and rebuild fiscal buffers.

Further fiscal adjustment is needed in most advanced economies to bring down debt ratios to safer levels... reining in age-related Debt (percent of GDP) spending could reduce longer-term fiscal risks."

Why debt ratios have to fall is an incognita, given that we now know that there is no evidence for a 100 percent, or any other for that matter, threshold that leads to lower growth. And it's really annoying that they still want to cut spending on pensions, and perhaps push for privatization (even Chile's famous case now is not an example anymore). For developing economies:

"the time has come to rebuild the fiscal buffers used during the crisis, and to strengthen the institutional fiscal policy framework."

In this case, the notion is that inflation is around the corner, and, hence, that 'emerging' markets are close to full employment. In sum:

"Fiscal consolidation is called for in many economies, advanced and emerging, to reduce high public debt ratios and rebuild fiscal buffers used during the crisis."

More importantly the IMF warns that the higher rates of interest in advanced economies might lead to a crisis in the developing world. They say:

"The historical record indicates that the unwinding of monetary policy support in advanced economies can have a material impact on emerging market public debt costs and on the incidence of fiscal stress episodes."

This suggests that emerging markets have to make an additional effort to promote fiscal adjustment, since the interests costs will go up soon. I'm not only very skeptical about the idea that developing economies are close to their potential output levels, but also about the risk that interest rates will grow substantially in advanced economies. Just check the IMF growth forecasts for the developed world, and you'll see that the probability of higher rates of interest anytime soon are exaggerated.

In addition, Blanchard, the IMF counselor, has published a new paper in line with his previous effort to re-think and evaluate macroeconomics. The interesting thing is that now he suggest more openly that there is a certain consensus between Rational Expectations authors like Lucas and New Keynesians like him and say Krugman. He tells us that:

"the old fresh water/salt water distinction has become largely irrelevant... Fifty years ago, Samuelson (1955) wrote: 

'In recent years, 90 per cent of American economists have stopped being 'Keynesian economists' or 'Anti-Keynesian economists.' Instead, they have worked toward a synthesis of whatever is valuable in older economics and in modern theories of income determination. The result might be called neo-classical economics and is accepted, in its broad outlines, by all but about five per cent of extreme left-wing and right-wing writers.'

I would guess we are not yet at such a corresponding stage today. But we may be getting there."

The consensus is the New Keynesian (NK) model as represented by Clarida et al (1999) and Woodford (2003), neo-Wicksellian really, but that's another story. Funny thing though. According to him: "One striking (and unpleasant) characteristic of the basic NK model is that there is no unemployment!" He explains that this can be circumvented by assuming that:

"unemployment arises from the fact that the labor market is a decentralized market, where, at any time, some workers are looking for jobs, while some jobs are looking for workers... this implies that the wage—and by implication, the cost of labor, employment, and unemployment—depends on the nature of bargaining... It allows one to think about the effects of labor market institutions on the natural rate of unemployment."

Doesn't matter how much lipstick you put on a pig, it's still a pig. The search model proposed basically suggests that unemployment results from frictions, and it would still be true that to solve it, eliminating frictions and reducing wages would lead to the ubiquitous natural rate. Truly Gattopardo Economics, as Tom Palley has called it.

PS: The comic strip above, Mafalda, got it right back in the 1960s. Her mom asks her to pick up her knitted sweater she left on the floor, and she says that she doesn't need to obey, since in her playdate with her friends she was a president. Her mom, astutely as Mafalda perceives, tells her she is the World Bank, the Paris Club and the IMF. Even kids in the periphery know who is really in charge.

CEPR | Stimulus and Fiscal Consolidation: The Evidence and Implications

In a previous post, see here, Matias provided a graph that displayed the fiscal results for the US as a share of GDP from 1993-2014, along with a discussion of the misconception that democrats are nothing but tax/spend liberals. I thought it would be pertinent to post this paper by Dean Baker and David Rosnick providing conclusive evidence on the effects of stimulus packages and fiscal consolidation during the recent economic crisis.

From the abstract:

The first part deals with the most important literature on the subject, the consensus in the research of the past decade attests a clear counter-cyclical effect of stimulus packages during a prolonged recession. The second part deals with the impact of changes in government consumption and investment to growth. For this data for developed countries in 1980 are analyzed. Consistent with much of the previous literature have increased government spending during a crisis has a positive effect on economic growth. In addition, the period is simulated after the crisis, the multiplier effect is around 1.5. The third part focuses on the production potential, which has declined sharply due to the economic crisis. This would have to include a comprehensive model that analyzes the effects of an economic stimulus package with, since the effect could turn out relative to the size of the stimulus package as significant.

Read rest here.

Mark Weisbrot on Economic and Social Policy and the Problems of the Eurozone and European Integration

By Mark Weisbrot

It was not because of the power of financial markets or because the Germans didn't want to "help" the Greeks that Europe suffered through about three years of recurring crises, in which the continued existence of the euro was thrown into question, until August 2012. It was because the European authorities were using these acute crises and did not want to resolve them until they had extracted certain "reforms" from the weaker European economies (and possibly even some of the stronger ones, if we consider the European Fiscal Compact and what the French government has been doing recently). We know this because as soon as the European Central Bank (ECB) wanted to do so, it put an end to these crises in a matter of weeks, in July-August 2012, by effectively establishing a ceiling on the interest rates of Italian and Spanish bonds - something it could have done at any time in the prior three years.

Read the rest here.

Lessons Unlearned: Latvia Adopts Euro

Latvia officially adopted the euro to start off the new year. The prime minister has noted that although this is not necessarily a guarantee towards economic prosperity, it's an opportunity...I deem it a death sentence - For more on the sinking ship that is the euro, see here.

Paul Krugman's The Phony Fear Factor

Much has been said on how economic demagoguery continues to reign supreme, particularly by heterodox writers, so I won't delve much into this topic. Nevertheless, it is interesting to see that in his NYT op-ed, Paul Krugman, a pretty mainstream economist, disparages the 'confidence fairy' by citing Kalecki's “Political Aspects of Full Employment” (a Monthly Review link, interestingly enough). Though, Krugman somehow can't see much of Marx in Kalecki...does he not want to see it?

From the article:

"We live in a golden age of economic debunkery; fallacious doctrines have been dropping like flies. No, monetary expansion needn’t cause hyperinflation. No, budget deficits in a depressed economy don’t cause soaring interest rates. No, slashing spending doesn’t create jobs. No, economic growth doesn’t collapse when debt exceeds 90 percent of G.D.P. And now the latest myth bites the dust: No, “economic policy uncertainty” — created, it goes without saying, by That Man in the White House — isn’t holding back the recovery. 

First, however, I want to recommend a very old essay that explains a great deal about the times we live in.The Polish economist Michal Kalecki published "Political Aspects of Full Employment" 70 years ago. Keynesian ideas were riding high; a “solid majority” of economists believed that full employment could be secured by government spending. Yet Kalecki predicted that such spending would, nonetheless, face fierce opposition from business and the wealthy, even in times of depression. Why?"

Read rest here.

PS: Check also this earlier entry on Kalecki's paper.

Fiscal consolidation, what does it mean really?

There are a few ways you can look at the term fiscal consolidation. Fiscal consolidation is often (in IMF-speak) equated with lower spending and higher revenues, which are policy instruments not outcomes. A more rational way of looking at consolidation is that it is about lower deficits and debt, which are outcomes. The point is that in general it is expansionary fiscal policy (higher spending and lower taxes) that lead to fiscal consolidation (lower deficits and debt), since expansionary policies increase income and revenue.

Hence, lower spending and higher taxes should be properly called fiscal austerity. And austerity, even if you do not follow functional finance, is contractionary. Mind you, it is not just the IMF that confuses consolidation with austerity.

Larry Summers in his recent op-ed on British economic policy says that:

"Britain must change the pace of fiscal consolidation to stand a chance of avoiding a lost decade. Rather than starving public investment, now is the time to add to confidence by making plans for structural reforms to contain the growth of public consumption spending over time. It is also time to take overdue measures to promote exports and, after years of appropriately low investment, to restart housing investment. But when demand is needed for growth and the private sector is hanging back, the first priority must be for the public sector to stop exacerbating the contraction."

Yes, he wants more spending (or lower taxes, God knows). But not much. Note that this continues to be the position of the IMF, even if the IMF has sort of admited that fiscal multipliers are larger than they previously thought (something that has made Krugman very happy; here too). In the last IMF Fiscal Monitor (October, 2012) you can read:

"With downside risks to the global economy mounting, policymakers must once again tread the narrow path that will permit them to continue strengthening the public finances while avoiding an excessive withdrawal of fiscal support for a still-fragile economic recovery."

I for one think that Europe and the US need a huge fiscal stimulus, and forget about consolidation. Consolidation is the result of economic growth and fiscal expansion is the best way to get it.

PS: And by the way, that's what was said in the Trade and Development Report 2011, which basically was a reply to the IMF's lukewarm pro-austerity views.

Europe’s Adjustment: How much has happened?

Austerity to reduce spending, and decrease the need for imports, and liberalization reforms to reduce real wages, and promote internal devaluation, have been going on for a while in the European periphery to promote rebalancing, that is, to reduce the current account deficits and allow for continuous service of the debt.

How much fiscal adjustment and wage reduction has already been pushed by the Troika (ECB, EU, IMF)? Quite a bit in fact. Figure 1 below shows the fiscal adjustment (all data from the European Commission’s Statistical Annex of the European Economy, Spring 2012). [Note that the crisis was not fiscal]

Read the rest here.

The IMF and stylized fiction

The IMF has posted their Top 20 list of most popular entries since the launch of the blog. At #3 they have the Ten Commandments of Fiscal Adjustement in Advanced Economies, which is from 2010, but still worth reading, since their views have hardly changed. I am not going to go through the whole list, even though it does merit careful analysis. I want just to point out a few problems with three of the commandments (do they really need the religious analogy?). This 10 Commandments are based on the IMF's views on the stylized facts of fiscal consolidations.

Note that the IMF wants a reduction in debt-to-GDP ratios in the long run (commandment #3), even if nobody knows exactly what is the difference of having a 40% ratio, which they recommend for 'emerging markets' (meaning developing economies), or a 250%, as the UK had during the Napoleonic Wars (here). My first concern is with the idea that consolidation (by which they mean austerity) should be done by cutting spending and not increasing taxes (#4), because this is more conducive to growth.

This is a proposition they repeat in their last Fiscal Monitor (2012: p. 35), where we are told that:

"a number of earlier studies have shown that expenditure-based fiscal consolidations have a more favorable effect on output than revenue-based consolidations, in spite of the standard multiplier analysis … Chapter 3 of the October 2010 World Economic Outlook reaches the same conclusion (IMF, 2010b) and notes that this result is partly because, on average, central banks lower interest rates more in the case of expenditure-based consolidations (perhaps because they regard them as more long-lasting)."

Note, however, that the reason for the superior performance for cutting spending instead of raising taxes (on the rich one would hope) is that the Central Bank does not hike rates in the former case, since it is part of a conservative plan to reduce the size of government (note that the IMF asks for consolidations to be fair, #6, but then wants to cuts social spending, #5). Worse the notion is also based on the idea that lower (higher) spending brings down (up) the rate of interest and leads to crowding in (out) of private investment. The problem is that the evidence for a positive (negative) effect of fiscal deficits (surplus), or public spending increase (reduction), on interest rates, is that it is almost non-existent (see UNCTAD, 2011, chapter 3 for a review).

The other point is related to the last commandment (#10), which says that you should coordinate your macroeconomic policies with other countries. I'm not even going to deal with the problems of coordination. My problem is that the arguments tend to be based on the Mundell-Fleming (MF) model (the ISLMBP with perfect capital mobility), which suggests that fiscal policy is less efficient in a small open economy. In this case, fiscal policy raises the rate of interest, with capital mobility, pressures for inflows lead to an appreciation of the currency, and lower trade surpluses. Instead of crowding out, meaning lower investment, one gets lower output from the external accounts. That's why they say in their last Fiscal Monitor that "in line with the theory, fiscal multipliers tend to be smaller in more open economies" (2012, p. 33).

Again this depends on a weak empirical relation. In the United States seldom is the case that expansionary fiscal policy causes higher rates of interest. In fact, the policy of the strong dollar, with the impact on manufacturing output and exports, has often been detached from fiscal expansionism or higher rates of interest (e.g. the Clinton years in which a strong dollar went hand in hand with fiscal consolidation and monetary easing to feed the dot-com bubble).

Finally, note that even small open economies in several periods were able to have very effective fiscal policies, because in spite of relatively flexible exchange rates, they used capital controls to avoid the effects of volatile capital flows on their external accounts. In this sense, the world of relatively regulated capital flows, rather than of fixed exchange rates (even if sometimes the two are confounded as a result of the Bretton Woods arrangement), seems to be more conducive to effective fiscal policy. So the lesson should not be that small open economies cannot do effective fiscal policy, but that capital controls (which they are not quite okay with contrary to what you might have heard, but I leave for another post) are necessary.

PS: For a more consistent theoretical critique of the MF model see Serrano and Summa (2012).