The wages of fiscal austerity

Martin Wolf has a nice graphic that captures the correlation between fiscal tightening (defined as the percentage point change in the structural or cyclically-adjusted general government deficit) and GDP growth rates in the 2008-12 period across Eurozone.

His conclusion,

The bigger the structural tightening, the larger the fall in GDP. The estimated fit is fairly good for this sort of calculation. Every percentage point of structural fiscal tightening is estimated to lower GDP by 1.5 per cent of its 2008 level. So the 8 percentage points of structural fiscal tightening in Greece lowered its GDP by 12 per cent.

The voices demanding an end to austerity are growing louder. In a hard-hitting op-ed, Lawrence Summers has argued that austerity is a misdiagnosis of Europe's problems,

Europe has misdiagnosed its problems and set the wrong strategic course. Outside Greece, which represents only 2 per cent of the eurozone, profligacy is not the root cause of problems. Spain and Ireland stood out for their low ratios of debt to gross domestic product five years ago with ratios well below Germany. Italy had a high debt ratio but a very favourable deficit position. Europe’s problem countries are in trouble because the financial crisis under way since 2008 has damaged their financial systems and led to a collapse in growth.High deficits are much more a symptom than a cause of their problems. 

Treating symptoms rather than causes is usually a good way to make a patient worse. So it is in Europe. Its financial problems stem from lack of growth. In any financial situation where interest rates far exceed growth rates, debt problems spiral out of control. The right focus for Europe is on growth. In this context increased austerity is a step in the wrong direction.

Furthermore, he suggests that austerity is worsening Europe's problems,

When economies are constrained by demand and safe short-term interest rates are near zero, policy measures that reduce the deficit by 1 per cent have a multiplier of 1 to 1.5. This implies a 1 per cent reduction in a country’s ratio of spending to GDP or an equivalent tax increase reduces its GDP growth rate by 1 to 1.5 per cent.

This means austerity measures at the national level are likely to be counterproductive in terms of creditworthiness. Fiscal contraction reduces incomes, limiting the capacity to repay debts. It achieves only very limited reductions in deficits once the adverse effects of contraction on tax revenues and benefit payments are taken into account. And it casts a shadow over future growth prospects by reducing capital investment and raising unemployment, which takes a toll on the capacity and willingness of the unemployed to work. These considerations are magnified in Europe as a whole. Slowdowns in one country reduce demand for the exports of others.

Christina Romer points to the need to adopt a twin-track approach to both restoring growth and addressing deficit problems. She advocates front-loaded and immediate fiscal spending to provide the growth stimulus and back-loaded and clearly defined tax increases and spending cuts to reduce the deficts. This has to be coupled with short to medium-term commitment to support these economies with bond-buying programs so as to keep their cost of borrowing and debt-service under control. She points to the successful examples of US in 1983 (with its backloaded Social Security reforms), Sweden in 1995 (to cut its deficit by 8% of G.D.P. over the next three years), and Australia in late nineties.

Happily, as the wages of austerity become clearer and more bitter, there appears to be some realization in Europe that the current path is unsustainable. However, the biggest challenge will be with breaking the entrenched German belief in fiscal adjustment. This becomes all the more formidable given the magnitude of fiscal transfer and monetary accommodation required.

Update 1 (6/5/2012)

Ezra Klein points to this graphic that highlights how austerity in UK is failing. Since 2010, when the David Cameron government introduced its austerity policies, the economy appears to have hit a wall.

 

The Swedish lessons for Europe

Fiscal austerity is the current buzzword in macroeconomic policymaking. Across Europe, despite very strong domestic political opposition, governments have embraced wildly ambitious fiscal adjustment targets in an attempt to rein in soaring public debts, restore market confidence, and thereby engineer economic recovery. 

However, evidence from nearly three years of such experimentation across Britain and the Eurozone economies has been dismal. Bond markets have remained unimpressed and sovereign bond yields continue to rise. Not only have the expected recovery not materialized, but these economies have slipped further down the abyss. And this has been the fate of economies within and outside the Eurozone. The latest casualty is Britain, which has officially slipped into a double-dip recession, its second recession in three years. It joins Belgium, the Czech Republic, Greece, Italy, the Netherlands and Spain who are already in recession.

As with Greece, Ireland, and Portugal earlier, Spain too is now experiencing the wages of the same austerity medicine. Amidst a contracting economy, its sovereign debt rating has been downgraded and cost of borrowing has been rising. One-in-four Spaniards are unemployed and half all Spanish youth are out of work, both the highest among advanced economies. Even with all the belt-tightening, Spain is expected to easily miss its target of lowering budget deficit from 8.5% of GDP to 5.3% in 2012 and do no better than 6.2% .   

As could have been anticipated, the blind embrace of austerity has had the effect of accepting the worst of all worlds. As economic growth has contracted, public debt-to-GDP ratios have gone up even higher and tax revenues have dipped sharply. In the absence of either the private sector or external sector stepping in top stanch the space vacated by public expenditures, it was natural that the economy would contract.

All this has raised unemployment rates and inflicted untold suffering on citizens across Europe. Economic hardship have triggered off pent-up social tensions. Political rebellions and protests have become commonplace in these countries. Many governments have lost power in the face of street protests and failures to push through the tough fiscal adjustment measures required to secure external funds. At last count governments in Greece, Ireland, Italy, Portugal, Spain, Netherlands, and now Romania have lost power due to the pains caused by spending cuts.     

In this context, it has become important that these economies abandon their dogmatic ideological embrace of austerity and fall back on policies that can get their economies growing. Robert Samuelson has a nice article which highlights the less-discussed economic turnaround of Sweden since its banking crisis induced economic recession in early nineties. In recent years, Sweden has emerged, along with Germany, as among the best performing developed economies.

Instead of being wedded to ideology-driven policies, Sweden embraced prudent policies that combined both the conservative and liberal social and economic agendas. For a start, it did not bail out its banks but forced them to take massive losses and virtually nationalized its banking sector. The real estate bubble that was inflated by the financial deregulation of the 1980s deflated in 1991-92. As pressure mounted on the krona, overnight interest rates spiked to 500%, and the Swedish economy contracted steeply and unemployment quadrupled in three years to 12%. After a series of bank failures, the government moved in swiftly with a series of measures,

In September 1992... the government announced that the Swedish state would guarantee all bank deposits and creditors of the nation’s 114 banks. Sweden formed a new agency to supervise institutions that needed recapitalization, and another that sold off the assets, mainly real estate, that the banks held as collateral. Sweden told its banks to write down their losses promptly before coming to the state for recapitalization. Facing its own problem later in the decade, Japan made the mistake of dragging this process out, delaying a solution for years...

By the end of the crisis, the Swedish government had seized a vast portion of the banking sector, and the agency had mostly fulfilled its hard-nosed mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again.

This was followed with several far-reaching structural reforms that turned the largely statist economy into one of the world's most dynamic economies, without compromising on its social-democratic principles. The reforms drew from both the conservative and liberal playbooks,  

Sweden’s income tax base was broadened and tax rates were sharply reduced (marginal tax rates fell from 46% in 1996 to 33% in 2010). Spending was cut on old-age pensions, child allowances, unemployment benefits and housing subsidies. Union power over wages was reduced. Many markets (banking, air travel, telecommunications, electricity production) were deregulated. Low inflation and balanced budgets became broadly embraced popular goals...

Although Sweden trimmed social benefits, it hardly abandoned the welfare state. Overall government spending is still about 50 percent of the GDP, much higher than in the United States... To reduce income tax rates, the government raised other taxes. Gasoline and cigarette taxes were increased; so were taxes on dividends and capital gains, hitting the rich. Altogether, deficit reduction totaled a huge 12 percent of GDP from 1991 to 1998. Slightly more than a third of that came from higher taxes...

The aims were clear: to reward work by cutting income tax rates; to push people back into the labor market by reducing some government benefits; and to promote productivity by increasing competition. Productivity and “real” (after-inflation) wage gains improved markedly. Still, Sweden has less economic inequality than most advanced countries.

Sweden also benefited from favorable external economic conditions. Its recession coincided with a sustained period of economic strength across much of the world. Sweden could therefore export its way out of recession. A 25% devaluation of the krona boosted exports. Unfortunately, none of the peripheral European economices today can afford this luxury. None of the Eurozone economies have the freedom to undertake this policy route. See also this excellent presentation by Swedish Finance Minister Anders Borg.

The choices facing Eurozone governments are stark. Currently the austerity policies are merely pushing their economies down the hill, with no hope of finding an anchor that can drive economic recovery in the foreseeable future. It is necessary for all the Eurozone economies to start regaining their economic competitiveness for any sustained recovery to take hold. This can happen only with either a Eurozone exit and/or fiscal transfers from the Eurozone's center. There has to be some period of fiscal accommodation in the periphery and consumption increase in the center.

This is an opportunity to push through the tough labour market liberalization and industry dergulation policies that have for long contributed to sclerosis in Europe. More than that it is an opportunity for the Europen monetary union to become a loose political union, a necessary requirement for the continent to stave off similar situations in future, leave alone escape the current mess.   

Fiscal policy Rules - Chilean experience

Arguably the biggest short-term challenge facing the Government of India is to get its fiscal balance in order. With elections due in two years, the propsects of any significant roll-back on subsidies, the major contributor to the fiscal imbalance, appears bleak. However, at a policy level what are the options available for the government to address this challenge?

The ultimate objective of any fiscal policy framework is to maintain long-term budget balance. In the long-run this can be achieved only by running up surpluses during the good times so as to build up the buffer to draw upon when the economy hits rough weather. But real world implementation of such counter-cyclical fiscal policy is difficult in democracies. As the good times arrive and tax revenues soar, pressure inevitably builds to spread it around. Not many countries have successfully managed this challenged.

The most famous experiment with fiscal policy rules is the European Union's Stability and Growth Pact, which defined a budget deficit target of 3% of GDP, beyond which defaulters could attract steep fines. It was thought that the clear target and the severity of the fines would deter countries from defaulting. But as we have seen over the past decade, this target was rarely met, even by its more fiscally prudent members.

Closer home, India's own experiment with fiscal policy rules has been disappointing. The Fiscal Responsibility and Budget Management (FRBM) Act was enacted in 2003 with the objective of eliminating revenue deficit and bringing down fiscal deficit to 3% of GDP by March 2008. However, the sub-prime crisis and the global economic slowdown resulted in the suspension of its implementation in 2009. In the context of India's dismal fiscal balance, there have been calls from within the government for reviving the FRBM.

However, Chile, as in many other cases of macroeconomic policy making, stands out as an excellent example of successful fiscal management. Since 2000, Chile has managed a truly counter-cyclical fiscal policy through a set of very clearly defined fiscal policy rules. At the heart of its fiscal policy framework is a clear budget target. The budget target was originally set as a surplus amounting to 1% of GDP, but was lowered to 0.5% in 2007 and to 0% in 2009. The government is permitted to run a deficit larger than the target only if the output falls short of its long-run trend (say, in a recession) or if the price of copper (it accounts for 16% of government's income) falls below its medium-term (10 year) equilibrium. Jeffrey Frankel writes,

The key institutional innovation is that there are two panels of experts whose job it is  each mid-year to make the judgments, respectively, what is the output gap and what is the medium term equilibrium price of copper. The experts on the copper panel are drawn from mining companies, the financial sector, research centers, and universities. The government then follows a set of procedures that translates these numbers, combined with any given set of tax and spending parameters, into the estimated structural budget balance. If the resulting estimated structural budget balance differs from the target, then the government adjusts spending plans until the desired balance is achieved.

He writes about how the government of Michelle Bachelet (2006-2010) instututionalized the structural budget rule (it was initially followed voluntarily by the government of Ricardo Lagos) into a Fiscal Responsibility Bill 2006 and resisted the temptation to indulge in public spending when copper prices boomed. 

The real test of the policy came during the latter years of the copper boom of 2003-2008 when, as usual, the political pressure was to declare the increase in the price of copper permanent thereby justifying spending on a par with export earnings. The expert panel ruled that most of the price increase was temporary so that most of the earnings had to be saved. This turned out to be right, as the 2008 spike indeed partly reversed the next year. As a result, the fiscal surplus reached almost 9% when copper  prices were high. The country paid down its debt to a mere 4 % of GDP and it saved about 12 % of GDP in the sovereign wealth fund. This allowed a substantial fiscal easing in the recession of 2008-09, when the stimulus was most sorely needed.

As indicated, the critical innovation in Chile was the clear identification of budget-relevant macroeconomic variables (output gap and copper prices), entrustment of its estimation to independent panels, and the fortification of this framework as a statutory mandate. This approach to fiscal policy making has the twin-benefits of letting a technocratic agency determine the outer boundaries of the fiscal balance at any time, while leaving elected governments with the freedom to allocate spending among competing claims. However, as is the case with all such neat solutions, the challenge lies with its political acceptability.

One encouraging sign as we set out in this pursuit of fiscal policy rules comes from the evolution of central banks and their monetary policy making role. We often take for granted the independence and objectivity of monetary policy decisions. This glosses over the fact that independent, target-focussed and rules-driven monetary policy decisions by central banks is, even in developed economies, a recent phenomenon. In countries like India, central banks have gained tremendous authority and credibility in their interest rate decisions over the past decade or so. Governments have exercised great caution and restraint in promoting central bank autonomy. There is some reason to hope that fiscal policy rules too could similarly evolve and gain strength over a period of time.

Hysteresis effects of recessions

What are the long-term consequences of prolonged periods of high unemployment and slower economic growth? As economic growth returns back to normal levels, does the labour market recover to its pre-crisis normal? Does capital investment by businesses and investments in research and development regain its pre-crisis trends? In simple terms, how much time does it take for the actual output to close the gap with the potential output? Or is there a danger that a permanent output gap will get crystallized?

In a recent paper, Brad DeLong and Lawrence Summers highlighted the important role of hysteresis effects. They claim that a long enough recession can erode the capability of both human and physical capital, and recovery cannot be taken for granted. There is enough evidence that long-term unemployment has scarring effects on those affected. I have blogged earlier about the harmful effects of long-term unemployment.

Greg Ip has written in Free Exchange about the possibility that America's potential output itself may have come down during the Great Recession. He points to the reduction in labour force participation rate, which appears to have stabilized at a lower level, and the lower (than trend rate) productivity rate in recent years. He argues that the actual output has been depressed for so long that hysteresis has set in and dragged the potential output down with it.

Mark Thoma has a striking illustration of the long-term consequences of deep recessions by pointing to the example of East Asian economies after their recessions following the 1997 currency devaluation crisis. All the major East Asian economies - South Korea, Malaysia, Indonesia, Hong Kong and Thailand - continue to remain considerably behind their long-term trend growth rates, even a decade after that crisis.











Much the same fate has befallen Japan since its early nineties asset prices crash. The economy fell-off the trend line for a prolonged period. Though there were signs of a recovery in the second half of last decade, the sub-prime crisis appears to have snuffed that out.


If hysteresis does indeed drag and keep down growth, then that alone would be a strong enough reason for governments to indulge in aggressive monetary and fiscal accommodation to boost aggregate demand and ensure that all idling resources are optimally employed.

Fiscal Policy in Depressions

Lawrence Summers and Brad DeLong have this paper which argues that in severely depressed economies, which are also constrained by the zero-interest rate bound, discretionary fiscal policy can be a powerful instrument to revive growth. They write,

In normal times central banks offset the effects of fiscal policy. This keeps the policy-relevant multiplier near zero. It leaves no space for expansionary fiscal policy as a stabilization policy tool. But when interest rates are constrained by the zero nominal lower bound, discretionary fiscal policy can be highly efficacious as a stabilization policy tool. Indeed, under what we defend as plausible assumptions of temporary expansionary fiscal policies may well reduce long-run debt-financing burdens. These conclusions derive from even modest assumptions about impact multiplier, hysteresis effects, the negative impact of expansionary fiscal policy on real interest rates, and from recognition of the impact of interest rates below growth rates on the evolution of debt-GDP ratios. While our analysis underscores the importance of governments pursuing sustainable long run fiscal policies, it suggests the need for considerable caution re-garding the pace of fiscal consolidation in depressed economies where interest rates are constrained by a zero lower bound.

Following the apparent triumph of monetarism in the seventies, Keynesianism had been upstaged as the dominant macroeconomic stabilization ideology for nearly three decades till the Great Recession took hold. It was believed that front-loaded fiscal consolidation for deficit-reduction coupled with accommodatory monetary policy would help achieve price stability, positively shape expectations and restore market confidence, encourage investment and consumption, and thereby boost aggregate demand. It would help successfully combat short-term business cycle problems and address medium-term growth dimensions.

It was also believed that the multiplier of discretionary fiscal policy was small. When the economy is close to its productive level, fiscal policy induced rise in demand will run up against supply constraints, thereby fuelling inflation, and rise in interest rates. This tightening of monetary policy, at a time when the economy needs accommodatory monetary policy, will end up crowding out private investments and off-setting the aggregate demand gains due to higher government spending. In contrast, monetary policy packs a much greater punch as an economic stabilization policy instrument. However, when there is a deep economic downturn coupled with interest rates touching the zero-bound, fiscal policy assumes a different character.

As Summers and DeLong write, there are atleast three distinguishing features of the current economic situation in many developed countries that leaves monetary policy without much traction and makes discretionary fiscal policy critical.

1. The absence of supply constraints and interest behavior associated with an economy constrained by the zero-bound means that the multiplier associated with fiscal expansion is likely to be substantially greater and longer lasting. The expectations of growth returning and raising inflation, and thereby lowering real interest rates, magnifies the multiplier.

2. Even very modest hysteresis effects through which output shortfalls affect the economy's future potential have a substantial effect on estimates of the impact of expansionary fiscal policies on future debt burdens. They find evidence that mitigating protracted output losses like those suffered by the United States in recent years raises potential future output. In other words, downturns have the potential to permanently lower the potential output and the trend rate of growth - "Large recessions may create labor-market as well as capital-stock hysteresis".

For example, the longer the economy stays depressed, the more likely that workers will quit the labour force altogether. Therefore, by putting these people back to work today, stimulus generates higher taxes not just this year but for years to come, lowering the long-term debt burden.

3. Extraordinarily low levels of real interest rates raise questions about the efficacy of monetary policy as a source of stimulus, and reduce the cost of fiscal stimulus.

In this context, Paul Krugman has this nice scatterplot of the changes in GDP growth rates against the change in government consumption among Eurozone economies. The correlation is unmistakably salient.

The Austerity Medicine!

(HT: The Washington Post)

The wages of "contractionary expansion"

This quote by an unemployed British youth may be an appropriate reflection of the mood of the moment across much of Europe as governments pursue "contractionary expansion" - aggressive austerity campaign in an effort to lower public debt and fiscal deficit, and thereby boost growth.

"If you are not working, in training or in college, you might as well be a thief — employers just do not take you seriously. At some point, you just say, 'I’m stuck and I will never find a job.'"

Though most Eurozone economies are purusing austerity policies to boost growth, the evidence so far is dismal. Unemployment rates, especially among the youth, have risen sharply across most of Europe.

Europe's suicide (com)pact

The draft of the fiscal compact, hailed as a masterpiece by Angela Merkel, was released yesterday (see here). Note article 3.1.a. which says that "the budgetary position of the general government shall be balanced or in surplus." This is more stringent than the old Stability and Growth Pact (SGP) that the fiscal compact supersedes. The consequences of fiscal austerity are already dramatic, and the notion that more of the same can actually have a positive effect is simple madness.

Central Banks hold sway, where are the governments?

There is a common feature in the respective policy responses to the current domestic economic situations in United States and India. In both countries Central Banks are at the frontline fighting the battle, while governments appear missing in action. In many respects, both the Fed and the RBI are, in different ways and degrees, fighting not only the monetary policy but also the fiscal policy battles. This over-reach in both areas is unsustainable and is generating distortions that could set the stage for even bigger crises.

More worryingly, not only do the central banks themselves appear convinced of their leadership role, but everyone else too believes that they should keep doing more. In the process, governments are getting away lightly. Nothing can take away from the fundamental fact that only governments can sustainably bring a closure to the ongoing economic crisis and set the stage for a more sustained economic recovery.

In the US, since late 2008, the Fed has unveiled a series of policies, ranging from classic monetary policy to outright fiscal policy, to not only keep the credit market open but also to backstop aggregate demand from falling and stimulate economic growth itself. It has lowered rates to near zero and has committed to keep there till end-2014 (a period of over 6 years of extraordinary monetary accommodation), multiplied its balance sheet many-fold to over $3 trillion by purchasing a large category of assets and injecting massive quantities of liquidity, and is now experimenting with greater transparency in communicating the Fed's monetary policy processes so as to mould market expectations.

In contrast, apart from the initial stimulus plan, ARRA, the US government has largely remained at the sidelines. All this, while averting a financial meltdown and deep deflationary economic recession, has created several incentive distortions, besides postponing important adjustments. Mohamed El-Erian summed it up nicely in a recent FT op-ed,

"Despite its repeated pleas for fiscal and housing engagement, the Fed has inadvertently provided cover for other government agencies to continue avoiding difficult, but necessary, decisions. Notwithstanding these shortfalls, the Fed still feels compelled to do even more. For both moral and political reasons, it believes that it cannot be seen to stand on the sideline as the economy struggles with a deeply-entrenched unemployment crisis and political dysfunctionality – even if this means having to use even more imperfect, indirect and, increasingly, unpredictable policy measures."

Unlike in the US where economic growth and financial market stability have been the central themes, inflation and burgeoning public deficits have been the biggest concerns. RBI has been pitchforked into the frontline of the inflation battle. In turn, since the onset of the initial signs of economic strains and inflationary pressures in early 2010, the RBI has increased interest rates 13 consecutive times. In the process, it has tempered the over-heating economy and appears to have brought inflation down to more tolerable limits.

It was evident to anyone who cared to go beyong stage one that India's inflation problem was fundamentally a supply side problem and could be sustainably managed only by easing supply constraints, especially by removing infrastructure bottlenecks and increasing foodgrain production. RBI's inflation fighting policies only managed to cool the over-heating economy and bring it down to its constrained production possibility frontier.

This long-period of inflation-fighting by monetary tightening was an ideal opportunity for the government to undertake policy measures and reforms that would initiate the process of declogging the supply-side and pushing up the production possibility frontier. But nothing of that sort was forthcoming. Worse still, the government added to the problem with a series of fiscal largesse, unconcerned about the severe fiscal strains that were clearly evident.

This in turn increased government borrowings and boosted aggregate demand at a time when supply was severely constrained, therefore adding to the inflationary pressures. With interest rates rising, inflationary expectations anchored upwards and policy parlysis gripping government, investment climate weakened. Instead of expanding aggressively in a growing economy, cash rich businesses turned off their investment taps and have preferred to wait and watch.

Now, with the inflationary pressures easing, the onus is again back on the RBI to take the centerstage. Everyone calls on the RBI to lower interest rates to encourage investment. Critics accuse it of being "behind the curve" in lowering rates, just as it was accused of being similarly slow to raise rates in the first place as the recession struck.

For sure, in the coming months, the RBI will lower rates and cost of capital will come down. Businesses will start investing and economic growth will recover somewhat. But all that will be pyrrhic victories if interest rate cuts are not accompanied with policy reforms to ease supply constraints. In its absence, we will witness another short-cycle of boom followed by over-heating and slowdown. The RBI will again be forced to step in an re-enact its current role.

Markets and central banks alone cannot set the foundations for economic growth. Governments have a critical role to play in laying the policy framework for expanding the economy's production possibility frontier. Markets thrive on the enabling policy environment established by public policy actions. Paralysed governments, which cede responsibility to technocratic institutions like central banks, are merely kicking the can down the road.

Satyajit das has an excellent article in FT which outlines the distortions caused by a prolonged period of ultra-low interest rates.

Update 1 (30/4/2012)

An excellent FT op-ed on how leveraging central bank balance sheet has come to be seen as the least costless route out of a financial crisis induced recession. The unprecedented liquidity injections have undoubtedly helped backstop the lurch into full-blow depressions. By early 2009, the Fed, the ECB and the BoE had all cut their main policy rates to all-time lows, and it has remained there since. However, the challenge for central banks is not to manage the retreat from these accommodatory policies before stoking inflationary pressures and without suffering massive losses.

The use of the balance sheet as a policy tool is no longer likely to be considered unconventional. The crisis has moved it to the centre.

 

The fiscal and monetary "wiggle-space" - where does India stand?

Free Exchange points to the contrasting macroeconomic positions of developed and emerging economies. While the former has limited fiscal and monetary space to stimulate their economies any more, the later have adequate cushion on both fronts, if the need arises.

The average budget deficit of emerging economies last year was only 2% of GDP, against 8% in the G7 economies. And their public debt ratios were on average only 36% of GDP, compared with 119% of GDP in the rich world.

The Economist article uses a mix of fiscal and monetary policy paramters to arrive at the respective nations flexibility to manoeuvre with expansionary policies. It points to five parameters that determine the monetary policy space - inflation, credit growth, real interest rate, exchange rate movements, and current account balance. It added up the scores on these five parameters to produce an overall measure of monetary manoeuvrability. On the fiscal policy side, it constructs a fiscal-flexibility index, combining government debt and the structural (ie, cyclically adjusted) budget deficit as a percentage of GDP.



It ranked 27 emerging economies according to their monetary manoeuvrability and fiscal flexibility using a "wiggle-room index" constructed using the aforementioned parameters. This index is a reflection of the ability of countries to withstand a global downturn by stimulating their economies. The verdict,

The index suggests that China, Indonesia and Saudi Arabia have the greatest room to support growth. At the other extreme, Egypt, India and Poland have the least room for a stimulus, thanks to excessive government borrowing, large current-account deficits, and uncomfortably high inflation. Brazil is also in the red zone.

At first glance, on most parameters, India stands out as being among the most constrained of emerging economies. On the fiscal side, its combined government fiscal deficit of around 9% of the GDP, means that there is limited space available for any stimulus spending.

However on the monetary side, given the recent declining trend in inflation, the 13 consecutive repo rate increases by the RBI in response to rising inflation gives the central bank adequate monetary space to stimulate the economy. Further, since credit growth has been below par and exchange rate appears to have weathered its brief period of volatility, the monetary side space may not be as constrained as it appears now.

Further, while its total public debt, at about 68% of GDP, may look high by the standards of emerging economies, closer analysis reveals that it may not be as dismal as is being projected. Here are three reasons

1. The overwhelming share of this public debt is owed to domestic creditors. In fact, the total external debt (public and private) is estimated to decline to 17.4 of GDP for 2011, with government share being a mere 4.4% of GDP. As of end-September 2011, of the total external debt of $326.6 bn, with government and non-government shares in the total external debt being 24.3% and 75.7% respectively. Short-term debt accounted for 21.9% of the country's total external debt, while 78.1% was long-term. Adjusted for this, the real effective debt burden, in relation to a sovereign debt default risk, shrinks considerably. The only area of slight concern should be the 27.4% CAGR in external commercial borrowings between end-March 2006 and end-March 2011.



2. At 122% of GDP, its overall debt is the second lowest among all the major economies. Only Russia has a lower overall debt-to-GDP ratio.

3. Though its government may be profligate, the other major engines of economic growth - households, non-financial corporates, and financial institutions - have the healthiest balance sheets among all major economies, including China.





This means that all the non-government drivers of economic growth stand on very strong platforms and have enough "wiggle-room" to manoeuvre. All that is now required is for the government to get governance and policies right. Will that happen?

The austerity-leads-to-growth evidence is missing

The three most cited examples of fiscal austerity in the face of economic contraction as the preferred strategy to restore economic normalcy are Ireland, Latvia, and United Kingdom.

A year on after it received a 67.5 billion euro bailout, Ireland represents a very mixed macroeconomic picture though the social impact of austerity has been much more damaging. In 2010, Ireland passed the most austere budget in the country’s history, and public sector pay cuts were a centerpiece of the government’s reform effort. Though green shoots of economic growth are back, exports have been rising, and deficit is shrinking (it fell from 32% in 2010 to estimated 10% for 2011), public debt burden far from plateauing and declining has been rising, albeit slower than earlier, and bond yields have been climbing. Most damagingly, unemployment rates are climbing and nearly 40,000 Irish have fled the country this year alone in search of a brighter future elsewhere.



More worryingly, as this Times report indicates, the platform for sustaining short- to medium-term growth looks shaky.

"Salaries of nurses, professors and other public sector workers have been cut around 20 percent. A range of taxes, including on housing and water, have increased. Investment in public works is virtually moribund... government is announcing an additional 3.8 billion euros in tax increases and spending cuts for 2012 that will affect health care, social protections and child benefits. Retail sales fell 3.8 percent in October from a year earlier as spending was down even on things like school textbooks, shoes and other basic goods... welfare payments have steadily been reduced even as the unemployment rate has ticked up to 14.5 percent, and is forecast to remain high at least through next year."

In this context, as Paul Krugman has repeatedly pointed out, the experience of Iceland, which went against conventional austerity, is instructive. Faced with a unsustainable external debt, run up by its reckless banks, Iceland let its bankers go bust and even expanded its social safety net. It also imposed capital control. Instead of internal devaluation through wage freezes, Ireland devalued the kroner. While, like others, it did suffer sharp output contraction, it has managed to keep unemployment rates from getting out of control.



In fact, this direct comparison of the Latvia and Ireland, is very stark. Even on output contraction, the austerity experiment appears a relative failure.



Admittedly, Iceland had its currency and could manage an external devaluation, and regain competitiveness and put the economy on recovery path. The Eurozone economies do not have that and other sovereign instruments to tide over such crises. But United Kingdom has the option of currency devaluation and other regular instruments, and still choses austerity.

More than a year on into its austerity program involving cutting 600,00 public sector jobs, the British economy appears no close to recovery. Early last week, the British chancellor of Exchequer has admitted that growth would be slower than forecast and "debt will not fall as fast as we’d hoped". This meant additional austerity measures, including pay freezes for two more years beyond 2015. The initial plan to eliminate budget deficts has been pushed back by two more years to 2017 and Britain would now require to borrow an additional £111 billion, or $172 billion, through 2015.

A report by the Office for Budget Responsibility has forecast that the British economy will grow 0.9% his year, less than the 1.7% predicted earlier, 0.7% next year, and 2.1% in 2013. It also predicted that debt as a share of GDP would peak at 78% in the fiscal year ending in 2015, higher than the 71% initially predicted. The output gap is expected to persist well past 2017, and the November 2011 estimate shows it worsening since the March 2011 estimate.



The austerity and the squeeze on public spending is expected to take a heavy toll on the GDP growth, as seen by this graphic. The contributions of government compensation, procurement, and investment to the economic growth is set to decline strongly in the years ahead.



Given the inevitability of output contraction and the difficulty of accommodation due to fiscal space, the only immediate political economy issue of concern is how to mitigate adverse consequences of the the slowdown on the nation's population. Atleast on this count, all the aforementioned experiences show that austerity fails.

For more on the social impact of savage austerity, see this report on Lithuania. It achieved a fiscal adjustment of 9% of GDP by cutting public spending by 30% (incluing slashing public sector wages 20-30% and reducing pensions by as much as 11%), raising corporate taxes to 20% from 15%, value added tax from 18% to 21%, and also taxes on a wide variety of goods. In Britain, the wages of austerity are taking an increasing toll and the winter of discontent appears to be making a comeback with nationwide strikes and protests.

Update 1 (2/2/2012)

The FT writes that "after the initial stimulative boost, fiscal policy began to steadily contribute less and less to growth until finally becoming a drag for most of last year and part of the prior year. That’s why the federal contribution to growth is roughly a wash during the recovery."



The CBPP graphic hilights the true magnitude of the austerity. In fact, the cuts backs in state and local government spending make it the worst period since 1944. As CBPP writes, "state and local governments have cut deeply their spending on schools and other public services for three straight years. In fact, economic output from state and local governments fell by 2.3 percent in 2011 — marking the steepest drop since the wartime economy of 1944. By reducing economic activity, these cuts have slowed the economic recovery."



David Leonhardt maps the evolution of the US economic growth over the past four years with respect to the trends in private and public sector consumption growth rates.

Fiscal Policy Matters - Big Time?

Christina Romer is anguished about the fiscal policy debate,

"Policymakers and far too many economists seem to be arguing from ideology rather than evidence... the evidence is stronger than it has ever been that fiscal policy matters — that fiscal stimulus helps the economy add jobs, and that reducing the budget deficit lowers growth at least in the near term. And yet, this evidence does not seem to be getting through to the legislative process. That is unacceptable. We are never going to solve our problems if we can’t agree at least on the facts. Evidence-based policymaking is essential if we are ever going to triumph over this recession and deal with our long-run budget problems."

She writes about the inherent difficulty of estimating the impact of fiscal policy on people's consumption decisions because there are other things happening in the economy and other unanticipated factors which might influence the policy. She points to the omitted variable bias while illustrating the case with the early 2008 Bush tax cut. The contribution of this tax rebate to holding up household consumption spending was offset by the tumbling houseprices and resultant lowering of household wealth which in turn squeezed disposable incomes. In other words, the omitted variable bias skews our understanding of important relationships, nowhere more so than in our assessment of fiscal policy.

Prof Romer also points to tax cuts made when the economy is slipping into recession and tax increases in response to increased spending needs (like, say, war). In the former, unless tax cut was very large and for a sustained period, the outcome would still be weak growth - the tax cut would have only mitigated the adversity. In the later case, there is a behavioural sleight of hand - the impression gains ground that the tax increase caused increase in spending, whereas it was only a small contributor to an already rising spending.

In order to address the omitted variable bias, she and husband David Romer excluded from their empirical analysis the tax changes taken in response to economic conditions and confined their dataset to tax changes made for ideological reasons (Reagan tax cut, Clinton tax increase etc). The graphic below shows two estimates of the impact of a tax cut of 1% of GDP on real output. The red line shows the result using the conventional measure of tax changes — the change in cyclically-adjusted revenues. The blue line shows the estimates based only on the relatively exogenous tax changes we identified from the narrative analysis.



The graphic shows that limiting omitted variable bias results in larger and more statistically significant estimated impacts of tax changes. Prof Romer also argues that nobody has done a similar study (one that controls for motivation) to assess the true impact (on output) of a government spending increase. In its absence, there is no way to derive more definitive conclusions about the real impact of direct government spending increases nor adjudicate beween the relative superiority of tax cuts and spending increases.

She highlights the counterfactual problem of what would have happened without the ARRA in the US,

"The metaphor I find helpful is to a patient who has been in a terrible accident and has massive internal bleeding. After life-saving surgery to stop the bleeding, the patient is likely to still feel pretty awful and will have a long way to go before he is fully healed. But that doesn’t mean the surgery didn’t work. You have to judge the effect of the surgery relative to what otherwise would have happened. Without surgery, the patient would have died."

She points to three studies which, albeit incomplete, point to the ARRA playing an important role in propping up demand and ensuring that the economy did not get any worse.

She also points to similar omitted variable bias in the study of Alberto Alesina and Silvia Ardagna which has become the touchstone for advocates of expansionary contraction to argue that fiscal austerity is generally expansionary. They mined budget data for a large number of advanced countries over the past 35 years and identified large fiscal consolidations by looking for times when the cyclically-adjusted budget deficit fell sharply. They find that output tended to rise on average after these consolidations, especially those focused on reductions in government spending. She writes about the omitted variable bias in their analysis,

"Some of their fiscal consolidations weren’t deliberate attempts to get the deficit down at all. Rather, they were times when the budget deficit fell because stock price booms were pushing up tax revenues. Stock prices were a big omitted variable. They were driving the deficit reduction and were likely correlated with rapid output growth. This omitted variable made it look as though deficit reduction was expansionary, when it really wasn’t."

An IMF working paper, about which I blogged earlier, sought to address the deficiencies of the Alesina-Ardagna study and found that austerity programs hurt. Their dataset was limited to deliberate fiscal consolidation - for reasons unrelated to short-run macroeconomic developments - moves in 15 advanced countries over the last 30 years. They find that unemployment typically rose and output fell following such austerity programs.

The Eurozone crisis in perspective

The crisis facing the Eurozone today is in someways inevitable given the impossibility of managing a monetary union without some form of fiscal union and a fully committed central bank.

To put the folly in its true perspective, let's compare the different Indian states to Eurozone members. Imagine 28 independent countries federate into a single country with a single monetary policy. All the countries embrace a single currency, rupee, and all monetary aggregates, including the interest rates, are harmonized across all states. Trade barriers have been brought down and there is unrestricted cross-border trade across states.

However, both the central bank, the Reserve Bank of India (RBI) and the central government at New Delhi will not make monetary and fiscal transfers to help any state if it runs into economic problems. All taxes are levied by the states and they refuse to allocate a share of their tax revenues to the central government. Driven by moral hazard concerns, the RBI is traditionally averse to monetary accommodation and banking bailouts.

In this context, consider this scenario. Maharashtra and Tamil Nadu are booming. In contrast, Uttar Pradesh and Rajasthan are experiencing a deep recession. The later two have a serious competitiveness problem, since their wages have been driven up by a positive economic shock. In this period, both state governments have indulged in populist fiscal profligacy and run up massive debts, including from neighbouring states and their banks. Both now stand at the verge of sovereign defaults.

Further, when the the states form the monetary union, the initial conditions of the different states vary widely. The economies of Uttar Pradesh and Rajasthan are uncompetitive in relation with Tamil Nadu and Maharashtra. The former have much lower labor productivity, though wages and prices remain more or less the same. There are also critical structural imbalances in these two states and they also suffer from high fiscal deficits.

There is more. Even as Rajasthan and UP struggle, the increasingly competitive states of Maharashtra and Tamil Nadu prosper, partly by increasing their exports to Rajasthan and UP, and in the process, atleast partially, displacing local production and driving out local jobs. Clearly, Maharashtra and Tamil Nadu are, atleast partially, prospering at the expense of Rajasthan and UP. So what is the way out for these two struggling states?

If Uttar Pradesh and Rajasthan were independent countries with their own currencies and interest rates, they would have responded to such a supply shock by either devaluing their currencies or lowering interest rates or both. They may even have welcomed a bout of moderate inflation to reduce the real debt burden and narrow the gap in labor costs. The objective in all these cases would have been to lower real wages and costs and thereby increase competitiveness and investments. Now that these states are part of a monetary union, they do not have access to these traditional options.

In the real world, India is a monetary and fiscal union. Faced with such a situation, the central government will invariably step in with fiscal transfers (packages, as they call it politically!) and restructure their loan books with help of the RBI. The central government will be committed to ensuring that even a solvency crisis will be averted. Sure, tough conditions will be imposed and the state will be forced to implement reforms that will help improve its competitiveness.

The only strategy to restore economic strength in these two states without compromising on the monetary union is for the central government to step in and provide fiscal transfers to these states and the RBI to open liquidity windows and ensure that the credit tap is kept open. Simulataneously, the two states will have to undertake structural reforms to increase their medium and longer term competitiveness. It has to be hoped that these measures will buy adequate time to restore the health of both the state economies.

Replace Rajasthan and UP with Greece and Italy, Maharashtra and Tamil Nadu with Germany and France. The problems facing Eurozone economies today are not much different. In this context, in an FT op-ed, the former British Prime Minister, John Major had this observation of Eurozone economies locked in Germany's embrace,

The powerful German economy is still locked within the same currency as weaker economies. She racks up huge trade surpluses within the eurozone while others have comparable deficits. Since Germany has an estimated 30 per cent currency advantage within the euro, this seems likely to continue. It is undesirable and unsettling.

In a sensible world, the southern states would devalue to become competitive – but they cannot. They are locked in a single currency. And because they cannot devalue their currency, they must devalue their living standards and promote reforms to enhance efficiency. This will take years. Meanwhile, wages must fall, unemployment will rise and social unrest will increase. The severity of this medicine may not be bearable in a liberal democracy.

His solution is similar to what India is today,

It must become a fiscal union; a union of transfer payments to off-set regional disparities; or it must shrink. The latter option – essentially expelling Greece – has political consequences. There is no mechanism to do it. What would Greece’s future be? Would she remain democratic in the chaos that might follow? Pushing Greece out is not a risk-free option.

Nor is a transfer union. Germany would hate it and transfer payments would institutionalise inefficiencies. That leaves fiscal union as the most likely destination. But it has huge political consequences. It implies a far greater level of integration, and is an escalator to a federal eurozone. This may be sensible economically, but it is profoundly undemocratic. It would drive voters and decision-makers dangerously far apart. More top-down Europe imposed by a remote elite could provoke a powerful antipathy.

The focus should shift from Mumbai to New Delhi

The sources of India's most recent bout of inflation, as pointed out in a series of excellent recent speeches and papers by RBI officials (see also Amol Agarwal here), may be rooted in structural factors like demand shocks (increased protein consumption) and supply constraints. The continued fiscal accommodation, especially by way of the expansion of the mandate of policies like NREGS, may have contributed towards amplifying the upward pressures.

This means that monetary policy may have limited traction with restraining inflationary pressures, beyond cooling the economy and restraining growth in aggregate demand. Any further changes in monetary policy can only have marginal impacts, especially since the markets have already priced in the RBI's firm commitment to rein in inflation by lowering aggregate demand and thereby slowing down the economy. Blaming the RBI for taking only baby steps or being too predictable with its interest rate increases or even giving up its shock value (the recent announcement that it may not hike rates in December) looks unconvincing.

Translated into English, all this effectively means that the focus of attention on inflation fighting has to shift from RBI to the Government. It means that governments, both states and center, will have to initiate steps to ease supply-side constraints - infrastructure bottlenecks and agriculture production capacity. An aggressive program of investments in these areas is immediately required. Fiscally constrained governments need private sector assistance in many of these areas if there is to be any meaningful impact to ease supply constraints. The very nature and dynamics of their interventions also means that the expectations for immediate outcomes that we associate with RBI's monetary policy actions should be shelved.

It is interesting that during the Great Recession and the economic slowdown that followed the sub-prime crisis, governments across the world have been largely missing in action. Almost expecting this, public debates have been focussed on getting monetary authorities to pull economies out of their current mess. In the developed economies, central banks have indulged in monetary accommodation through unprecedented quantitative easing policies.

In India, the focus on its central bank has been for a different reason. Unlike the developed economies, the problem here is an overheating economy which has unleashed inflationary pressures. Accordingly, attention has been on the RBI to use monetary policy to deliver the magic bullets to lower inflation and boost growth. But, as aforementioned, this strategy has serious limitations and will not yield results. RBI can at best buy time by cooling the economy and buying time for the government to get its act in order. Only governments can fulfill the growth creation and sustaining role effectively.

The only issue at debate is whether the RBI should pause or not. The fundamental objective of the 13 consecutive rate hikes has been to rein in an over-heating economy. This growth restricting objective has to be weighed against the more important medium to long term goal of getting the economy to quickly expand its potential output and productive capacity. This requires massive investments in infrastructure and food production, both by the governments and the private sector.

Has the interest rate crossed the threshold where it has started adversely affecting these investments? This should be the critical question guiding RBI's monetary policy decisions in the months ahead. As for inflation, it is time for New Delhi to assume centerstage and take the "inflation bull" by its horns.

Debt restructuring or default - Is it enough?

Call it whatever you like, Greece has effectively defaulted on its sovereign debt, atleast half of its private external debt. The agreement that private investors will take a 50% haircut on their bonds constitutes a virtual default. The agreement reached to resolve Eurozone crisis contains this restructuring of Greek debt, a bank recapitalization plan, and an expansion of Eurozone bailout fund.

The agreement to restructure Greek debt also includes a new €130 bn bail-out of Greece by the European Union and the International Monetary Fund and is estimated to reduce Greek debt levels to 120% of GDP by end of the decade. The deal includes a decision to force the continental banks to raise new capital amounting to a total of €106 bn ($150 bn) by June 2012 to raise their Tier I capital ratio to 9% of total capital so as to provide them with greater cushion against potential losses on loans to the PIIGS.

They also agreed to increase the firepower of the remaining amount in the €440 bn ($610 bn) European Financial Stability Fund (EFSF) (estimated to be about €250bn after the proposed new Greece debt deal) by providing "risk insurance" to new bonds issued by struggling eurozone countries, especially Italy. This would limit bondholder losses by guaranteeing a portion of potential losses - EFSF effectively offers credit protection on Greek debt. It is hoped that this would increase the size of the EFSF by 4-5 times to about €1,000bn. Efforts are also on to get outside investors like sovereign welath funds from China, Russia and others.

Though any agreement is welcome, there are several doubts about whether this is a case of too little too late. Critically, even after the haircuts and bailout, Greece will still have a debt-to-GDP ratio of 120% even in 2020. This raises questions about its effectiveness and increases the possibility of more write-downs and bailouts. This would mean complete wiping out of private bondholders and even write-downs by official lenders (who will be the last to suffer any haircuts). Of the 340 billion euros in Greek government debt, only about 200 billion euros is owed to private creditors and therefore covered by the restructuring plan. The rest of the debt is controlled by the European Central Bank, the International Monetary Fund and other institutions that have said they would not participate in a debt restructuring. FT Alphaville has several interesting questions here about the details of the three-pronged bailout plan.

In addition there are more fundamental issues. Eurozone countries' economic stagnation which is driven by a combination of declining economic competitiveness, huge sovereign debts, and difficulty in financing government deficits. The beleaguered peripheral Eurozone economies are handicapped by the unavailability of all the remedies traditionally used by countries facing recession and sovereign debt crisis - inability to indulge in fiscal and monetary expansion, reflate their economies, or devalue their currencies. Though notionally a currency union with a harmonized monetary policy, it does not have any central fiscal authority nor does it have a monetary authority willing to assume its traditional role. In simple terms, Eurozone is a monetary union without a fiscal federation or a full-fledged central bank.

The better placed economies like Germany are strongly opposed to fiscal transfers to bail out their reckless peripheral partners. The European Central Bank (ECB) has refused to lend to its struggling member states. It has preferred to let the newly created and limited European Financial Stability Fund (EFSF) assume the responsibility of lending to those countries and stabilizing the financial markets.

This is in sharp contrast to the policy followed by the US Treasury and the Federal Reserve when faced with similar (some would say, less severe) crisis in late 2008. The Government announced a massive stimulus package to stabilize the economy, while the Fed deployed extraordinary measures to emerge as the lender, buyer and insurer of last resort.

In fact, unlike the US and British bank recapitalization plans in which the respective central banks injected funds directly, the ECB has refused to do so. The banks are therefore relying on private investors to raise their capital so as to reach the 9% level. However, raising money from private investors will be difficult especially given the conditions.

The current conditions call out for proactive central bank leadership. No one seriously disputes that Spain and Italy, currently the biggest concerns, are solvent and are only experiencing a liquidity crisis. Such crises are best averted when central banks step in and open liquidity windows and function as lender of last resort. As Martin Wolf wrote recently, if sovereign default risk is addressed, it will "also automatically stabilise the banks, since it is fears of sovereign defaults that are driving worries over banking insolvency". See also this excellent paper by Paul De Grauwe. In light of all this, it remains to be seen whether the latest bailout will be effective.

Times, as always, has this nice graphic that captures the three prongs of the bailout plan.



The market reaction has be positive, with Greek CDS spreads nearly halving from 6000 to 3500.

Galbraith on long term growth

Link to the interview here, where he says that we need to spend ourselves out of the stagnant economy.

PS: Here link to his upcoming conference on the European crisis.

More deficits, not fiscal responsibility

So there is a short review of the Hinckley Forum debate here. Not bad, but the title is misleading, since nobody was for for fiscal responsibility in the way it is usually defined, i.e. fiscal contraction. By the way, fiscal responsibility, like fiscal consolidation, is one of those code words for adjustment, that should be avoided. At any rate, if you missed it, that is a reasonable summary.

PS: I also emphasized that uncertainty is not central for the current weak recovery, lack of demand is and Steve agreed that without more demand there will be no more confidence. In fact, Steve's plea was for public investment in infrastructure. That's a way of recovering confidence that I'm also for.

Christina Romer gets it right on the deficit

Romer's column in the NYTimes, a few days ago, is certainly worth reading. She says among other things:

"Fiscal austerity, not more stimulus, is the answer. This argument makes me crazy. There’s simply no evidence that concern about the current deficit is a significant factor limiting consumer spending or business investment. And government borrowing rates are at record lows, suggesting that financial markets are not worried about the deficit, either... The best evidence shows that fiscal austerity depresses growth and raises unemployment in the near term. That’s the experience of countries like Greece, Portugal and Britain, which have embarked on drastic deficit reduction plans over the last two years. Cut the current deficit and you will raise unemployment, not lower it."

It's high time for Keynesians, of any sort, that may have some influence with the President to be for fiscal expansion.

The New IMF and Argentina

There has been a certain view, that was already quite popular around the time Strauss-Kahn still managed the IMF, that with Christine Lagarde the Fund has become less orthodox, not just regarding capital controls, but now also supposedly on fiscal issues. See for example the article in the NYTimes by Liz Alderman.

In the last World Economic Outlook, the Fund argues (WEO, p. 110) that Argentina's inflation results from excessively expansionary policies (no analysis backs this claim and the effects of a more devalued currency and commodity prices are not discussed) and suggests (p. 42) that monetary tightening is necessary. Also, the report continues the tone of the previous WEO, suggesting that in developed countries fiscal adjustment should continue to reduce the debt burden, and in developing ones, like Argentina, to avoid overheating.

So fiscal and monetary contraction is their policy advice. The IMF forecasts a significant slowdown next year for Argentina (4.6% for 2012 down from 8% this year). The logic is that Argentina's growth is not sustainable and perhaps a crisis is around the corner.

Andrés Velasco, ex-finance minister of Chile, suggests so much in his last column for project syndicate. This notion that Argentina is close to an external crisis is peculiar to say the least. Velasco had published a paper with Ricardo Hausmann after the 2001-2 crisis that recognized that the problems were not fiscal, but related to exchange rate misalignments, export performance and access to international financial markets.

Although shrinking, Argentina still has a current account surplus, has not depended on international financial inflows (but on its own exports), and the ratio of short term external obligations to reserves is relatively small. So if the whole world economy sinks into lower growth, Argentina, that is forecasted to be the second fastest growing economy after China in 2011, will probably slowdown, but there is no reason for the macroeconomic policy to push for a slowdown for fears of an external crisis.

In that sense, it seems that the default position at the Fund, and in mainstream academic circles (Velasco was at Harvard, before returning to Chile) is that fiscal adjustment is needed in Argentina. And apparently almost anywhere in the world. The New IMF looks a lot like the old one to me!

The IMF still believes in fiscal austerity

In May, Olivier Blanchard, the head of the research department at the IMF, said:

"Earlier fears of a double-dip recession—which we did not share—have not materialized... The inventory cycle is now largely over and fiscal stimulus has turned to fiscal consolidation, but private demand has, for the most part, taken the baton."

The lame excuse for this ludicrous forecast now is that:

"the initial U.S. data understated the size of the slowdown itself. Now that the numbers are in, it is clear that more was going on."

In all fairness I criticized that view in May (here) and in July (here), since it was clear that fiscal austerity (Blanchard says consolidation, but he means reduction of spending and increases in taxes, that is austerity measures, which may not lead to a reduction in deficits, i.e. consolidation; one day I'll publish the IMF-English/English-IMF Dictionary) would not work.

Now that he admits that private demand has not taken the baton you think he would admit that fiscal consolidation (austerity really) is not the solution. You would be wrong, of course. He says in the new World Economic Outlook foreword (WEO, Sept, 2011) that:

"Fiscal consolidation cannot be too fast or it will kill growth. It cannot be too slow or it will kill credibility."

Not very different from what Christine Lagarde, his boss, has been saying. That is, we need fiscal austerity, but not too much (see my critique here). The new claim (in the last WEO) is that China has to import more, since the US private demand will not pick up (and fiscal austerity is needed).

By the way, according to the IMF China will grow 9.5% in 2011, and the yuan has appreciated strongly in real terms (particularly when you deflate by the real wage, that grows astronomically in China). So it's unclear how China could, besides growing sufficiently fast to keep a good chunk of the world economy (in particular exporters of commodities) expanding, also get the US out of its recession.

Perhaps, Blanchard and the IMF should revise their views on fiscal policy for developed countries (the IMF could also change it's adjustment programs based on austerity in Europe too!).