The IMF’s cavalier call for spending — with caveats

Yesterday the IMF chided the United States and the United Kingdom for their recent pursuit of austerity. The organization released its latest World Economic Outlook in anticipation of the annual World Bank-IMF spring meetings in Washington, when global financial dignitaries gather.

The IMF put forth top officials to discuss the organization’s forecast — which I’ll take up in another post — and also to critique the state of fiscal affairs in major countries. Carlo Cottarelli, the director of the IMF’s fiscal affairs division, described 10 economies with serious fiscal problems — debt in excess of 90 percent of GDP and rising. These 10 — the United States, Japan, the UK, France, Italy, Spain, Belgium, Greece, Ireland, and Portugal — account for 40 percent of world GDP (for all the headlines they draw, Greece, Ireland, and Portugal account for very little of that global GDP).

Cottarelli warned that there were numerous studies indicating that when debt hit 80 to 90 percent of GDP, growth would suffer. This seemed an oblique reference to the bubbling controversy over the work of Ken Rogoff and Carmen Reinhart. Count the IMF in the camp that think Rogoff and Reinhart are basically right. Cottarelli’s conclusion, given his reading of the broader evidence, was that a country should not seek to stabilize debt/GDP at the 90 percent level, but rather should aim for significantly lower levels of debt.

While that might seem to support a call for austerity, the IMF’s short-term policy conclusions were just the opposite. As the Wall Street Journal reported it:

"…the International Monetary Fund on Tuesday called on countries that can afford it — including the U.S. and Britain — to slow the pace of their austerity measures … it warned euro-area policy makers against focusing too much on hitting tough deficit targets, saying they risked further deepening their downturn. ‘Fiscal adjustment needs to proceed gradually, building on measures that limit damage to demand in the short term,’ the IMF said."

There were two interesting caveats to this call, however:

1. This recommendation to back off austerity only applied to countries that are not currently subject to market pressures.

2. Short-term easing needs to be paired with credible medium-term restraint. (Borrow more today; pay it back tomorrow). 

Those caveats are critical and raise all sorts of questions. Fortunately, I was at Cottarelli’s press conference and got to ask.

Take the "market pressures" exception. You know a country is experiencing "market pressures" when that country’s bondholders are panicking, a debt sell-off is underway, and interest rates on sovereign debt are soaring. When no one wants to buy or hold your debt, it is an awkward time to try issuing more. On this, there is broad agreement.

But how do you know when investors are about to lose faith in your debt? Is there any reason to expect advance warning? When should preparations begin?

Cottarelli’s response was that we do not really know in advance. We have to guess. There are some indications of vulnerabilities — a country whose debt is held more by international investors is more vulnerable — but it’s an art, not a science.

An honest but unsatisfactory reply. It does little good to say that we know market pressures when we see them. Once the market has turned on your debt, it’s too late. Budget processes are slow, with long lags from initial discussion to actual spending. If interest rates were to spike on U.S. debt in September 2014, borrowing for that time period is covered by the budgets currently under discussion in Congress. And, for the record, Federal Reserve data show that in 2011 roughly 46 percent of U.S. debt was held by international investors. 

On the question of repaying additional short-term borrowing with medium-term frugality, I asked about judging the credibility of fiscal plans. The U.S. fiscal stimulus of 2009 was supposed to be a temporary measure, but worked itself into spending baselines. Congress regularly adopts measures that ‘balance’ 10-year budgets, only to repeal those measures when the time comes. A classic example is the attempt to cut payments to Medicare providers, requiring a regular "doc fix" when it turns out there is a limit to the pro bono services doctors will provide.  So how do we know that medium-term promises are credible?

Cottarelli suggested that a first step was to look at whether a plan contained sufficient detail. Beyond that, though, he acknowledged it was a much more difficult issue. His recommendation was to look at a country’s past record of implementing fiscal adjustment.

Other than the recent austerity, to which they object, it was unclear which episodes in recent British or U.S. fiscal history offer reassurance on this count.

The rationale for the IMF’s call to set aside austerity is pretty clear — large parts of the world are slumping, central banks are doing all they can on the monetary side, so the IMF would like to see a boost to demand through looser fiscal policy (lower taxes or higher spending). The Reinhart-Rogoff controversy is a sideshow here. The IMF is not embracing ever-rising debt levels; it is pushing select countries to adopt a temporary slump-busting burst.

Yet if one runs through the IMF’s own check-list of pre-requisites for short-term relaxation — current debt at sustainable levels; freedom from worry about a market panic; credible medium-run plans for cuts — none of them seem to apply. The IMF prescription appears less a careful calculation than a double gamble. It is a bet that further short-term measures are appropriate to address a slow-down that has now dragged on for five years, and also a bet that those who adopt the prescription will not have to pay a hefty price down the line.