For years, the International Monetary Fund helped to ensure global financial stability. Lately it has changed its mind on what used to be a core principle -- and, strangely enough, it appears to have done so on the basis of a single far-from-convincing working paper.
The IMF is probably the most powerful international organization in the world. It has been effective not just because of the resources at its disposal but also because it has focused on one issue: financial stability.
Critics pay it a backhanded compliment when they say its initials stand for, “It’s mostly fiscal.” In fact, when it comes to the crises that the IMF is asked to manage, it really is mostly fiscal. If the IMF forgets that, it becomes part of the problem.
For decades, the IMF demanded that countries in crisis cut their government budgets. In the East Asian crisis of 1997-98, many complained that it went beyond its usual financial mandate in demanding broader structural reforms. Sensibly, it got back to basics afterward.
In the current global financial crisis, the IMF has deviated in a new way. In 2008-09, Managing Director Dominique Strauss-Kahn advocated fiscal stimulus for all countries that had “fiscal space.” In that list he included Spain, Slovenia and Cyprus. All of them followed his advice and ended up in worse trouble.
Last October, the IMF published a note in its authoritative semi-annual World Economic Outlook, arguing that fiscal multipliers -- the change in output induced by a change in the government’s budget deficit -- were larger in current circumstances than previously thought. Tight fiscal policy, in other words, would squeeze output more than economic modelers had typically supposed. The implication was that fiscal adjustment should be delayed.
In January, the IMF’s chief economist, Olivier Blanchard, and his colleague Daniel Leigh explained this finding in a working paper. The authors wisely end the study with a series of caveats, emphasizing that their “results should not be construed as arguing for any specific policy stance in any specific country.”
Indeed they shouldn’t be so construed -- for at least four reasons.
First, the whole paper is based on forecasts of economic growth. In the early stage of a crisis, forecasts tend to be widely off the mark. Until the bottom has been reached, they tend to be too optimistic. In December 2008, the IMF forecast that Latvia’s gross domestic product would fall 5 percent in 2009; it plummeted 18 percent. The cause wasn’t austerity but a complete liquidity freeze. Since state revenue collapsed along with output, fiscal restraint was unavoidable -- a matter of financial survival.
Toward the end of a crisis, however, forecasts usually underestimate growth. My favorite example is Russia in 1999. In December 1998, the IMF predicted that Russia’s GDP would fall 8.9 percent in 1999; it rose 6.4 percent. Other forecasters were no better.
Attributing forecast errors to unexpectedly large fiscal multipliers implies that the models are otherwise reliable -- that they aren’t systematically flawed in some other way. This assumption is unwarranted. The performance of the forecasts is just too poor to support it. The study by Blanchard and Leigh fails on this single objection. There’s more.
Second, the argument presumes that a country has access to the capital market. But countries in crisis often lose access to private international funding -- sometimes suddenly and unexpectedly, despite having little public debt. In late 2008, Latvia lost its access although its public debt was less than 20 percent of GDP. Slovenia was shut out of the international debt market for most of last year with a debt ratio of only 50 percent. When Argentina defaulted in 2001, its public debt was just 50 percent of GDP.
Third, in the midst of a crisis, people are often ready to accept radical budget reform and severe belt-tightening. Later, it’s much more difficult to convince them of the need. A crisis is a terrible thing to waste.
Fourth, and relatedly, the Blanchard-Leigh paper is entirely short-term. It studies GDP in the year after a fiscal adjustment, but what matters is long-term economic growth, and that depends on structural reforms. A fiscal crisis rarely has exclusively financial causes. Normally, labor-market reform, deregulation of monopolized markets, and other far-reaching reforms are needed, as well. Again, a crisis helps.
Blanchard and Leigh wisely concluded by saying, “The short- term effects of fiscal policy on economic activity are only one of the many factors that need to be considered in determining the appropriate pace of fiscal consolidation for any single country.” Yet the IMF management has gone ahead and made fiscal forbearance its official policy.
At the annual meeting of the IMF in October 2012, Managing Director Christine Lagarde urged countries to refrain from new austerity measures. Warning against front-loading spending cuts and tax increases, she stated: “It’s sometimes better to have a bit more time,” and she named Portugal, Spain, and Greece as instances. Remarkably, she added: “We do not think it is sensible to actually stick to nominal targets.”
The very essence of IMF programs has been to hold crisis countries to nominal targets, extending IMF credits when the countries comply and withholding them when they don’t. Today, the fund is doing the opposite: It’s helping the opponents of fiscal reform. Its calls for a loosening of fiscal policy have been used to attack governments conscientiously pursuing financial stability. Recently, Bulgaria’s finance minister at the time, Simeon Djankov, complained that the IMF had abandoned its disciples; the next week, the Bulgarian government was ousted after public protests against austerity.
Until now, the IMF’s raison d’etre has been to support financial stability through hard-headed analysis and strict demands. Lagarde and Blanchard have undermined their institution and set back the cause of economic reform.
Anders Aslund is a senior fellow at the Peterson Institute for International Economics. He is co-author with Valdis Dombrovskis, the prime minister of Latvia, of How Latvia Came Through the Financial Crisis.