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Has the IMF Missed the Point on Public Debt Overhangs?



The October World Economic Outlook of the International Monetary Fund (IMF), issued semi-annually, contains an ambitious chapter 3, "The Good, the Bad, and the Ugly: 100 Years of Dealing with Public Debt Overhangs." It is an empirical study of developed countries that have had public debt of more than 100 percent of GDP in the last century, clearly inspired by Carmen Reinhart and Kenneth Rogoff's book This Time Is Different.

In typical IMF fashion, it is cautiously empirical. At first glance it is difficult to quarrel with its two main conclusions: "First, support for growth is essential to cope with the contractionary effects of fiscal consolidation. Policies must emphasize the resolution of underlying structural problems within the economy, and monetary policy must be as supportive as possible... Second, because debt reduction takes time, fiscal consolidation should focus on enduring structural change" (p. 126).

The problem with this meticulous and interesting empirical chapter does not lie in what it says, but in its framework and what it does not say. The authors have limited themselves to developed countries in history and they discuss almost exclusively aggregate macroeconomic measures, as the IMF is apt to do. Laudably, this chapter has a long-term outlook, while the IMF tends to be preoccupied with the next year.

The most interesting observation in this chapter is that contractionary expansion works: "Among countries with the same debt levels, the growth performance over the subsequent 15 years in countries for which debt is decreasing when the threshold [100 percent of GDP] is passed is better than in countries for which it is increasing" (p. 108). This is quite a revelation.

Two years ago the IMF October World Economic Outlook tried to dispute this point, but its argument focused on the very short term. Similarly, on October 11, Managing Director Christine Lagarde warned about the contractionary effects of austerity: "The fact [is] that time is of the essence, meaning that instead of frontloading heavily,... it is sometimes better to have a bit more time. That is what we advocated for Portugal; that is what we advocated for Spain; and this is what we are advocating for Greece, where I said repeatedly that an additional two years was necessary." Well, these policies are guaranteeing Greece seven years of contracting output, suggesting that they might not work. But the empirical evidence cited by the IMF says the opposite. The IMF needs to reconcile its evidence and reach the obvious conclusion that contractionary expansion works in the medium and long term, if not the short term. This should have been the main conclusion of this chapter, but its omission may mean that it did not pass the management's censorship.

Second, Greece has just defaulted on its sovereign debt, and the big recent theme has been the elevated sovereign bond yields in Ireland, Portugal, Spain, and Italy. Therefore, it is strange and unrealistic for the IMF not to discuss the risk of sovereign default for high debt developed countries. While the IMF's observations about Belgium and Canada in comparatively calm times are interesting, they are irrelevant to the current problem of countries at the risk of default. It is pointless to discuss countries that do not need an IMF program, while discussing EU countries that have or may need IMF emergency programs.

The adjustments analyzed by the IMF were very slow and incremental because these countries were not in serious crisis and thus did not feel the threat of default. Nor were Belgium or Italy success stories. Why should they be followed as examples? The IMF seems to be trying to tell us that they demonstrate how a reform program is to be done. For the current situation, it would have been more relevant to study countries in severe crises, and they tend to carry out much more robust austerity programs. For example, Russia cut public expenditures by 14 percent of GDP from 1997 to 2000, and Russia slashed its public debt from 100 percent of GDP in 1999 to 9 percent of GDP in 2006 amidst massive economic growth. Bulgaria went from a public debt of 108 percent of GDP in 1997 to 17 percent of GDP in 2007, while achieving sound economic growth. Most other post-communist countries undertook similar adjustments, and they have been prepared to do so again. Latvia has just carried out a fiscal adjustment of 16 percent of GDP in four years. Estonia and Lithuania recorded similar achievements. All three returned to solid growth in 2010 after only two years of recession. By sticking to an irrelevant box of non-crisis politics, the IMF diverts thinking from sensible paths.

Third, one of the big lessons from the fiscal consolidation of Sweden and Finland in the 1990s and from the Baltic states in 2009–12 is that it is better to cut public expenditures than to raise taxes. In general, two-thirds of their fiscal adjustments consisted of expenditure cuts and the rest tax hikes. In fact, the October 2010 World Economic Outlook (p. 113) found "that spending-based deficit cuts...have smaller contractionary effects than tax-based adjustments." The traditional problem of the IMF is its reluctance to say whether it is better to close a budget deficit by moving to a smaller or a bigger government. It should dare to take a stand on that question based on good empirical work. Sweden's recent economic successes are based on a cut in public expenditures of 20 percent of GDP since 1993. And of its fiscal adjustment in the 1990s (amounting to 13 percent of GDP), 8 percent of GDP was public expenditure cuts and 5 percent of GDP revenue measures.

Fourth, the IMF always discusses economic growth, but essentially it limits itself to three macroeconomic variables—fiscal balance, monetary policy, and exchange rates. Sometimes it adds the state of the banking sector. But we all know that economic growth depends on so many other things—human capital, investment, technology, incentives, and business environment.  The IMF authors rightly laud Belgium for its structural reforms. "The policies pursued focused on trimming the share of public employment, reducing an excessively generous system of welfare payments, cutting family allowances and unemployment insurance benefits, and increasing the retirement age" (p. 118). Such reforms are mostly forced by rapid cuts in public expenditures. Therefore rapid austerity can drive economic growth, as we see so well in the Baltic countries.

On the basis of these observations, I would suggest very different policy conclusions. The first aim of economic policy in a country with large public debt must be to avoid default, whose costs are usually so large that a responsible government will do what it takes to avoid it.

Second, time is vital. By examining irrelevant cases, the IMF in effect recommends slow adjustment. No stabilization program should allow for more than two to three years of economic decline. We do not need more countries that continue to contract for seven years because of too little fiscal adjustment, as the case is with Greece. The same happened in the former Soviet Union, which largely lost the 1990s because of persistent budget deficits. Therefore fiscal adjustment should be front-loaded.

Furthermore, sudden action leads to greater public expenditure cuts, because a swift rise in state revenues is impossible to achieve, and quick, large cuts in public expenditures prompt growth-promoting structural reforms of the public sector and major deregulation.

The two main IMF conclusions make sense, but the IMF has left out what is most essential for a successful fiscal restructuring and early, strong economic growth.

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