The IMF Was Right to Criticize UK Fiscal Policy
British policymakers claim that the United Kingdom's recent strong growth momentum vindicates the government's strategy of harsh fiscal austerity after 2010, prompting Christine Lagarde, the International Monetary Fund's managing director, to apologize for getting it wrong. Her regret was not warranted, however.
In a speech in Washington in April 2014, just as the IMF revised its forecast to show that the United Kingdom will grow faster than any other G-7 economy this year, George Osborne, British chancellor of the exchequer, said, "Pessimistic predictions that fiscal consolidation was incompatible with economic recovery have been proved comprehensively wrong by events." And just days before the IMF concluded its June 2014 annual economic health check visit to London (Article IV consultations, in the parlance), Andrew Tyrie, chairman of the House of Commons Treasury Committee, wrote that the IMF "would have done better to keep quiet" about its criticism that the UK's budget deficit was being reduced too quickly and that the economic recovery "has defied the IMF's expectations." Subsequently, in an interview at the conclusion of the IMF visit, Lagarde stated: "We got it wrong. We acknowledged it. Clearly the confidence building that has resulted from the economic policies adopted by the government has surprised many of us."
These statements do not stand up to scrutiny. I must disclose that I am not a disinterested party in this debate. From 2008 to 2012 I was the IMF's mission chief for the annual consultations with the United Kingdom, and was thus one of the architects of the IMF's policy recommendations. After giving the new government's June 2010 fiscal strategy the benefit of the doubt—with a warning that contingency planning was essential—IMF staff soon began to express greater concerns, especially in 2012 , that the strategy was not optimal.
Yes, the IMF staff got the growth forecasts for the United Kingdom wrong, missing both the timing and vigor of the rebound. This was a failure and needs to be acknowledged. But this failure was, sadly, not that remarkable—forecasts by the Bank of England and the UK's Office for Budget Responsibility (OBR) were no better. Economists' ability to predict turning points is limited, as recently confirmed by the IMF researcher Prakash Loungani using data from the Great Recession.
More fundamentally, as pointed out by many, underestimating the strength of the recovery does not mean that the government's path for fiscal policy was right, or that concerns expressed by the IMF and others were wrong.1 The prediction was not that there would be no recovery, but that it would be slow and delayed because of substantial fiscal drag at a time when the private sector was already contracting.
This prediction has been borne out. Notwithstanding the recent growth spurt, the United Kingdom has had an exceptionally dismal recovery. A report by the UK's Office for National Statistics shows that the recovery has been one of the slowest in the G-7, with only Italy doing worse. It is also the slowest in 90 years of UK economic history—the National Institute of Economic and Social Research estimates that it has taken 76 months for the level of GDP to return to its prerecession peak; after the Great Depression it took 48 months. And Bank of England economists Spencer Dale and James Talbot show that this recovery has been weaker even by standards of recoveries that follow financial crises. The labor market has done better than output, but good employment trends have come with an ugly counterpart—dreadful productivity and the inability to generate real wage growth.
The drag from fiscal consolidation has been a major reason for the tardy recovery. OBR estimates of the impact of discretionary fiscal policy on the level of GDP show that as the 2008–09 fiscal stimulus waned, fiscal tightening reduced output by just over 5 percent of GDP between 2010 and 2013. This big number is, moreover, likely to be a conservative estimate because fiscal multipliers may be larger than those used by the OBR, which is plausible when monetary policy is constrained by the zero lower bound. OBR estimates also show that the impact of discretionary budget cuts tapered off in fiscal 2013 (which began April 2013). The government's easing off of the austerity brake has helped spur the recovery, as has the Help to Buy scheme for houses, which is fiscal policy through the back door.
Necessary retrenchment by the private sector as it adjusted overleveraged balance sheets also contributed to the slow recovery. The Bank of England was aggressive in trying to cushion this adjustment, implementing an additional slug of quantitative easing even when inflation temporarily jumped to 5 percent. But there are limits to what monetary policy can achieve when interest rates reach zero. It is precisely in these circumstances that fiscal policy needs to play a more supportive role.
Analytical work by the IMF's Kevin Fletcher and Damiano Sandri (in annex 3 of the IMF 2012 staff report ), which extends an influential paper by Bradford DeLong and Lawrence Summers , shows that when fiscal multipliers are asymmetric over the cycle and there are hysteresis effects, consolidation should be delayed until the economy is stronger. Put simply, UK fiscal policy was too tight for the weak economy. With less fiscal austerity the recession would have been less severe and the recovery would have been faster.
The typical counterargument has been that the government's credibility was being tested and markets would lose confidence in the government's ability to manage its finances had it not embarked on austerity. But by autumn 2011 the British government had bought itself a great deal of fiscal credibility with its front-loaded adjustment. More forceful fiscal easing while committing to a multiyear plan to reduce the structural deficit when the economy was stronger would have been appropriate because higher growth would have also sustained market confidence that public debt would not become unmanageable.
The IMF was right to raise its voice about the risks of the UK's fiscal strategy and advocate even greater budget easing than was eventually implemented. Furthermore, IMF surveillance and policy advice are more robust when they are well-grounded in economics and do not succumb to intimidation by country authorities. As observed by Ashoka Mody, unwarranted apologies undermine the IMF's credibility.
That the UK economy is now growing fast is most welcome, but it does not condone past policy errors. The forthcoming IMF report for the 2014 UK consultation, which provides a more independent staff view, is a good opportunity to set the record straight.