THE IMF FOOLISH PRAISE FOR AUSTERITY / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

The IMF’s foolish praise for austerity

By Martin Wolf

Last updated: September 30 2010 23:55

“The government’s strong and credible multi-year fiscal deficit reduction plan is essential to ensure debt sustainability. The plan greatly reduces the risk of a costly loss of confidence in public finances and supports a balanced recovery.” Thus does the staff of the International Monetary Fund assess the UK’s fiscal strategy. George Osborne, the chancellor of the exchequer, must be ecstatic. This is more than an evaluation. It is a love letter.


Yet it is also hardly a surprise. It would be extraordinary for the IMF to attack a sharp fiscal tightening by a member of the group of seven leading high-income countries with a large structural fiscal deficit. IMF is often thought to stand for “it’s mostly fiscal”. Dog bites man.


Yet the IMF also states that it expects economic growth to be 2 per cent next year rising gradually to 2½ per cent in the medium term. Unless the UK’s potential rate of economic growth has collapsed, the staff is implicitly assuming that existing excess capacity will – indeed should – endure. Since the economy is, as Spencer Dale, the Bank of England’s chief economist, notes, 10 per cent smaller than implied by continuation of its pre-recession trend, it is hard to understand why this is a “balanced recovery”. It accepts huge losses of output as quasi-permanent. Why does it do so?


Adam Posen, a member of the Bank’s monetary policy committee, shows, in a powerful recent speech (entitled “The Case for Doing More”), that this is a very good question. He argues: first, that the economy now possesses large, possibly very large, excess capacity; second, the big danger is not a resurgence of inflation, but deflation, as happened to Japan; and, third, there is a substantial risk that prolonged weak demand will make temporary losses in output structural and permanent, via weak investment and long-term unemployment: “The damage to our economy, our companies and our workforce can be made permanent through inaction by policymakers.”


Some will counter that excess capacity is minimal. True, some part of the pre-crisis output was surely an illusion. But is all of it? That would imply a loss of potential gross domestic product as large as the output of the whole financial sector. Even the Treasury does not believe that. Again, some point to today’s high inflation rate. But there are good reasons to believe this is a lagging indicator, largely reflecting the 25 per cent devaluation of sterling since mid-2007. Crucially, as Mr Dale notes, “annual private sector earnings growth has averaged a little below 1½ per cent since the start of the recession, around a third of its rate in the five preceding years”. That is consistent with zero inflation of nominal unit labour costs. With the government’s job cuts to come, the chances of a wage-price spiral are surely negligible.


Some argue that we have no right to bequeath higher debt to future generations. But why would it be wise to bequeath a smaller economy to posterity, instead? Some point to the huge efforts already undertaken. That confuses input with output. But, as Mr Posen notes, this is like saying that the “fire must be out, because we’ve already pumped more water than for any previous fire”. It confuses action taken with outcomes.


Then, as the killer argument, comes the declaration that this is the “naive Keynesianism” of the 1970s. But those who lived through that era know how different conditions now are: no serious trade union militancy and negligible inflation. Yes, inflation expectations should remain anchored. But, in the medium term, the danger is one of very low inflation, if not deflation, rather than the reverse. The widely held view that expansion of the central bank’s balance sheet must generate high inflation is wrong. With a broken credit system, it does no such thing.


So what is to be done? Since Mr Posen is a member of the MPC he has to focus on “large-scale asset purchases” by the central bank. That almost certainly means purchase of government bonds. Some would argue for buying private assets as well, though the benefits are unclear. The most effective policy, however, would be for the government to increase its deficit and have this rise funded by the Bank.


This is entirely compatible with the programme of spending cuts to be implemented by the coalition government. The  size  and composition of government spending are political decisions. But the target for the fiscal deficit can be independent of the desired spending. If one accepts Mr Posen’s argument that the economy is likely to suffer from deficient demand in the medium term, a simple option would be to proceed with the spending cuts, but slash taxes temporarily – national insurance contributions, for example – and fund the revenue shortfall by borrowing from the central bank. This would give a direct injection of purchasing power into the economy, while promoting employment. Then, as the economy rebounds, these tax cuts can be reversed.


Such a co-ordinated policy by the government and the central bank would be just the “Plan B” many are looking for. Accepting years of feeble growth and chronic excess capacity would surely be a foolish alternative.


Copyright The Financial Times Limited 2010.