The IMF addresses public debt overhangs, but questions remain

As was the case with the chapter on household debt, the IMF has provided a timely and useful analysis of public debt. It provides a lot of great advice, but questions still remain on the policies and economic context that support successful reduction of debt to GDP ratios.

The IMF’s World Economic Outlook has again provided a very timely analysis of a critical economic and political topic. Whereas their focus last report was on household debt, the focus now is on public debt, which is incredibly topical given the problems of the Eurozone and the political discussions in the US regarding their debt and deficit.

There are three main findings from their analysis, which will be discussed in turn:

1) Successful debt reduction requires fiscal consolidation and a policy mix that supports growth. Key elements of this policy mix are measures that address structural weaknesses in the economy and supportive monetary policy.

The concept of the right ‘policy mix’ comes out strongly in the IMF analysis. In basic terms, debt reduction requires fiscal consolidation (and probably an outright primary surplus), but these should be offset by supportive monetary policy. Highlighting the opposite case for this mix, the IMF examined Britain after WW1. The UK Government was successful in maintaining a major primary surplus during the 1920s, but the Bank of England raised rates to 7% in an attempt to return to pre-war parity with gold. This delivered extremely high real rates, as deflation also ensued, leading to very poor growth and high unemployment. Needless to say, the outcome on the debt dynamics was terrible, as debt to GDP reached 190% in 1933.

Implications for present day US

Whilst the report is highly informative, it does seem to contradict itself in relation to what these findings imply for the current US economic situation. For the US, they state that conditions seem suitable for fiscal consolidation as monetary policy is supportive and the financial system has been restored following the crisis. However, there is a problem here with the words ‘supportive’ and ‘offset’, which they use in other parts of the report.

Even though I view QE3 as having a positive contribution to the economy , I would argue that it is at the end of its effectiveness, especially when compared to monetary policy that could reduce nominal rates from high levels to low levels. Such a reduction in rates would help to ‘offset’ the fiscal consolidation, but with rates at the zero lower bound, the ability to offset fiscal consolidation is limited.

Implications for present day UK

In discussing Japan’s experience of debt dynamics over the last two decades, the report states the following:

When structural weakness in the financial system prevents the normal transmission of monetary stimulus and when policy rates are constrained by the zero lower bound, the risk of anaemic and fragile growth is high regardless of the fiscal setting. Such a macroeconomic environment clearly precluded successful fiscal consolidation: whenever such measures were taken the economy dipped into recession.

Even though the report does not link this with the present fiscal policy of the UK Government, I cannot help to draw comparisons between the two. When George Osborne undertook his dramatic fiscal contraction, with more emphasis on front loaded austerity than back loaded austerity, the UK financial system was very much (and still is) like that described for Japan. Crucially, for Japan, the debt to GDP ratio has kept climbing over the last two decades, despite a brief period where it stabilised at 185% of GDP in the mid 2000s.

Implications for present day Eurozone

On the EU, they do mention that the financial system is not strong enough, but the case is more clearly made using their own debt dynamics equation. They state that real growth and real interest rate can balance each other out, meaning that primary deficit is very important, but right now in the EU, there is a big difference with high real rates on the debt and no growth, as I discussed previously . So the outlook for debt to GDP ratios in peripheral Euro countries looks poor, with a lack of growth, real interest rates that are not supportive and primary deficits that are difficult to get down.

2) Fiscal consolidation must emphasize persistent, structural reforms to public finances over temporary or short-lived fiscal measures. In this respect, fiscal institutions can help lock in any gains.

This area does not seem controversial, so will not be elaborated upon here.

3) Reducing public debt takes time, especially in the context of a weak external environment.

Has this been taken into account with the deficit targets of the Eurozone periphery? This serves to emphasise the point made by many commentators that the austerity enforced on the Eurozone periphery was both a misdiagnosis of the problem and a mistaken way of reducing public debt. By asking this austerity of peripheral countries all at the same time, with little stimulus to offset this from the core, they basically ensured a weak external environment for the entire region. Right now, one can only hope that the conditionality of the new ECB program (that will support Euro countries with their short dated debt) will not add to this austerity induced downward spiral.


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