Powers need to heed the IMF's words of warning

In a sensible world, policy makers would apply strong fiscal support to the economy and robust efforts to heal private sectors

In its relations with its most powerful clients, the International Monetary Fund possesses “the right to be consulted, the right to encourage and the right to warn”. Walter Bagehot, the great Victorian economic journalist, gave this description of the role of the British monarch in the 19th century. I applied this phrase to the role of the fund in a paper I submitted to its 2011 triennial surveillance review. At the annual meetings in Tokyo, the fund fulfilled precisely this role. What matters, however, is that its members, above all, the US and Germany, act upon the warnings and encouragement they have received.

The warning provided by the IMF’s World Economic Outlook was that: “The recovery continues, but it has weakened. In advanced countries, growth is now too low to make a substantial dent in unemployment. And in major emerging market economies, growth that had been strong earlier has also decreased.”

The IMF revised its forecast for 2013 growth in advanced economies from the 2 per cent it forecast in April to 1.5 per cent. For developing countries, it cut its forecast from April’s prediction of 6 per cent to 5.6 per cent. The performance of the US, with forecast growth of 2.1 per cent next year (just 0.1 percentage points lower than forecast in July), is expected to be far better than that of the euro zone, where growth is forecast at 0.2 per cent next year (0.5 percentage points lower than forecast in July), after -0.4 per cent in 2012. Even Germany’s economy is forecast to grow by a mere 0.9 per cent in 2012 and 2013. Spain’s is forecast to shrink by 1.5 per cent and then 1.3 per cent. The euro zone is a cage for masochists.

It is no secret why growth is slowing in high-income countries: this is due to fiscal tightening, weak financial systems and powerful uncertainty. This toxic combination is particularly threatening inside the euro zone, where, again no surprise, countries reliant on exports are affected by the shrinking economies of big trading partners. As the latest Global Financial Stability Report shows, cumulative capital flight from peripheral euro zone economies is more than 10 per cent of gross domestic product.

Indeed, without support, principally from the European Central Bank, peripheral economies would have had to impose exchange controls. They might even have left the euro zone. The fear of break-up remains pervasive: it is always hard to make masochism a credible strategy.

So far, so bad. But even these depressing forecasts make two possibly optimistic assumptions. The first is that the US avoids the “fiscal cliff” created by its quarrelling legislators. If not avoided, this would impose a tightening of 4 per cent of GDP. Sane people know the result: a deep recession and, possibly, outright deflation. Can US legislators be that stupid? One must assume not.

The second optimistic assumption is that “European policy makers take additional action to advance adjustment at national levels and integration at the euro area level. As a result, policy credibility and confidence improve gradually.” Will European policy makers be that effective? One wonders, even if they have been more decisive recently.

So much for the warnings. What about the encouragement? The IMF argues, boldly and controversially, that fiscal multipliers have been far greater than normal in the Great Recession. This would hardly be surprising, since the Keynesian conditions of interest rates close to zero and tight constraints on credit now apply. Its conclusion is that multipliers have been in the range of 0.9 to 1.7, instead of the standard assumption of 0.5. This means that a tightening of, say, 5 per cent of GDP, roughly the cyclically adjusted tightening expected of Spain between 2009 and 2013, would lower GDP by between 5 and 9 per cent, other things being equal. If anything close to this were true, even the fiscal deficit would fail to improve, as revenue fell and spending rose.