States 'under the gun' must cut deficits, says IMF researcher

 

COUNTRIES THAT are “under the gun” in financial markets have no choice but to start immediately reducing budget deficits, according to a visiting official from the International Monetary Fund.

Daniel Leigh, an economic researcher at the IMF’s Washington DC headquarters, was speaking at the Department of Finance yesterday as part of the fund’s “outreach” programme designed to disseminate its research more widely. He did not discuss issues related specifically to Ireland or give views on the Government’s economic policy.

However, his presentation, based on research published two weeks ago, made a number of points relevant to Ireland.

The IMF team found that the relationship between fiscal adjustment and economic growth is largely linear. This suggests that as fiscal retrenchment increases in magnitude, it has a proportionately negative effect on employment and economic growth.

On the one hand this could scotch hopes that consumers and businesses would respond positively to a large, credible Government adjustment programme by increasing their spending.

At the other extreme it could assuage concerns that a further large budget adjustment would push the economy past a tipping point and into a downward cycle.

The research also points to the negative effects of fiscal tightening being twice as large in the absence of monetary loosening (ie cuts in interest rates).

It is twice as large again if fiscal tightening is taking place simultaneously elsewhere.

From an Irish perspective in the current context this suggests that deficit reduction measures will have a significant negative effect on employment and economic growth. Dr Leigh did, however, say that countries that were paying high rates of interests to borrow could benefit if consolidation plans were put into effect.

The IMF’s new work contradicts earlier research by other economists, most notably Harvard University’s Alberto Alesina, which found that the negative effects of budget tightening on economic growth and employment could be more than offset by positive confidence-boosting effects. This is called the “contractionary fiscal expansion” hypothesis.

Dr Leigh and his colleagues can find little evidence to support the hypothesis, believing that retrenchment will bring pain in the short term and only in the long term will gains be reaped by lower interest rates and greater fiscal flexibility.

Prof Alesina, writing on his webpage in response to the IMF research and reporting of it, has strongly defended his stance, stating: “Many other papers using different methodologies have identified cases of expansionary fiscal adjustments, thereby drawing similar conclusions to our paper.”