The IMF and its fiscal recipe

18.02.08 Publication:

If you think back ten years ago, to the East Asian financial crisis that began in Thailand and then spread all over the region, brought down the Suharto dictatorship in Indonesia and then hit other emerging markets such as Russia and Brazil, what is the main image you have of the IMF? Perhaps you don’t have one, for international organisations known chiefly by their initials tend to be colourless creatures. Or perhaps you remember the large demonstrations held in South Korea, Thailand, Indonesia and elsewhere in which colourful protestors held placards denouncing the IMF? I am in the news business, and so the image I remember is different. It was a photographic image of a severe-looking Frenchman folding his arms.

            That Frenchman was Michel Camdessus, and in 1997-98 he was the managing director of the International Monetary Fund. His arm-folding took place during a ceremony in Indonesia in which that country’s government was signing an agreement with the IMF under which it would receive a huge loan and in return it would cut its budget deficit and implement other austerity measures.

The photograph was later considered a notorious symbol of the supposedly imperialist ways of the IMF. A year or two later, I saw it displayed in the office of a senior Indonesian public official in Jakarta, as a reminder of how bad things had become in 1997-98. It was also a reminder that whenever the IMF gets involved in solving a problem, its solution is always painful, with budget cuts at the top of its list of required actions.

            There is now a financial crisis unfolding in the rich world, centred on America but also affecting Britain, France and the rest of the European Union. And the head of the IMF is again a Frenchman, and he has again caused consternation. This time, however, Dominique Strauss-Kahn, the new IMF managing director, has sprung a big surprise. He seems to have thrown away the old IMF formula that every financial crisis demands government budget cuts. Instead, at the World Economic Forum in Davos in late January and then in an article in the Financial Times on January 30th, he called on governments around the world to deal with the crisis by expanding their budget deficits, by doing whatever they could to stimulate economic growth using their fiscal policies.

            Perhaps this should not have been a surprise. Mr Strauss-Kahn, after all, is a former Socialist finance minister in France, and French Socialists have often believed that good can come from budget deficits. Yet he has always sounded quite austere in the past, and the most surprising thing about his intervention is its timing. There have been plenty of predictions that America will slide into a recession, and that a global slowdown will also occur, but so far there is little hard evidence that it is happening. Unemployment in America has been rising, but not yet by very much.

            The only dramatic news has come in financial markets, thanks to the huge losses reported by American and European banks (and smaller losses by Asian banks) as a result of the crash in value of sub-prime mortgages and of complex credit derivatives. In the week before Mr Strauss-Kahn made his call for fiscal stimulus, America’s central bank, the Federal Reserve, had made its biggest one-day cut in interest rates since 1984, soon followed by a further cut.

            Nevertheless, even though the IMF boss may be making a rather premature intervention, some governments around the globe have responded enthusiastically. In America, Congress and the White House were already striking a deal for a $168 billion fiscal package. In India, the finance minister Palianappan Chidambaram was reported to have responded by saying India might have some room to help with more fiscal stimulus. In Europe, politicians in France and Italy jumped quickly into line, pressing for greater fiscal laxity.

            But is Mr Strauss-Kahn correct? Would it be right for everyone to cut taxes and raise public spending in order to keep the world economy growing rapidly? The general answer is that it would not be right. As the sky-high prices for oil, metals and wheat show, the world as a whole has too much demand, not too little. Fiscal stimulus makes sense only when demand needs to be boosted. That is not currently the case, nor would it be if the global economy slows down according to the IMF’s new forecast growth rate for 2008 of 4.1%, down from 4.9% in 2007.

            A more sophisticated answer, though, is that there are some countries where fiscal policy could indeed help to mitigate the likely economic slowdown in those places. Almost certainly, however, they are not the countries where politicians have reacted enthusiastically to Mr Strauss-Kahn’s call.

For example, they do not include India, where the government budget deficit is already 6.4% of GDP and where demand has been so strong that consumer-price inflation has recently exceeded 5%. But they may well include Japan, where the budget deficit is high but demand is chronically weak, and likely to be made weaker still by the rise of the yen’s value against the dollar. The Japanese government has been debating when to raise taxes in order to cut back public debt. That debate should now be ended, to be replaced by discussion of whether some fiscal stimulus would help support economic growth—but by cutting taxes, not by spending money on public construction projects as during the 1990s.

The countries where a fiscal stimulus would make sense are those where demand is weak and where deflation is becoming a bigger problem than inflation. That may soon include America, which is why it is good news that there will be a fiscal package, flawed though it is bound to be thanks to the political bargaining process.

It doesn’t, however, include the fast-growing emerging economies such as China and India, where inflation is the danger, not deflation. Only as and when that changes, with a growth slowdown much worse than the IMF expects, should they consider increasing their budget deficits. Their finance ministers should emulate Mr Camdessus and not Mr Strauss-Kahn, and should keep their arms folded.