The IMF and economic support: It's Mainly Fiscal

On a day when the UK reported another eye-wateringly high level of government borrowing, one MP tweeted that “the state of the public finances should alarm everyone who understands them.” My advice would be let’s not get too alarmed just yet. It is also the advice given by the IMF in its latest Fiscal Monitor (FM) published this week. Politicians’ views are usually based on the assumption that public finances can be equated with household finances thus prompting howls of outrage when deficits and debt are deemed to be “too high” because they look at the monetary amount of the deficit or debt without putting it into some form of economic context.

When it comes to debt, what matters is the ability to service it in the short-term and reduce the burden it poses on the economy in the longer-term. Admittedly the UK’s public debt now exceeds 100% of GDP which is higher than we would ideally like but as I have pointed out previously, many countries have lived with higher debt ratios. To the extent that GDP represents a measure of annual income, the UK (in common with many other European economies) has a debt level which exceeds its annual income. But households routinely borrow significant multiples of their annual income to buy a house, and for the record the UK household sector has debt equivalent to 139% of its annual income. Calls for the government to cut back on the support it provides, despite the fact that the Covid pandemic is getting worse rather than better, are thus deluded.

The IMF points out that in a global context, “public debt is expected to stabilize at about 100 percent of GDP until 2025, benefiting from negative interest-growth differentials. These high levels of public debt are hence not the most immediate risk. The near-term priority is to avoid premature withdrawal of fiscal support.” A crucial reason for this is that fiscal measures have undoubtedly “saved lives, supported vulnerable people and firms, and mitigated the fallout on economic activity” and unsurprisingly the IMF advocates devoting considerable fiscal resources to health. But “further support is necessary to protect people who cannot make a living under the current circumstances” (a message which might be directed at UK the government following the heated discussions regarding how much support it should be expected to provide to those regions of the country which have been subjected to a more intense lockdown).

Quite how long the pandemic will last is obviously unknown, and this explains why governments are not willing to make open-ended commitments. On the basis that eventually we will overcome the worst effects of Covid-19, governments will have to make some important decisions about when and how to reduce their fiscal support. But the IMF, which has undergone a form of Damascene conversion on fiscal policy since the 2008 crisis, argues that governments should continue a programme of public investment even after the worst of the crisis has passed. It makes the point that the bang for the buck from higher public investment is larger during times of economic uncertainty (i.e. the fiscal multiplier is higher) than during more “normal” times. Moreover, low interest rates, high precautionary savings and weak private investment are strong arguments for boosting public investment to “crowd in” private investment. This is all a long way from the IMF’s advice in October 2008 when it suggested “policymakers must be very careful about how stimulus packages are implemented, ensuring that they are timely and that they are not likely to become entrenched and raise concerns about debt sustainability.”

Indeed in October 2012, the IMF concluded that it had systematically underestimated fiscal multipliers since the start of the Great Recession by between 0.4 and 1.2. Thus, if we thought pre-crisis that the multiplier was around 0.5, it would in fact be more likely to be in the range 0.9 to 1.7 (a figure greater than unity implies that a fiscal expansion of x% of GDP would lead to an increase in output of more than x%). Subsequent IMF research also suggested that fiscal multipliers are significantly larger in times of a negative output gap than when the output gap is positive (I was not very popular amongst my German colleagues in 2015 for pointing this out). In the latest FM, the IMF’s empirical results suggest that an increase of public investment equivalent to 1% of GDP increases the level of output by a factor of more than two in a high uncertainty environment versus 0.6 in the baseline case (chart below).

However, much of the public debate proceeds on the basis that all government spending is somehow equal and that as long as “something is done” all will be well. This is not the case. As Chris Giles pointed out in the FT last week, the UK government spent 0.6% of GDP on its much-vaunted Covid track and trace system in the expectation that this would allow the economy to reopen safely with the result that the economic benefits would significantly outweigh the costs. The project has not worked out like that and it currently looks like an expensive failure. It may yet match expectations with additional outlays but the point is made that public projects have to be carefully scrutinised to ensure that they generate decent rates of return (either social or financial). BoE Governor Andrew Bailey made this point to a parliamentary Economic Affairs Committee last week, noting that investment “has to be in projects that earn a rate of return. History is quite mixed on that front.”

The IMF notes that in “advanced economies that do well on the World Economic Forum’s index of government-spending wastefulness, public investment has been found to have a fiscal multiplier of 0.8 in the first year and above 2.0 at the four-year horizon.” For the record, the UK ranks 34 out of 136 countries behind Germany (20) and Japan (22) but ahead of France (73) and the US (74). Whilst it is all very well arguing for higher public investment, there is a question of where it should be targeted. Aside from health, education is high up the priority list since it results in significant externalities which produce very high rates of social return (although these returns tend to accumulate only over long horizons). I have increasingly become an advocate of investing in climate-proofing the economy where the evidence suggests that returns are often in excess of 100%, and well above this in regions particularly exposed to extremes of weather. Investment in digital infrastructure is another area likely to generate significant returns in the near future and I will undoubtedly return to these issues another time.

Governments have clearly learned from past experience that they have to step in to make up for a shortfall in private demand in times of extreme crisis such as we are experiencing today. Whether they will learn from the experience of the past decade remains to be seen. Too many governments were quick to turn off the taps following the GFC in a bid to improve their fiscal position. The trick in coming years will be to recognise that this cannot be achieved in a matter of a few years – this is a multi-decade problem which will be made all the easier by policies which support growth rather than hinder it.