"One has the feeling that at any moment, things could get very bad again.” With these words, Olivier Blanchard, the International Monetary Fund’s chief economist, has set the tone for this year’s spring meeting of the IMF.
By Jeremy Warner
Blanchard is more optimistic about growth than he was, which is obviously progress of sorts. Unlike last year, when the IMF was constantly on the back foot in cutting its growth forecasts to keep up with reality, it’s now raising them again, albeit not by very much. But it is all based on the assumption that another European flare-up will be avoided. Few here in Washington would bet on such an outcome.
What is more, the IMF’s own analysis suggests that, come what may, there will be a further collapse in the supply of eurozone credit this year and next, with European banks contracting their balance sheets by a full 7pc – $2.6 trillion (£1.6 trillion) – by the end of 2013. This would imply an additional reduction in credit over the next two years of 1.7pc as banks seek to restore balance-sheet strength by shedding assets and rebuilding capital.
On a worse-case basis, says the IMF, the shrinkage could be as much as 10pc ($3.8 trillion), reducing credit supply by 4.4pc and growth by 1.4pc. Naturally, the great bulk of this adjustment would be felt in the troubled eurozone periphery, reinforcing the gulf between a depression hit and jobless south and a more prosperous but stagnant core.
There is also an unspoken further worry that underlies much of the IMF’s latest analysis – that policy has simply run out of road. There may not be much more the politicians and central bankers can do, even if willing, to ease the pain of the economic adjustment. Nearly five years after the crisis began, there remains little sign of resolution. Lasting solutions are as elusive as ever. The IMF’s depressingly orthodox policy prescription falls a long way short of providing them.
To all intents and purposes, what the IMF proposes is just a souped-up version of the eurozone’s existing approach to the crisis, a collection of half measures and conventional thinking that seeks to band-aid the euro without properly addressing the underlying causes of its crisis.
Prof Blanchard has referred to the dilemma at the heart of policy by characterising markets as “somewhat schizophrenic”. On the one hand they demand fiscal consolidation, but then they react badly when fiscal contraction leads to lower growth. They want the banks to shrink their balance sheets and rebuild capital, but, understandably, they worry about the effects of tightening credit on economic output.
It appears that many of the actions deemed necessary to bring the crisis to an end confound the chances of achieving it. But they do so largely because of the constraints of the euro, which deprives the south of the monetary freedom it needs to recover.
The latest outbreak of jitters about Spain provides a telling case study. By cutting the deficit so sharply, Spain is further undermining growth, thereby increasing the scale of the consolidation needed to eliminate the deficit. It’s a vicious circle from which there appears to be no escape.
A devastating analysis by the economist Luis Garicano has convincingly argued that the fiscal consolidation needed in Spain to meet any given level of deficit reduction would be up to double what the government is projecting.
The government’s calculations are based on a simple extrapolation of the necessary fiscal adjustment from nominal GDP. In an economy of roughly €1 trillion (£819bn), the 3.2 percentage point targeted reduction in the deficit would, on the government’s thinking, therefore require a €32bn consolidation.
You hardly need to be an economist as accomplished as Prof Garicano to figure out that ripping 3.2pc of demand out of the economy will cause it to be smaller at the end than it was at the beginning. In order to achieve the required reduction relative to GDP, the consolidation therefore has to be quite a bit bigger. The policy prescribed is self-defeating.
The same might be said of other aspects of the policy response to the crisis. In a system of free-floating exchange rates, divergent competitiveness is corrected through currency adjustment, with the uncompetitive devaluing against the competitive. Obviously, this cannot happen in a monetary union, so countries must attempt to regain lost pricing power through “internal devaluation”, or cuts in nominal prices and wages.
Politically and socially, internal devaluations are extraordinarily difficult to achieve. Prices and wages are “sticky”, and outside the public sector, they are not easily cut. But the effect of such price and wage deflation is also to add to the burden of the debt overhang, which, in the absence of default or debt forgiveness, will remain the same even as income reduces. The scale of the deleveraging challenge therefore gets bigger.
Having urged such actions, the IMF is being forced to nuance its position. “Manana, manana” is its latest mantra. Yes, let’s have credible medium-term fiscal consolidation plans, but let’s not be too hasty in imposing them. And those with the “fiscal headroom” to do so, by which is meant largely Germany, should ease back. The fact that Germany bizarrely thinks itself in the midst of an inflationary bubble, and is therefore most reluctant to do so, is completely ignored.
Some forms of bank deleveraging, the IMF now says, are better than others. Like Goldilocks, the amount, pace and location of deleveraging must be just right - not too large, too fast, or too concentrated in one region.
Unfortunately, what’s happening in practice is that as funding dries up, banks in the eurozone periphery are indeed biting into core lending, causing a fully-blown credit squeeze. Fearing break-up and default, banks in the more creditworthy north are also withdrawing lending from the periphery. The south is therefore experiencing a double-whammy of bank deleveraging. The IMF may have revised up its growth forecasts, but monetary union ensures that this is not a crisis capable of resolution.
