The International Monetary Fund should loosen up

Olivier Blanchard, chief economist of the International Monetary Fund, has egg on his face. He attacked George Osborne, the UK chancellor of the exchequer, for seeking to reduce the UK’s fiscal deficit too rapidly, claiming that it would prolong recession. Mr Blanchard has had to admit that he was wrong but his admission has been reluctant and ungracious. (This is the same mistake that cost former UK culture secretary Maria Miller her seat in the cabinet this month.)

Mr Blanchard seems to think that his error lies in the inevitable uncertainty of forecasts, rather than in his analysis. I differ. Economic forecasts are fallible but so, I think, is his analysis.

Mr Blanchard is now claiming that, while his forecast has proved wrong, the UK’s growth is unbalanced — and, by implication, unsustainable. His new comments are correct but at odds with his earlier views. Unbalanced growth is the consequence of the UK’s policy of boosting housing but it would have also been the consequence of more fiscal stimulus.

The IMF is among many that have been wrong about the UK. It comes from the “one size fits all” school of economists, whose love of mathematical models makes them hanker after universal answers. Countries, however, differ from one another and they change over time.

One size, therefore, does not fit everyone. Fiscal stimulus is sometimes but not always a sensible policy response to weak demand. It is badly needed today in the eurozone. A large increase in the German deficit would increase the zone’s chances of survival; sadly, however, German policy wills the end but not the means.

Fiscal deficits are needed to prevent recession if certain sectors of the economy wish to save more than they invest. In a closed economy — such as the world as a whole, where there is no external sector — recessions are caused by the imbalance between savings and investment intentions in the household and business sectors (in economic terminology, the existence of an ex ante savings surplus.) Historically it has been the changes in the wishes of business that have been the main swing factor, as I show for the US, Japan and the UK in charts one, two and three. (These cover all the relevant data I have been able to find. The correlation coefficients are US 0.88; Japan 0.76; and UK 0.76. I suspect that the lower correlations for Japan and the UK are largely a result of the fact that these economies are more open and therefore more sensitive to changes in their current account balances. It may, however, reflect the shorter time periods for which Japanese and UK data are available compared to US data.)

Recognising the importance of business, which is illustrated in these charts, John Maynard Keynes expected the need for fiscal deficits to be short-lived, ending when entrepreneurs recovered their animal spirits. He assumed that ex ante savings’ surpluses were temporary (aka cyclical) phenomenona, and this has been the assumption, sometimes explicit but usually only implicit, of those Keynesians who have called for more fiscal stimulus.

Unfortunately, the current fiscal deficits of the US, Japan and the UK all have important structural elements. For Japan, the problem is that it invests too much (see my blog post, “Why Japan invests too much“) but companies are also driven to save too much by excessive allowances for depreciation (see my post, Japan must cut depreciation allowances ). In the US and the UK management remuneration systems encourage both high savings, by driving up profit margins, and low investment (see my book, The Road to Recovery). In addition, the UK has a structural current account deficit (see my two recent blogs on sterling).

Neither Japan, nor the UK nor the US should seek to boost their economies by more fiscal stimuli. Policy makers in all three must recognise that their country’s need for fiscal deficits comes from structural problems not from temporary cyclical ones, and that policy must seek to overcome these secular hindrances to reducing their fiscal deficits. The IMF is at present an added obstacle to improving policy.