IMF and manufacture of consent

The economic realities are so complex that the orderly adjustment that the IMF seeks to construct in its latest World Economic Outlook could well end up in disorderly retreat.

THE annual spring and autumn meetings of the International Monetary Fund (IMF) and the World Bank are partly about discussions within the international community of bankers about their priorities and problems. In part, it is also about the manufacture of consent.

The latest version of the IMF's World Economic Outlook, WEO, (April 2004), which was part of the documentary background to the latest meeting at Washington D.C., illustrates many of these characteristics. For most economists, the fiscal policy mix that the Bush administration put in place shortly after its inauguration in January 2001 has been an unmitigated disaster.

Nobel laureate Joseph Stiglitz has castigated Bush for emulating the crooked chief executives of the 1990s, the only difference being that the corporate bosses purveyed inflated stocks with no underlying value, while Bush has sold "a tax cut that (is) beyond the means of even the richest country of the world".

George Akerloff, co-recipient with Stiglitz of the Nobel Prize in 2001, described the tax cut proposals as "a form of looting" and called for active "civil disobedience" by the U.S. public against a government that was "not really telling the truth". Paul Krugman of Princeton University has argued persuasively that the Bush policies as a sure route to "fiscal train-wreck". And no fewer than 450 economists in the U.S., including the country's celebrated scholars like Paul Samuelson, Franco Modigliani, Lawrence Klein, Robert Solow and Kenneth Arrow, signed a public declaration in February 2003, warning against the tax cuts which they said, would only "worsen the long-term budget outlook, reduce the capacity of the government to finance Social Security and Medicare benefits as well as ... schools, health, infrastructure, and basic research, (and) generate further inequalities in after-tax income".

Economists at the IMF are certainly not at liberty to use similar language, especially in relation to U.S. fiscal policy. The prescriptive tone is reserved for developing countries suffering chronic budgetary and external payments difficulties. But to render a policy stance that has been condemned by a wide spectrum of economists into a positive feature of the current situation, is clearly a remarkable feat.

Thus, the April 2004 edition of the WEO rather delicately refers to the Bush tax cuts as "active fiscal policies by the federal government to help restart the U.S. economy". These tax cuts have been the principal ingredient in a mix of policies and developments that has underpinned an extraordinary deterioration in the U.S. federal budget position from a surplus estimated at 2.5 per cent of GDP (gross domestic product) in 2000, to a deficit of 4.5 per cent in 2004. This 7 percentage point plunge in four years, the IMF concedes, is by far the sharpest fiscal reversal seen since the Second World War, and the sum of money involved is 6 per cent of gross world savings.

In an open economy with deregulated financial structures, the fiscal deficit feeds through national frontiers and shows up as a current account deficit of 5.2 per cent of GDP. Recent estimates by United Nations economists have revealed that the appetite of foreigners to invest in U.S. assets is flagging. The 2004 Survey by the U.N.'s Economic and Social Commission for Asia and the Pacific, for instance, reveals certain interesting features about the manner in which the U.S. external deficit is financed: "In the last two years the composition of capital flows has changed significantly. FDI (foreign direct investment) in the U.S. has become negative and private portfolio flows financed only about a quarter of the deficit up to mid-2003, the remainder being funded by short-term speculative capital flows and official purchases of bonds by foreign central banks".

This is a situation that obviously calls for firm intervention. In the context of developing countries, the shift from long-term finance to short-term speculative capital has been a characteristic marker of an incipient financial crisis, even meltdown. The same signals in the context of the U.S. though, are read very differently by the IMF.

There is, for instance, the persistent description of the current phase of fiscal policy in the U.S. as "expansionary". This does considerable violence to the conventional understanding of the term "expansion", which normally bears reference to a programme of stepped up government expenditure, financed in varying part, by higher taxes and higher deficits. IMF estimates show that only 2.1 percentage points in the 7-point deterioration of the U.S. budgetary balance is on account of higher spending, which it may be parenthetically added, has been mostly on the military component. By avoiding the Bush tax cuts, and perhaps increasing certain items of taxation to counter the cyclical downturn in the economy, the U.S. could, in other words, have neutralised the main part of the budgetary plunge into the red.

Economists with a basic sense of respect for the traditional vocabulary have argued that the U.S. economy, in fact, needed an expansionary dose of fiscal policy, but did not get one. Stiglitz, for instance, has pointed out that the basic ingredients of a "powerful and effective tax stimulus" are well known: "Give money to those who will spend it, and spend it quickly: the unemployed, the cities and States that are starving for funds, and for lower income workers. A strong stimulus is also an equitable stimulus: for the money, by and large, goes to the poorest Americans, those who have benefited least from the growth of the last quarter century".

In short, fiscal expansion, would have meant taxing the U.S. rich and spending money on the poor, in sorely under-funded welfare and infrastructure sectors. It is a rather gross travesty that the Bush recipe of cutting taxes on the rich and meeting extra expenditure on defence and security by borrowing from the rest of the world, should be categorised in this manner by the IMF.

Apart from the inversion of terminology, the IMF also repeatedly performs the analogous feat of extolling the so-called "expansionary" U.S. fiscal stance for its contribution to the global recovery. But in simulating future scenarios, it tacitly concedes that this recovery has been built on sand. With an unchanged U.S. fiscal policy stance, the IMF finds the "positive effects" of the stimulus rapidly waning - in fact, from the current year on - with interest rates rising and the dollar falling in value against other currencies. In terms of policy, the implications are that the U.S. should adopt "a phased withdrawal of fiscal stimulus over the next few years in a manner that pays due attention to incentives to work and invest in the United States". In other words, the Bush tax cuts were good for no more than temporary gratification. Of far greater moment are the long-term problems it has engendered, which leaves the global economy with the twin tasks of securing an orderly decline of the dollar and a rise in interest rates that does not threaten it with serious instability.

A COMPLEX menu of policy measures has been outlined by the IMF as the minimal requirements for restoring a semblance of stability to the global economy in the medium term. The U.S. would, to begin with, need to restore its budget to some semblance of a balance. The euro area would need to increase its "pace of structural reforms". Japan would need to accelerate the reform of its corporate and financial sectors. And "emerging Asia" - which in the IMF terminology includes India, China, Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan and Thailand - would need to switch to more flexible exchange rates, allowing their currencies to appreciate against the dollar.

This mix of policies, it is clear, needs a high degree of coordination across national frontiers. And it is not clear that all the countries that are players would see their interests as congruent. China, for instance, has been following a policy of aligning its currency closely to the dollar and sees no benefit from allowing it to float, to the detriment of its exports sector.

The euro zone economies, meanwhile, have been on divergent paths. But the two largest and most influential countries, Germany and France, have already signalled that contrary to IMF projections, they look forward to a regime of softening interest rates. Both countries have gone beyond the fiscal deficit ceilings prescribed in the European Stability and Growth Pact. And both countries are facing the prospect of increasing domestic strife if they go ahead with structural reforms - including in the vital area of pensions - in a context of growing unemployment. Germany and France recently sharply attacked the European Central Bank for its rigid anti-inflationary stance, which keeps interest rates at historically high levels in the euro zone. With employment in the region not far below 10 per cent, they have argued that a soft interest rates regime is more in the public interest.

Optimism in large part is derived from the example of "emerging Asia". IMF estimates show that in 2002, these countries between them accounted for 44 per cent of world GDP growth. In 2003, with the region as a whole growing by 7 per cent, its share in world GDP growth was 50 per cent. The consequence of close to three decades of patchy but persistent growth has been that emerging Asia's share in world GDP now stands at 25 per cent, compared to 21 per cent for the U.S.

Export and import transactions within the region have been an important factor in this growth. Between 1998 and 2002, the intra-regional trade accounted for more than half of export growth in emerging Asia. China has been a major factor driving this process. Together with its Hong Kong region, China "absorbed 17 per cent of exports of other countries in emerging Asia in 2002, and accounted for 35 per cent of export growth of other countries in the region in 1998-2002".

Underpinning all this is the mammoth trade surplus that China enjoys with the U.S., which it partly offsets in deficits with its trading partners in "emerging Asia". The situation is sustained in part by China's massive purchases of dollar assets and its accumulation of reserves, since economic fundamentals otherwise dictate that its surplus with the U.S. should push up the value of its currency in relation to the dollar.

The IMF prescription that China should now allow its currency to appreciate, places the elaborate network of trade relations it has built up within the region in jeopardy. Without its trade surplus with the U.S., China would be unable to perform its recently acquired role as the dynamo of growth in the Asian region. The IMF recognises this fact by calling for domestic demand boosting measures that would accompany the realignment of currencies. This would of course, involve the risk of inflation in a context when inflation is already becoming a worry for policymakers in the region. Even if this is partly offset by the deflationary impact of currency appreciation, the adjustments require a far higher degree of inter-governmental cooperation than is currently available, and place at risk the recent growth record of a number of countries.

WITH all the complexities involved, the orderly adjustment that the IMF seeks to construct, could well end up in disorderly retreat. Aside from the depreciation of the dollar against the euro and the yen, which is being engineered by the markets, there are already signals from the U.S. Federal Reserve, that interest rates could be raised in the near future. The immediate outcome could be felt in the housing market in several advanced countries, including the U.S., the U.K., and Australia. Over the last few years, plunging interest rates and rising disposable incomes have pushed up housing prices in several countries to historically unprecedented levels.

The "wealth effect" that this has spawned - encouraging home-owners to borrow more on the security of their property price - has in turn, fed the consumption boom in these countries. This has been among the main props of what currently passes off as an economic recovery.

A rise in interest rates would inevitably raise mortgage payments and severely cut into household disposable incomes. A slump in the housing market would also curtail personal consumption expenditure rather dramatically.

The IMF, naturally enough, has little time or inclination to study the final implications for financial stability in an overheated world economic environment. But the statistics it presents are revealing. Fully 57 per cent of U.S. mortgage lending is securitised, implying that this volume of personal housing loans in the U.S. is traded in international capital markets and is perhaps held by investors in Japan, Korea and China. If the dollar depreciates, they could well call in their loans, naturally enough after carefully studying what the impact on their real exports would be. That would be the final signal that the recovery constructed out of the Bush tax cuts has been little else than illusion.