Three Women – Georgieva, Lagarde, Reinhart – One Austerity War – International Debts and Mr. Powell

When the coronavirus spread beyond Wuhan, economies crashed in unison. Around the world, output sank at a scale not witnessed in peacetime.

The IMF said in its World Economic Outlook, released last month, that the global economy will shrink by 4.4% this year – an awful figure, but not quite as bad as the 5.2% decline forecast in June. The prospects of recovery, however, are far from even.

Of the world’s largest economies, China, buoyed by strong export sales and a reduction in caseloads that has enabled an economic reopening, is set to grow by 1.9% this year – a far more optimistic results than expected. The US and European economies, meanwhile, are still set to experience sharp contractions as a result of not being able to remove restrictions on movement.

There are marked differences within the world’s two largest economic blocs. The US, where the Federal Reserve and the Treasury acted swiftly to shore up financial and labour markets, will perform much better than Europe. Its economy is seen as shrinking by 4.3%, compared with 8.3% in the eurozone. The UK economy meanwhile, is forecast to shrink by 9.8% – a slight improvement on what the IMF expected in June.

Divergences within the major emerging markets are stark too. In contrast with China and other east Asian economies such as South Korea, India has struggled to contain the outbreak and is expected to see its economy shrink by 10.3% over the course of 2020.

In Latin America, the outlook for Mexico remains bleak, while the fortunes of Brazil have improved substantially.

The composition of economies matters, too. The surge in China’s imports in September highlights countries that rely more on manufacturing exports to power growth are at an advantage; oil exporters and those that rely on demand for domestic services are not.

In the coming quarters, the recovery will depend largely on countries’ ability to contain the virus. If vaccines come more quickly than expected, or if treatments prove more effective than hoped, then the outlook for next year, when the IMF expects growth of 5.2%, will be stronger still.

It is in our opinion still remarkable how time has changed in just one decade:

When Greece accepted the first of several bailouts in May 2010, creditors – among them the IMF – forced Athens to take an axe to public spending in exchange for the funds.

What a difference now. Fiscal deficits have ballooned since the pandemic struck, with global public debt set to reach 100% of gross domestic product this year as governments spend aggressive to counter the devastation Covid-19 has caused. Yet the IMF is sanguine. Indeed, its advice last month was that, where possible, governments should continue to spend until the virus is finally behind us and recoveries entrenched. At the same time IMF’s chief economist Gita Gopinath correctly states, an uncertain and uneven road lies ahead with the pandemic being far from over.

The IMF’s tolerance of debt in our opinion marks the final nail in the coffin for the doctrine of austerity. But the grip that it held on economic ideology has long been loosening. The IMF itself acknowledge as early as 2013 that some elements of its prescription for Greece, which saw its GDP contract by 25%, was too harsh. Lawmakers such as Jeremy Corbyn in the UK and Bernie Sanders in the US helped swing the political pendulum in favour of more aggressive sate intervention in the economy. Yet until now, much of the heavy lifting was still being done by the world’s central banks, many of which have not only cut nominal interest rates close to zero but have spent trillions of dollars buying mostly sovereign debt. With monetary policymakers short on ammunition, there is, for the first time since the 1970s, an acceptance that fiscal policy must do its share. Even countries renowned for frugality, such as Germany, are spending big.

Borrowing has rarely been as cheap. Many countries now benefit from negative yields – including places such as Italy, where debt-to-GDP ratios are at levels that would have been considered high enough to warrant a rapid fiscal retrenchment in years gone by. Rates are likely to stay at rock bottom levels for years to come, meaning refinancing costs will remain low even if debt-to-GDP ratios rise further.

Monetary policymakers, with a few exceptions, are onside. Jay Powell, who as chair of the US Federal Reserve is the most powerful central banker in the world, has become fiscal cheerleader-in-chief, urging Congress to spend more to sustain the recovery.

The US budget deficit in the meanwhile more than tripled to a record 3.1 trillion USD in the latest fiscal year on the government’s massive spending aimed at softening the blow from the coronavirus pandemic.

The increase brought the deficit as a share of gross domestic product (GDP) to 16% in the year ending in September, the largest since 1945. At the end of the financial crisis in 2009, the ratio was close to 10% before slowly narrowing through 2015. Federal spending jumped 47.3% to 6.55 trillion USD in fiscal 2020, driven by increased outlays for unemployment compensation and small businesses including tax cuts.

His counterparts in the UK and the eurozone have made similar pronouncements – unthinkable 10 years ago, when a clear separation between the fiscal and monetary arms of policymaking was seen as sacrosanct.

European leaders last month deliberately avoided putting the EU budget and recovery plan on their summit agenda for fear of a breakdown in the talks. As a result, they have barely tried to bridge differences over the 750 billion euro recovery and resilience packaged agreed in July.

Critical issues between the European Parliament and the member states remain , and a Sword of Damocles therefore hangs in our opinion over the whole plan. What seemed like a historic breakthrough in July increasingly looks like a quagmire that is consuming extraordinary political goodwill, creating lots of uncertainty and leading neither to a great Hamiltonian leap forward nor to a very meaningful fiscal stimulus.

What in our opinion is most concerning, perhaps, is that many member states are still betting on a sharp recovery in 2021 and planning fiscal policy accordingly. Few really understand that while the political agreement of July might turnout to be a turning point of European fiscal federalism it will not address its own the depth and breadth of the economic shock in 2020 and 2021. The initiative’s force lay in the fact that, by partly mutualizing the recovery effort, it would politically sanction the already large national fiscal responses, as well as the European Central Bank’s sovereign debt purchase programme.

After some hesitation, the ECB has played its part in delivering significant stimulus and called a common European response. But it means too shy in advocating a bold fiscal expansion by national governments. ECB board member Isabel Schnabel has stressed that “these are not the times to worry that rising government debt today could undermine price stability tomorrow” and has applauded the common European fiscal efforts in the making. But she has failed to encourage more active national fiscal expansion.

Unlike Jay Powell, she has not stressed enough the risks of an economic setback from too tittle national fiscal support.

Germany has moved tremendously on European fiscal matters and delivered a bold expansion in 2020, while refusing to engage in a meaningful conversation around reforms of the European fiscal framework and the German constitutional debt brake. Germany plans to reduce its budget deficit next year to 4.25% of gross domestic product from 6.25% this year. France is also planning to cut its deficit.

Other eurozone governments plan to go deeper into the red than ever before this year, racking up budget deficits of close to 1 trillion euro as they splash out on emergency measures to counter the coronavirus crisis.

Draft budget plans published by member states on the European Commission Website indicate the 19-country bloc will slide to an aggregate fiscal deficit of 976 billion euro, equal to 8.9% of gross domestic product this year. That means this year’s budget deficits would be almost 10 times higher than last year’s levels and the commission’s forecasts for this year. Governments estimated that their deficits would stay high even when their economies rebound in 2021, when they expect an aggregate shortfall of just under 700 billion euro, or 6% of GDP.

The previous peak in eurozone deficits came a decade ago in early 2010, according to the European Central Bank,when budget shortfalls rose to 6.6% of GDP. That led to levels of public indebtedness that unsettled investors and sowed the seeds of the subsequent eurozone sovereign debt crisis.

However, investors and policymakers have shown few signs of alarm about this year’s surge in spending and debt levels. Borrowing costs of peripheral eurozone countries, such as Italy and Greece, fell to record lows recently, driven down by the ECB’s massive bond-buying programme. “It is clear that both fiscal support and monetary policy support have to remain in place far as long as necessary and ‘cliff effects’ must be avoided, “ Christine Lagarde, president of the ECB, said last month.

How time has changed over the last decade; one question remains: who is now setting the tone for the rest of Europe? Next year’s German elections may even inhibit, rather than encourage, a more aggressive national fiscal response and a more open political discussion about the future fiscal policy and architecture of Germany and Europe.

In our opinion, it’s time for German tax payers to get worried – the alarm bells are on!

The more relaxed attitude was summed up at last month meetings of the International Monetary Fund (IMF) and World Bank, where senior officials have shifted from calling for austerity to the wind by borrowing heavily to tackle the fallout from the pandemic. “First you worry about fighting the war, then you figure out how to pay for it,” and “this is war. During wars governments finance their war expenditures however they can and right now there are dire needs. The scenario we are in is not a sustainable one,” said Carmen Reinhart, chief economist of the World Bank.

The IMF last month predicted that eurozone’s government debt, having surged more than 15 percentage points from last year’s pre-Covid level, would top 100% of GDP this year and hover at a similar level in 2021.

In our opinion we witnessed the funeral of austerity last month. Those who used to worship at its altar now urge countries to throw caution to the wind. Fiscal orthodoxy, practiced over decades since the debt crisis and inflation of the 1970s and 1980s, has been replaced with fiscal activism.

The IMF itself warned after the global financial crisis that “many countries face large retrenchment needs going forward”, but now it tells all countries that have access to financial markets to issue debt and to spend without the prospect of austerity later.Kristalina Georgieva, head of the IMF said, “Only one thing matters – to be able to dare”.

In terms of fiscal policy, this time in our opinion really is different. The fiscal consensus that prevailed until the past few years was build on the lessons learnt internationally after the boom decades of the 1950s and 1960s. The experience was that raising or lowering taxes and changing public expenditure was too slow in most political systems to be effective in taming the economic cycle and, instead tended to amplify it. Monetary policy – set ideally by independent policymakers in central banks – took on that role.

The second part of this fiscal consensus accepted that the best policy would target longer-term stability in public finances, ensuring debt and deficits met broad rules of thumb that would almost always ensure that compliant countries would face no difficulties in financing themselves – allowing them to concentrate on improving the efficiency of their tax systems and public spending.

That consensus was still dominant at the time of the 2008-2009 crisis, culminating in the Toronto G20 summit declaration in 2010 that highlighted “the importance of sustainable public finances” and warned that “countries with serious fiscal challenges need to accelerate the pace of consolidation”. Greece, for example, had already lost at that time the confidence of its lenders.

The question now is why has the thinking changed so radically. Answers in our opinion cover three distinct categories: bitter experience of the past decade changed circumstances and raw politics.

There is little doubt that the 2010s was difficult decade for almost all economies around the world, with underlying growth considerably lower than hoped at the time of the Toronto summit. Most of this had more to do with a global fall in underlying productivity performance than with tax and public spending strategies, but even with the potential for growth lowered economic performance disappointed, largely because monetary policy did not have the ammunition to stimulate economies sufficiently.

The world’s big economic blocs in our opinion never achieved the conditions that would have induced rapidly rising wages and inflation, so interest rates could rise towards more normal levels, despite the drama of officials such as Mario Draghi at the European Central Bank doing “whatever it takes”. Monetary policy could not have provided the 11.7 trillion euro boost that fiscal policy managed this year.

After the past decade, instead of jealously guarding their independence, leading central bankers now talk of the need for fiscal policy to help keep inflation from falling. In recent weeks, jay Powell said “the recovery will go faster if we have both tools – fiscal and monetary – working together”, while Andrew Bailey, Bank of England governor, called for “a very close and sensible co-ordination” of the two economic policies.

Long gone is the nation, supported by former UK chancellor George Osborne, that it was imperative to have a credible plan to reduce deficits in the public finances because that would give households the confidence to spend rather than save.

There are also economic circumstances that did not apply until recently. The main change, most notably highlighted by Oliver Blanchard, former IMF chief economist, is that with government borrowing costs in advanced economies below or close to zero-at almost all durations – and likely to remain so, countries could afford to service considerably higher levels of debt without posing a greater long-term burden on their finances because economies were likely to grow faster than the interest on debt.

“The issuance of debt without a later increase in taxes may well be feasible,” Prof. Blanchard said in January 2019. The example he gave was for a one-off increase in debt, which at the time was seen as an otherworldly scenario because few countries ever borrow a huge chunk of money for a strictly limited period in peacetime. But in 2020, the pandemic has arguably provided just this situation and the one-off nature of deficits has been used by the IMF as the justification for supporting the borrowing that countries are undertaking.

Finally, there is no longer any desire for austerity after the difficult 2010s, so the political and public mood fits with the new economies. Arguably, austerity sowed the seeds of its own destruction by raising support for populist politicians in Donald Trump and Boris Johnson who had no truck with difficult budgetary issues and rarely saw any problem with public spending largesse. We wish them good luck!

After the financial crisis, President Barack Obama and Democratic politicians joined forces with Republican fiscal hawks in the difficult process of reducing the US deficit only to watch Donald Trump gain popularity with enormous tax outs in 2017.

In the UK, Boris Johnson’s Conservative government has ruled out austerity as the way to resolve the nation’s public finance difficulties and, even in Germany, the bastion of fiscal probity, politicians such as economy minister Peter Altmaier now boast about introducing “the biggest stimulus programme of all time” in response to coronavirus.

It would be wrong, however, to say that everyone has signed up to the new consensus that deficits and public debt do not matter any more. Let’s just hope that this group is growing fast. Even within the IMF, there are tensions. While its managing director urges countries to dare to do new things, officials still insist on austerity for countries that are forced to borrow from the fund.

Oxfam, the anti-poverty charity, complains that the IMF has pushed austerity measures on 80% of countries forced into its lending programmes during the coronavirus pandemic. “This austerity drive will hurt the countries it claims to help and flies in the face of the fund’s own research findings, showing it worsens poverty and inequality,” says Ana Arendar, Oxfam’s head of inequality policy.

But it is not just lenders who worry that countries might in time need a more conservative approach to fiscal policy. It is also investors like us.

In the UK for example, the Institute of Fiscal Studies warns that the crisis is likely to require higher health and social care spending in future, far in excess of any benefit from lower borrowing costs. It said recently the UK would ultimately need to find tax rises of probably around 2% of GDP to limit a likely persistent rise in public debt.

We at Calvin • Farel see a different problem as well – most probably more pressing. With ageing populations across advanced economies, this is likely to become an ever more pressing issues in the decade ahead. Austerity might have been buried for now, but if governments’ luck does not hold on borrowing costs and when ageing hits, there is no guarantee it will not be resurrected.