Memo from top IMF economists to world leaders: You are not out of economic ammo (yet)

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Amid the ever-gloomier outlook for long-term economic growth of the world economy, a team of top economists at the International Monetary Fund are offering a ray of hope:

Even though interest rates around the world are bumping along the floor and government debt loads are heavy, they say that there is still room for fiscal, monetary and structural policies to lift global growth provided they are “comprehensive, consistent and coordinated.”

Whether triggered by an unanticipated global recession or by a realization among leaders of the world’s big economies that “the current policy approach falls short of reviving growth,” these policies will be substantially more potent if they are coordinated across countries than implemented piecemeal one country at a time, the IMF economists argue in a new Staff Discussion Note, “Macroeconomic Management When Policy Space is Constrained.”

Staff discussion notes reflect the latest thinking of IMF economists, not the policy of the institution, but this one is noteworthy because its co-authors come from the very top of the IMF hierarchy: Vitor Gaspar, director of the Fiscal Affairs Department; Maurice Obstfeld, chief economist, and Ratna Sahay, acting director of the Monetary and Capital Markets Department.  David Lipton, the IMF’s deputy managing director, played a behind-the-scenes role in shaping the argument.

The IMF economists realize that the leaders of the world economy aren’t about to take their advice now.   Instead, they are fighting occasional assertions that fiscal and monetary policies will be unable to respond if the world tumbles into recession. “Perceptions that each individual policy instrument could be reaching its limit are undermining policy credibility,” they warn.

“The global macroeconomic risks of 2016 are one-sided,” they add, suggesting that bad-news surprises are a bigger worry right now than good-news surprises. “A major downdraft now would push the global economy closer to and, in some regions definitely into, a low-inflation quagmire.”

The top IMF economists are floating ideas now in the hopes that global leaders may, eventually, seek to do something besides talk about the persistently slow rate of global economic growth. In the 2014 Brisbane summit, for instance, leaders of the Group of 20 big economies set a goal of lifting their GDP growth by two percentage points by 2018. Achieving that goal now seems highly unlikely.

To emphasize that policies have to be tailored to the economic circumstances in each country, the IMF economists present model-based simulations of the contrasting cases of Canada, which has a relatively light government debt burden, and Japan, which has a very heavy one, to make their point.

In the simulation, Canada deploys fiscal stimulus to offset any negative shock and help the central bank boost inflation to meet its inflation target.  For heavily indebted Japan, they simulate a set of policies they dub “Three Arrows Plus” (after Prime Minister Shinzo Abe’s three-arrow policy of fiscal, monetary and structural reform.) The policies prescribed for Japan include a government policy to promote wage increases, a stronger Bank of Japan commitment to meet its inflation target, a very gradual increase in the value-added tax and labor market reforms.

In both cases, the simulation suggests that these policies “would increase rather than decrease monetary and fiscal policy space over the medium term,” the economists say. They would boost output and inflation enough to produce a lower government debt-to-GDP ratio than would be the case if the policies hadn’t been pursued.  The illustrations underscore the view that coordination of economic policies is important both within a country and among countries.

In the not-so-distant past, the IMF was derisively labeled “It’s Mostly Fiscal” for its unwavering advice to governments to cut their budget deficits. Those days have clearly passed.   The economists do, however, argue that governments that seek to borrow and spend in the short-term need to have credible longer-term fiscal strategies.

But mostly they are sending a simple message to the finance ministers and central bankers who gather in Washington next week for the IMF’s annual meetings: You are not out of ammo, but use the ammo you have left wisely.