October 11, 2012 6:22 pm

Troika a barrier to IMF new fiscal faith

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For an institution once nicknamed “It’s Mostly Fiscal” for espousing austerity during financial crises, the International Monetary Fund’s assessment in its World Economic Outlook (WEO) of threats from fiscal consolidation mark an important stage in a remarkable intellectual shift.

Some of the IMF’s critics – its demands for fiscal tightening during the Asian financial crisis of 1997-1998 created intense controversy and are still remembered in the region – are no doubt pleased to see the fund’s management sitting down to a fricassee of sacred cow.

Yet as far as its involvement in rescue programmes for Greece – and potentially Spain and Italy – is concerned, the fund will find it easier to change its mind than its policies. Its junior role in the rescue “troika”, alongside the European Commission and the European Central Bank, means it will have to convince its more sceptical fellow lenders that slower fiscal consolidation would be helpful.

“The WEO section on fiscal multipliers is a very important finding, which shows the IMF is a credible empirically driven institution which is not shy of giving up its own dogma on these issues,” says Jacob Funk Kierkegaard at the Peterson Institute think-tank in Washington. “But it is likely to make only a marginal difference in forward-looking changes to [rescue lending] programmes”.

Even within the fund, the views of staff and management do not necessarily translate into those of the executive board of shareholder countries, which makes the final decisions on lending programmes.

“These are political decisions made by the board, and I am not sure they are going to care too much about what the staff thinks,” Mr Kierkegaard says.

Within the troika, the European Commission has at least shown some signs of flexibility, giving Portugal and Spain another year to hit their fiscal deficit targets. But it remains short of accepting the IMF view entirely. Olli Rehn, commissioner for economic and monetary affairs, said this week he thought the IMF had underestimated the boost to confidence in financial markets from rapid fiscal tightening.

Christine Lagarde’s open disagreement with Wolfgang Schäuble on Thursday showed the EU’s most influential member state starkly disagreeing with the IMF.

And the ECB, whose prospective use of “outright monetary transactions” or direct bond purchases will give it much more prominence in any rescue for Spain or Italy, will probably be even slower to come around.

Guntram Wolff, deputy director of Bruegel, a Brussels-based think tank, says: “The ECB staff have generally taken a conservative view on fiscal consolidation and it remains to be seen whether the president [Mario Draghi] will change direction”.

The eurozone crisis has already shown that a change of heart at the fund does not easily translate into policy on the ground. More than a decade ago, the IMF went through a similar evolution of ideology about the need for restructuring private sector holdings of sovereign bonds during a debt crisis, infuriating investors by espousing a statutory bankruptcy mechanism for insolvent governments.

In depth

Austerity Europe

EU unemployment

Europeans are braced for a new age of austerity as governments across the region take action to eliminate unsustainable budget deficits

But although IMF staff wanted early on to consider restructuring sovereign debt as part of the Greek rescue, they were overruled by eurozone governments and the ECB, which feared for the health of European banks holding Greek bonds, until a writedown became inevitable. An internal review of the conditions the IMF attaches to lending admits: “Institutional constraints in the euro area occasionally limited alternative policy options that could otherwise have been considered – notably, debt restructuring to strengthen debt sustainability”.

Accepting that the IMF has a point on fiscal multipliers could have similarly unpleasant consequences for eurozone governments and the ECB in the Greek rescue. Throughout this year, the fund has been struggling to get the other troika members to accept that their debt sustainability analyses for Greece have systematically been too optimistic, overestimating likely growth and consequent tax revenues at a time of spending cuts. If rapid fiscal tightening is exacerbating rather than ameliorating Greece’s debt burden, the implication is that official money in the form of fresh lending or writing down existing loans will have to fill the financing gap.

Paul de Grauwe, professor at the London School of Economics, says: “Given that the implication of the IMF view is more official financing, that closes the door for the other troika members.”

He says of eurozone officials: “Sometimes when you talk with them, they accept the intellectual argument – but then claim they are bound by treaties and are unable to act on it”.

Additional reporting by Peter Spiegel in Brussels

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