IMF’s the Good, the Bad and the Ugly
By Economics Correspondent Sean Whelan @seanwhelanRTE
“Assuredly it does not pay to be good”, said economist John Maynard Keynes. The economist was writing about Britain’s efforts to deal with the high level of debt it had built up after the first World War (140% of GDP). The IMF have pulled out this quote as part of a review of how a number of advanced economies coped with debt ratios above 100% over the past 100 years – and they agree with Keynes that Britain did it all wrong in the 1920s. And that holds lessons for us in Ireland today.
Britain’s postwar policy of returning the pound to the Gold Standard at pre-war parity to restore trade prosperity and prestige, and pay off debt to preserve creditworthiness proved disastrous. The government imposed savage spending cuts, ran a budget surplus of 7%, and continued the high tax levels introduced during the war. The Bank of England raised interest rates to 7% to return the pound to pre-war parity, while severe deflation led to very high real interest rates.
Economic growth was very weak, averaging 0.5% a year, well below competitor countries. Economic output in 1938 was barely higher than in 1918. And that wasn’t the fault of the great depression – in 1928 output was actually lower than in 1918. The strong pound ruined the export sector and allowed rivals to gain.
Such an appalling policy outcome might have been acceptable if it had resulted in a fall in debt, but it didn’t. It rose to 170% of GDP in 1930, and 190% in 1933. In fact Britain didn’t get back to its pre World War I debt ratio until 1990!
This little history lesson has been served up as part of an IMF report on how advanced economies have dealt with periods of high debt – that is in excess of 100% of GDP. Ireland is into its second such period.
Britain in the 1920’s and 1930’s is cited as an example of how not to do it, with the IMF throwing in this quote from Lloyd George for good measure: “Here (Britain’s) present activity and profit earning power have been sacrificed in large measure to the maintenance of integrity and good faith to all her creditors at home and abroad”.
It’s the IMF’s genteel way of saying don’t try this at home, kids.
But history is no good unless we learn the lessons of history (which history teaches us we usually fail to do!). The IMF has a go, and surveys how Britain, the US, Japan Italy and Belgium dealt with very high debt levels since 1918.
The warning of Britain then is that countries attempting a so called “internal devaluation” – an effort to bring down prices to become more competitive – do so at considerable risk. High unemployment, low growth and rising debt were the outcome. Although it says countries attempting internal devaluation (like Ireland in the Euro area) today are not trying to bring about as much change as Britain in the 1920s, “similar dynamics are evident”, notes the IMF.
“A reduction in the price level, a necessary part of internal devaluation, comes at a high cost”, it warns. The first lesson is that a supportive monetary environment is needed – in other words low interest rates.
The Americans did use inflation, credit control and a floor on government bond prices to cut their post second World War debt by 35 percentage points (from the 120% of GDP they started with). But the IMF thinks such “financial repression” is not practical in today’s interconnected world.
It thinks the Americans have achieved the necessary conditions for a debt reduction to take place, having largely addressed financial sector weaknesses and with the Fed setting ultra low interest rates and using QE to keep government bond yields low,
But it warns that for the European periphery (which our course includes Ireland) the financial sectors remain weak and fundamental issues relating to monetary union remain to be addressed, saying progress on debt may be limited until these issues are addressed.
Above all it stresses that debt reduction is a long, slow process, with primary deficits typically taking a decade to turn into substantial surpluses. That is about the timeframe Irelands fiscal repair plan has been running to over the past five years.
Instead it recommends the Belgian, Italian and Canadian approach, where large fiscal adjustments were made in low inflation environments. But they were helped by strong external demand – a growing world economy helped.
The IMF’s main conclusion should strike a chord here – “Fiscal consolidation efforts need to be complemented by measures that support growth: structural issues need to be addressed and monetary conditions need to be as supportive as possible”.
“The Good, the Bad and the Ugly – 100 years of dealing with public debt overhangs” – IMF World Economic Outlook , September 2012, chapter 3.