IMF urges policy makers to reduce debt, but in ways that do not inhibit growth
by Sean Whelan, Economics Correspondent
The IMF has just published a new book by a number of its staffers called “Jobs and Growth : supporting the European Recovery”.
Christine Lagarde, the IMF’s managing director, identifies three priorities – a better way of running the Euro Area economy, product and labour market reforms (as usual), and debt reduction – starting in the household and corporate sectors and, later on, reducing the states debt level as well.
That sequencing is important. And although there is much talk of ideas to get growth moving again after decades of underperformance in Europe, there is no getting away from the need to deal with the fact of high debt levels.
The IMF has identified balance sheet weaknesses – bank, public, corporate and household – as a key factor in holding back growth in the EU.
Although the immediate response of the authorities prevented worst-case scenarios materialising and created space for adjustment, it did not deal with the “unusual combinations of balance sheet issues brought about by the crisis”, the International Monetary Fund stated.
It noted that in many EU states, already high debt ratios in households and corporates worsened as a result of the property crash, and weak or negative income growth. And public sector debt increased significantly.
Given the slow pace of growth, “there is little hope for either sector to simply grow out of its debt”, it said.
Instead pressure to deleverage – the need to bring down debt by reducing consumption, investment and net government spending – threatens to hamper the recovery.
The fact that at the same time many banks continue to rebuild capital buffers and restrain credit only adds to the headwinds. When all sectors of the economy are trying to adjust at the same time, the risk of negative spillovers from one to the other is heightened.
All countries would have benefited from structural reforms if they had been made prior to the crisis, especially if it involved shifting away from low productivity activities like construction, and towards those that can support exports and future growth. This is more pronounced in those countries most affected by the crisis, including Ireland.
Current account deficits in a number of cases point to a need to raise productivity and for more competitive wage setting – Ireland with its high current account surplus is surely not one of these cases.
In other countries, including the euro zone core, there are significant untapped reforms remaining that can unleash “additional growth momentum, including in investment and the services sector”.
The IMF warns that the success rate of countries attempting to reduce high debt levels falls with growth levels – that without growth it becomes much more difficult to reduce debt. This is also true of the private sector, and it notes that although in the past private sector adjustment benefited from periods of high inflation and fiscal support, neither will be forthcoming “at the current juncture”.
This could lead to job shedding in the private sector as it attempts to cut debt in places where wage adjustment is inhibited by institutions.
Policy makers are advised to reduce debt, but in ways that do not inhibit growth.
Good policies can help.
The IMF said that in the past deleveraging has tended to match cumulative pre-crisis build-up almost one to one (typically during the course of 5 to 10 years), bringing debt ratios back to where they started.
It noted that such large deleveraging efforts require “fast and flexible corporate and personal bankruptcy proceedings to help avoid lengthy periods of deleveraging and to protect growth”.
The IMF quoted research by Bornhort and Ruiz-Arranz suggesting that while high private sector debt tends to unambiguously lower growth, public sector debt is more harmful if the private sector is highly leveraged (as is the case in Ireland).
This result would suggest that addressing private sector debt reductions first can help mitigate the impact on growth – advice mirrored in current IMF practice of advising countries to seek a gradual pace of fiscal consolidation anchored in a credible medium term framework – if circumstances allow.
However, as in Ireland’s case, “frontloaded consolidations may be necessary if market confidence is critical, as is the case in countries facing particularly high costs of finance”.
The design of programmes matters too, with advice to cut less productive spending, protect investment (we haven’t done this), and shifting emphasis from direct to indirect taxes will help”. More generally consolidation efforts provide opportunities for tax and subsidy reforms.
Structural reforms to boost growth are key – especially labour market reforms, according to the IMF.
Improving Europe’s growth potential is crucial. Growth in the euro area countries had lagged that of peers since the 1980s. Having reached 90% of US per capita GDP in 1980, euro area output today stands at about 70% of that figure, and for the economies of Greece, Ireland, Portugal, Italy and Spain, it measures less than 60%
“Much of the relative decline can be explained by weak total factor productivity growth – and action on many fronts will be required to address this shortcoming,” the IMF states.
IMF authors trace the dismal performance to bad policy choices made in the EU since 1990 – suggesting better choices in future will produce better results.
The good news is that the largest boost to long term real GDP is in the peripheral countries, reflecting larger scope for reform as well as positive spillovers from trade and technology in the core countries.
Piecemeal reforms should be avoided – especially in labour markets – 85% of past labour market reforms in EU have concentrated on specific aspects of institutions or were incremental. The explosive growth of youth unemployment in some countries is particularly telling in the case of reform priorities.
Near term efforts to bolster the nascent recovery should concentrate on demand support and an effective resolution of the balance sheet weaknesses of the banking sector to jump start credit flow and private investment. Banking union is also a priority, and if all else fails there may be a need for more fiscal support for activity.
“Now is the time for governments to get to work on implementing the reforms needed to ensure that more Europeans can at last get back to work,” the IMF urged.