IMF in fiscal policy fantasyland

International Monetary Fund (IMF) Managing Director Kristalina Georgieva has responded to the COVID-19 economy by telling the IMF’s member countries to “spend as much as you can but keep the receipts.” By so doing, she is rendering the world economy both a service and a disservice.

She is doing us a service by reminding us that it would be a big mistake to withdraw budget support from the world economy too early. This is especially true at the time when we are experiencing the worst global economic recession in the past 90 years and at a time when the world economic recovery seems to be stalling. She is correctly advising us to avoid the mistake made during the 2009 Great Recession.

However, the IMF is doing us a great disservice by downplaying the longer run challenges that rapidly rising public debt levels will create for future generations. Had the IMF been more mindful of those challenges, it would not be giving its member countries the green light to spend with abandon. Rather, it would have cautioned them to carefully target their spending in a manner that got the most bang for the buck and that avoided any unnecessary build-up in the public debt burden.

At the heart of the IMF’s flawed budget policy advice is its excessively rosy forecasts about how quickly its member countries will be able to stabilize their public debt-to-GDP ratios. Indeed, after anticipating that its member countries debt ratios will skyrocket in 2020, it optimistically forecasts that these ratios will stabilize as early as 2021 and then begin gradually declining thereafter.

The excessive unrealism of the IMF’s budget forecasts may be illustrated by taking a closer look at the details of the IMF’s recently released United States and Italian public finance forecasts. 

For the United States, the IMF projects that on a cyclically adjusted basis the budget deficit will balloon from less than 5 percent of GDP in 2019 to 13 percent of GDP in 2020 as a result of the bold U.S. fiscal policy response to the pandemic. That in turn will cause the U.S. government debt-to-GDP ratio to jump by more than 20 percentage points, to 131 percent by end 2020. Yet somehow as early as 2021, the IMF forecasts that the U.S. debt-to-GDP ratio will stabilize as a result of an economic recovery and a tightening in budget policy by as much as 7.5 percent of GDP. 

Surprisingly, the IMF seems to be blissfully unaware that Congress and the White House may be close to agreeing on another fiscal stimulus package with a price tag of some $ 2 trillion. That would make any notion of the large U.S. fiscal policy tightening that the IMF seems to be anticipating for next year risible. One also wonders how the IMF thinks that a U.S. economic recovery would be sustained next year with such a large amount of budget belt-tightening, especially at a time when Italy may be on the cusp of a second major wave of the pandemic. 

The IMF’s Italian public finance projections appear to be no less Panglossian than they are for the United States. As a result of a very deep economic recession and a strong budget policy response to the pandemic, the IMF is projecting that Italy’s public debt-to-GDP ratio will skyrocket from 135 percent in 2019 to over 160 percent in 2020. Yet somehow the IMF is projecting that Italy’s public debt-to-GDP ratio will stabilize as early as next year as a result of around 6.5 percent of GDP in budget belt-tightening and a strong rebound in the Italian economy. 

Surprisingly, in forecasting a quick improvement in Italy’s public finances, the IMF is forgetting how difficult it was for that country to mend its budget in the wake of its 2012 sovereign debt crisis. Stuck in a Euro straitjacket, which precluded Italy from using interest rate or exchange rate policy to cushion the blow from budget belt-tightening, Italy found that it could not grow its economy with budget austerity policies. One would think that still stuck in a Euro straitjacket and experiencing its worst economic recession in 90 years, any attempt at substantial budget austerity next year would sink the Italian economy and thereby keep the country’s public debt-to-GDP ratio on a rising path.

All of this is not to say that the IMF is mistaken in encouraging countries to keep providing budget support to their economies at a time of deep economic recession. But it is to say that the IMF does us a great disservice by being overly optimistic in its long-run public debt forecasts. By so doing, it lends support to those who believe that excessively large public debts are not something to worry about.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.