IMF Chief Economist's Four Lessons From 2011

In What a difference a year makes …, Olivier Blanchard, Chief Economist of the IMF, reflects on the year that just passed. Back in January last year, it seemed to most observers that 2011 was going to be a year of solid economic growth due to strong fiscal and monetary stimuli. Most also expected an improvement in the business climate and in consumer sentiment.

I, for one, expected high growth in 2011 but expressed serious doubt that it could persist beyond 2012. I thought that it would falter soon after the stimuli would be retired. It all cratered much quicker than anybody anticipated. Below, Olivier Blanchard draws four lessons from 2011 on why this happened and why the crisis is lingering.

Although there was growth in the first half of 2011, rather than improved over time, economic growth faltered in the second half of the year. To compound the problem, increasingly worrying woes in peripheral Europe finally quashed any hopes that the outlook would soon improved in early 2012. As a result, investment and consumption growth remained modest and the situation is likely to persist into 2012. SME investment also suffered from the continued unwillingness of banks to expand their balance sheets while consumers were constrained by the weight of their indebtedness. And, as inflation did not pick up despite the coordinated best efforts of western central banks, the process of deleveraging continues to progress at a snail’s pace.

This friction is obviously only prolonging the pain of the crisis as it pushes further down into the future the end of this sub-par growth episode. In other words, there is nothing in the cards yet to signal that the proverbial pent-up demand from the private sector (which usually forms during the recession) could spring up anytime soon and eventually propel the economy into a sustainable and lasting recovery.

There was hope this summer that some policies would target damaged balance sheets. The rumored initiatives, aimed at improving the financial situation of underwater home owners whose obligations continue to be a drag on economic growth, never came to life. Some policy makers then started to talk about the need to engineer mild inflation to gradually reduce the burden of our debt on economic growth. It’s a dangerous path to follow and a difficult policy to implement because it could cause interest rates to rise instead. And who needs higher interest rates when we are crippled by tons of debt?

To ensure that such scheme would work, inflation would have to increase by more than interest rates, thereby moderately reducing real interest rates on a long term basis (i.e. for 10 to 20 years). How to successfully implement such an outcome is being discussed at the highest levels of government. It is the solution which is now favored and being considered as the cure to the debt problem. The scheme is being labeled “financial repression”. It is nothing new. Such a strategy was used to gradually get rid of government debt in the decades that followed WWII. Yet, I had not heard of it in years. And for good reasons: alchemy does not usually work!

To succeed it requires that governments increase their control on banks (through regulation and/or nationalization of banks) to force them to channel funds to the public sector at negative or very low real long term interest rates. With efficient capital markets today this is a very difficult strategy to engineer as capital rationing - which would favor public borrowers over private ones - risks choking SME investments and inhibiting entrepreneurship; the machines behind job creation in this country. This is because small firms and would-be entrepreneurs would have to pay higher interest rates to finance their investments and ventures as governments would be crowding out financial markets.

The winners are thus easy to identify: besides governments, they would be large firms without cash constraints. If financial repression is implemented, there is no way to know if it could be successful but it would provide investors with an actionable asset allocation strategy that could be rewarding over the new few years: invest in large firms with tons of cash and little leverage and avoid government nominal bonds which will likely yields less than inflation.

Here is the Blanchard article which was recently published on iMFdirect, the IMF Blog. The piece is also available in several languages (French, Arabic, Chinese, Japanese, etc.). Just click on the link above to have access to these translations:

We started 2011 in recovery mode, admittedly weak and unbalanced, but nevertheless there was hope. The issues appeared more tractable: how to deal with excessive housing debt in the United States, how to deal with adjustment in countries at the periphery of the Euro area, how to handle volatile capital inflows to emerging economies, and how to improve financial sector regulation.

It was a long agenda, but one that appeared within reach.

Yet, as the year draws to a close, the recovery in many advanced economies is at a standstill, with some investors even exploring the implications of a potential breakup of the euro zone, and the real possibility that conditions may be worse than we saw in 2008.

I draw four main lessons from what has happened.

• First, post the 2008-09 crisis, the world economy is pregnant with multiple equilibria—self-fulfilling outcomes of pessimism or optimism, with major macroeconomic implications.

Multiple equilibria are not new. We have known for a long time about self-fulfilling bank runs; this is why deposit insurance was created. Self-fulfilling attacks against pegged exchange rates are the stuff of textbooks. And we learned early on in the crisis that wholesale funding could have the same effects, and that runs could affect banks and non-banks alike. This is what led central banks to provide liquidity to a much larger set of financial institutions.

What has become clearer this year is that liquidity problems, and associated runs, can also affect governments. Like banks, government liabilities are much more liquid than their assets—largely future tax receipts. If investors believe they are solvent, they can borrow at a riskless rate; if investors start having doubts, and require a higher rate, the high rate may well lead to default. The higher the level of debt, the smaller the distance between solvency and default, and the smaller the distance between the interest rate associated with solvency and the interest rate associated with default. Italy is the current poster child, but we should be under no illusion: in the post-crisis environment of high government debt and worried investors, many governments are exposed. Without adequate liquidity provision to ensure that interest rates remain reasonable, the danger is there.

• Second, incomplete or partial policy measures can make things worse.

We saw how perceptions often got worse after high-level meetings promised a solution, but delivered only half of one. Or when plans announced with fanfare turned out to be insufficient or hit practical obstacles.

The reason, I believe, is that these meetings and plans revealed the limits of policy, typically because of disagreements across countries. Before the fact, investors could not be certain, but put some probability on the ability of players to deliver. The high-profile attempts made it clear that delivery simply could not be fully achieved, at least not then. Clearly, the proverb, “Better to have tried and failed, than not to have tried at all,” does not always apply.

• Third, financial investors are schizophrenic about fiscal consolidation and growth.

They react positively to news of fiscal consolidation, but then react negatively later, when consolidation leads to lower growth—which it often does. Some preliminary estimates that the IMF is working on suggest that it does not take large multipliers for the joint effects of fiscal consolidation and the implied lower growth to lead in the end to an increase, not a decrease, in risk spreads on government bonds. To the extent that governments feel they have to respond to markets, they may be induced to consolidate too fast, even from the narrow point of view of debt sustainability.

I should be clear here. Substantial fiscal consolidation is needed, and debt levels must decrease. But it should be, in the words of Angela Merkel, a marathon rather than a sprint. It will take more than two decades to return to prudent levels of debt. There is a proverb that actually applies here too: “slow and steady wins the race.”

• Fourth, perception molds reality.

Right or wrong, conceptual frames change with events. And once they have changed, there is no going back. For example, nothing much happened in Italy over the summer. But, once Italy was perceived as at risk, this perception did not go away. And perceptions matter: once the “real money’’ investors have left a market, they do not come back overnight.

A further example: not much happened to change the economic situation in the Euro zone in the second half of the year. But once markets and commentators started to mention the possible breakup of Euro, the perception remained and it also will not easily go away. Many financial investors are busy constructing strategies in case it happens.

Put these four factors together, and you can explain why the year ends much worse than it started.

Is all hope lost? No, but putting the recovery back on track will be harder than it was a year ago. It will take credible but realistic fiscal consolidation plans. It will take liquidity provision to avoid multiple equilibria. It will take plans that are not only announced, but implemented. And it will take much more effective collaboration among all involved.

I am hopeful it will happen. The alternative is just too unattractive.