Merkel and Scholz Have Put the IMF in a Pickle

The IMF, I think, believes:

1. Fiscally-led rebalancing requires expansionary fiscal policies in current account surplus countries/regions, and contractionary fiscal policies in current account deficit countries.
2. Fiscal consolidation has a bigger contractionary impact when a country is at the zero bound, and the risks of financial distortions go up when fiscal tightening forces a country or region to rely heavily on unconventional monetary policies.
3. The weaker members of the eurozone lack fiscal space, and, broadly speaking, need to pursue contractionary fiscal policies. The IMF has long wanted more or less everyone other than Germany and the Netherlands to tighten by about 50 basis points of GDP a year. The legacy of the stability and growth pact runs deep.*

The problem with number 3 of course is that fiscal consolidation in the weaker countries on its own would result in a tightening of the eurozone’s aggregate fiscal stance.

And that runs against the notion that it is better to tighten when you aren’t at the zero bound, and monetary policy has room to offset the drag from fiscal policy (or to put it differently, fiscal policy should not work against an attempt to reflate the economy through monetary policy).  See Guntrum Wolff, among others.

And from a global point of view, fiscal consolidation by the euro area as a whole would tend to push the eurozone’s already substantial (€400 billions) current account surplus up. Especially if it keeps the ECB on hold more or less indefinitely. That, among other things, means large bond outflows from the eurozone, as German and Dutch savers (pension and insurance funds) flee low eurozone interest rates (and Italian bonds?) and buy debt from the U.S. and UK.

The IMF has not, in its surveillance, emphasized the eurozone’s aggregate current account surplus (see paragraphs 5 and 19 of the 2017 staff report), even though it is now well over three percent of GDP (remember the Obama Administration’s push, together with the UK, to create a norm against current account surpluses over four percent of GDP—I sure do). Thanks to some questionable modelling decisions to improve the fit with Germany in the IMF’s workhorse current account model, the IMF’s estimate for the current account surplus the eurozone should run has moved up from about 1 percent of eurozone GDP to just below 3 percent of eurozone GDP—which in effect gives the IMF license to ignore the eurozone’s aggregate fiscal stance so long as it is neutral. 

I think this is a classic case over-fitting a model ...

No matter.  The IMF believes that the surpluses of some individual countries are too big, and notably has criticized Germany's surplus.   The IMF also recognizes that if it wants fiscal tightening that would raise the surpluses of Spain and Italy that creates a demand drag for the eurozone, and would push the eurozone’s overall surplus up. And it doesn’t necessarily want that.

So the IMF more or less has argued that the fiscal offset to consolidation in France, Italy, and Spain (and no doubt others) should come from Germany, as Germany could provide a positive fiscal impulse by bringing its 1 percent of GDP surplus down to zero (the IMF actually says Germany could run a tiny deficit and remain within the “rules”).**

And if not from Germany (and the Netherlands),  the offset could come through mobilizing the eurozone’s combined fiscal strength and issuing joint bonds to support say a big infrastructure investment fund.

The eurozone, remember, now has by far the tightest fiscal policy of any of the world’s major economies. It now has a primary surplus of around 1 percent of GD.  The U.S. is heading toward a primary deficit of around 3 percent of its GDP, Japan has a primary deficit of between 3 and 4 percnet of its GDP and, well, China is complicated (its fiscal stance has lots of Chinese characteristics).  But judged on the IMF’s preferred measure (the augmented balance) it has the biggest deficit of any of the big four.  The eurozone has fiscal space—and it could basically mobilize some of the funds it now lends to the rest of the world (financing buybacks and the leverage the private equity industry increasingly deploys as much as any increase in business investment) to invest in Europe.

But Scholz has ruled out any significant fiscal expansion in Germany. Now that Germany has a surplus of over 1 percent of its GDP (the OECD puts the general government surplus at 1.25 percent of GDP in 2017, up 25 basis points from 2016) Germany wants to keep it. The black zero has become the black eins. Debt needs to fall absolutely. Wolfgang Munchau: “Mr Scholz’s ambition is to push the budget into a surplus of 1 per cent of GDP or higher. Such a surplus would, over time, eradicate all public debt.”

And Merkel has ruled out any meaningful stabilization fund that is financed commonly.

Plus some of the changes to the European architecture that Germany wants—notably a stronger linkage between future European rescue lending and debt restructuring—would make it harder for the weaker countries to continue to run fiscal deficits.

All that’s pro-imbalance. Not to mention a set of policies that will work against the demand recovery the eurozone still needs (demand has only grown 4 percent in the last 10 years—an anemic, almost Japanese performance).

So what’s the IMF to do?***

Logically, if the IMF thinks that the eurozone’s overall fiscal stance should be neutral (I would go further and say it should be slightly expansionary to help the ECB) and if Germany has ruled out fiscal expansion in Germany, doesn’t the IMF need to reconsider its fiscal advice for some other countries?

France or Italy say…

Otherwise, I think it is effectively arguing for continued consolidation in a region with a large balance of payments surplus that is still at the zero bound, as it is clear that Germany won't provide a significant fiscal offset to consolidation elsewhere.  Nor, for that matter, will the Dutch.

P.S. This could have been addressed to the Trump administration rather than the IMF, but that feels rather hopeless. The Trump team has never focused on macroeconomic drivers of trade imbalances. If it did, though, it should now be able to find G7 allies in a push to get Germany to loosen its fiscal stance.

*/ An alternative approach, one I associate with the FT’s Martin Sandbu, would argue that eurozone countries with weak demand should pursue expansionary fiscal policies—which would reduce slack in the eurozone and pull down the eurozone’s overall surplus but also would increase risk of a debt crisis in the “weaker” eurozone countries.

**/ See paragraph 31 of the euro area staff report and the German article IV

***/ The IMF in 2017 thought the eurozone would have a modestly expansionary fiscal stance in 2017, and a neutral one in 2018. But that hinged on a forecasted fiscal easing in Germany that didn’t materialize (emphasis added): “The aggregate fiscal stance of the eurozone is expected to be mildly expansionary in 2017. The structural fiscal balance is expected to ease by 0.3 percentage points of potential GDP (Figure 5). The fiscal easing comes primarily from Germany, and, to a lesser extent, from Italy, France, Finland, and Portugal (Table 5).” That German easing didn’t materialize obviously. The headline primary balance improved in Germany—and for the eurozone. The IMF has a 50 basis point reduction in the EA’s 2017 primary deficit, and a smaller fall in the structural deficit (e.g. a fiscal tightening by any measure).  The new IMF’s assessment for the eurozone as a whole should be out soon.