Hold the Press: The IMF Changes Sides

A significant event has taken place this week.  It will alter the balance of power between creditors and debtors and help shape the contours of the ongoing policy response to the end of historic credit cycle.  The IMF has not only delivered a mea culpa of sorts, but urges its members to do so too.  

The IMF used to stand for It's Mostly Fiscal.  The IMF articulated and defended the neoliberal solution for nearly every country's problems: Cut government spending and raise taxes, or so it often seemed. Its research now shows that policy makers have systematically underestimated the fiscal multiplier.  The IMF's World Economic Outlook (WEO) warned against prematurely and aggressively tightening fiscal policy. 

It now recognizes the vicious cycle many of the IMF's critics have argued all along were a consequence of its policies:  tightening of fiscal policy leads to weaker growth, which worsens public finances further, and then requiring greater austerity.  Isn't this what has played out, not only in the periphery of Europe, but also core countries, such as France, the Netherlands and Belgium, and even the UK? 

It is one thing to bury this new assessment in a research report that more people talk about than actually read.  It is yet another thing for the managing director to forceful articulate the new stance on the world stage and that is exactly what has happened.  

Lagarde has thrown the weight of the IMF to the side of the debtors.  Countries, including Greece, should be given more time to reach fiscal goals.  Lagarde could be more persuasive if she did not recuse the IMF from participating in the official sector involvement in a restructuring (read haircut) of Greece's debt that she has advocated.  

Some observers are emphasizing the continuity of the IMF's position.  The IMF is not changing, they insist.  It is the facts that have changed.  The increased economic sensitivity to tighter fiscal policy is an unintended consequence of the near-zero interest rate policies that dominate the high income and/or the synchronized pro-cyclical fiscal policy among so many countries,  

Yet the creditors know that something has changed when Lagarde cautioned European leaders to ease up on the austerity demands.  Germany's Schaeuble sounded betrayed. Germany believed that the IMF had its back:  high debt levels undermined growth. Instead, the European head of the IMF argued against forcing countries to allow "automatic stabilizers" (the traditional Keynesian policies) to sustain aggregate demand through increased transfer payments.  

"It is sometimes better to have more time", Lagarde was quoted explaining.   Greece's Prime Minister Samaras has been saying the same thing (as have we).   That is startling, and by itself, suggestive of the major change signaled by the IMF's WEO and Largarde's endorsement. 

Schaeuble may feel Germany has been outmaneuvered.  He may perceive the soft money camp moving into ascendancy at the European Central Bank.  He may sense that Lagarde's move has left Germany even more isolated.  However, Merkel's political savvy should not be under-estimated.   The IMF's shift fits well into her own transition.

Merkel has already softened her stance toward Greece.  She has helped quiet the German voices seeking to push Greece out of EMU. She has also held out the possibility of new tax cuts to help stimulate domestic German demand, which is clearly flagging.  The Chancellor also recognized that as the regional leader (first among equals), Germany is obligated "to do something for the stimulation of the economy in Europe".

Ironically, despite Schaeuble's misgivings, Lagarde's shift will support Merkel's election year agenda.  The IMF's new position is also consistent with other official efforts to reduce tail risks in Europe.  Greece's Samaras and Spain's Rajoy may directly benefit from the IMF's new orthodoxy. It may also influence next spring's Italian elections.  France's Hollande, who has seen his popular support trend lower over the past several months, may see a new ally in his fellow country woman.