The International Monetary Fund seems to have one set of rules for developing countries and another entirely for developed economies. And neither is particularly effective.
This is a tale of two countries, which both ignored International Monetary Fund (IMF) advice and went on to grow their economies – the UK and Sri Lanka. The interesting part is that the IMF advice given was not only wrong in both cases but consisted of completely different and starkly contrasting policy prescriptions.
With the UK straining under one of the largest budget deficits in Europe, the IMF advised the incoming coalition government in 2010 not to cut spending too fast and to offset the impact from fiscal tightening by bringing forward capital investment (a sort of contemporary equivalent of the Hoover Dam project in 1930s depression US). In fact, the UK went ahead with politically difficult spending cuts, designed to bring the deficit under control faster, and has been rewarded in 2014 with one of the fastest growing economies in Europe, at a time when much of the eurozone remains mired in recession.
So in this case the IMF said spend more, which would have increased the deficit initially, on the basis that the extra activity generated would revive the economy faster and bring the deficit down eventually but over a longer period – a classic Keynesian response also advocated by the UK’s opposition Labour Party.
By contrast, in Sri Lanka the IMF advice was to put on the brakes – to depreciate the currency as a way of bringing down trade and current account deficits, and to raise taxes to boost government revenues. This is akin to the conventional Washington Consensus approach that informed IMF policy prescriptions for decades and has caused all kinds of hardships in developing countries, not least in the Asia crisis of 1997. (Back then it was Malaysia that bucked IMF prescriptions by imposing capital controls to rather good effect.)
Sri Lanka ignored the IMF’s advice. The government’s argument was that after the 26-year-old civil war ended in 2009, and even with a large fiscal deficit and high debt-to-GDP ratio, the country needed to rebuild. It went for a classic Keynesian response by engaging in a large-scale rebuilding and reconstruction programme, and by lowering tax rates at the same time. The massive stimulus this produced has pushed Sri Lanka along at growth rates of 7% to 8%, and helped the government bring the deficit down to 5.2%. (See The Banker's interview with Sri Lanka’s central bank governor Ajith Nivard Cabraal)
A cynic might argue that the IMF has one policy for developing countries, which 'need to get their finances in order and be taught a lesson' and another for developed countries, which are so 'sophisticated' that they can be 'trusted to be smartly anti-cyclical'.
In both cases it turns out that the governments understood their situation better than the IMF. The key reason for this is that the IMF did not appreciate as well as the governments the role confidence plays as a key driver of economic growth. Without it almost every policy will fail. That is why very different policy prescriptions can both be right.
What the IMF failed to realise in the case of the UK is that the previous Labour government had already broken a golden Keynesian rule by not running a budget surplus in the good times. (“The boom, not the slump, is the right time for austerity at the Treasury”, as John Maynard Keynes put it.)
Or, to quote Sweden’s finance minister, Anders Borg, in The Economist magazine: “If you want to run a big welfare state you need to run surpluses in good times. That was a huge difference between the Swedish Social Democrats and the [UK] Labour Party. Ours were far more prudent in terms of fiscal policy”.
The confidence of the markets in the UK was already shattered. Only austerity would provide the confidence for investors to keep buying UK government debt in vast quantities at record low yields and keep the UK's credit rating as high as possible. The IMF’s advice to spend more would have sent investors running for cover and prolonged the recession.
By contrast, Sri Lanka desperately needed to rebuild a war-shattered economy that did not have the in-built stabilisers of an advanced economy (transfer payments through welfare and government spending programmes), which prevent aggregate demand from falling too far. Confidence was at a low ebb and old fashioned pump priming through infrastructure and lower taxes were needed to get it back and to attract foreign investment. As a developing economy with huge growth potential it was a fairly safe bet that the economy would respond to the stimulus.
Somehow, the IMF failed to understand the different economic circumstances fully and the role confidence would play in the future recovery of both countries. As a result, it got both policy recommendations wrong even though they were opposite in nature.
Brian Caplen is the editor of The Banker.
