20 July 2012

The IMF has debunked the myth of Osborne’s fiscal “credibility“

Slowing the cuts would not trigger a bond market revolt.

There is a huge amount of interesting material in the full IMF staff report on the UK, released today, in particular the lasting damage (“hysteresis” to economists) done by this prolonged period of very low growth. But in this post I wanted to draw attention to one particular paragraph (it is para 43 on page 38). I reproduce it here in full:

Some further slowing of consolidation is unlikely to trigger major market turmoil

43. Further slowing consolidation would likely entail the government reneging on its net debt mandate. Would this trigger an adverse market reaction? Such hypotheticals are impossible to answer definitively, but there is little evidence that it would. In particular, fiscal indicators such as deficit and debt levels appear to be weakly related to government bond yields for advanced economies with monetary independence. Though such simple relationships are only suggestive, they indicate that a moderate increase in the UK’s debt-to-GDP ratio may have small effects on UK sovereign risk premia (though a slower pace of fiscal tightening may increase yields through expectations of higher near-term growth and tighter monetary policy). This conclusion is further supported by the absence of a market response to the easing of the pace of structural adjustment in the 2011 Autumn Statement. Bond yields in the US and UK during the Great Recession have also correlated positively with equity price movements, indicating that bond yields have been driven more by growth expectations than fears of a sovereign crisis.

This couldn’t be clearer. It is saying two things. First, the reason long-term gilt yields are low in the UK (and similarly in virtually every other “advanced economy with monetary independence”) is weak growth, not “confidence” or “credibility”. “Bond yields are driven more by growth expectations.” That is, yields are low not because of economic confidence but because of its exact opposite. This is precisely what I and others (Simon Wren-Lewis here, and of course Paul Krugman in the US) have long been arguing. Indeed, the specific evidence the IMF cites – that yields have fallen when stock markets have fallen – is precisely that, in the UK, I first pointed here a year ago.

Second, that there is no reason to believe that slowing fiscal consolidation would “trigger an adverse market reaction”. In other words, when the Chancellor said that “these risks [of slowing consolidation] are very real, not imaginary”, he was, once again, indulging in evidence-free speculation, not serious analysis. Indeed, the Fund accurately points out that the main reason yields might rise (slightly, not precipitiously) if fiscal policy were to be loosened would be because of “expectations of higher near-term growth”. As I pointed out here, this would be good news.

So, the IMF agrees that the reason gilt yields are low is because of weak growth, not confidence; and that we could loosen policy with minimal risk and probable benefit. This is an explicit endorsement of the argument set out by Paul Krugman and Richard Layard (and endorsed by a long list of eminent economists, not to mention me) in their Manifesto for Economic Sense: “there is massive evidence against the confidence argument; all the alleged evidence in favor of the doctrine has evaporated on closer examination.”

As I noted, the Fund’s recommendations are, to be polite, inconsistent. But the analysis is spot on. And it explodes whatever is left of the credibility of the analysis underlying the government’s fiscal strategy.