One of the biggest supporters of Prime Minister Justin Trudeau’s decision to try to boost economic growth by running deficits is the International Monetary Fund. This will come as a surprise to anyone who still sees the IMF as the overlord of the Washington Consensus, shorthand for the neo-liberal economic agenda that the fund promoted through the 1990s and in the years ahead of the Great Recession. But over the past number if years, the IMF has become far less doctrinaire. It now says it is okay if countries seek to regulate hot money, and it talks openly about income inequality as a threat to economic growth. This shift was based on research, and Canada’s Jonathan Ostry was responsible for much of it. Ostry, born in Ottawa and educated at the University of Chicago, wields influence as the deputy director of the IMF’s research department. Last year, he challenged orthodoxy again by showing that austerity could actually make it harder for countries to manage their debts by constraining economic growth. Ostry spoke to Maclean’s recently in Washington.
Q: When you started your work on deficits and debt, what did you think you were going to find?
A: What got us thinking about this idea was that after the global financial crisis, many, many advanced countries woke up with a huge increase in their public debt. It is not the case that the reason for that increase is primarily the fiscal stimulus that was undertaken. That was a part of it, but the larger part was the need to bail out the financial sector as well as the impact of low growth. There was a period of low growth when money was not coming into treasuries around the world, so there was a big run up in public debt. You had a sense throughout the world that, ‘Okay, debt is really high and it should be paid down. What goes up should come down.’
We at the fund and elsewhere seemed more concerned about the pace at which the debt ratio should be brought down, rather than whether it should be brought down in the first place. The argument went: ‘if you pay it down too quickly, you will undermine the recovery; and if you pay it down too slowly, you might unnerve markets.’ I felt one needed to ask a more basic question: should the debt be paid down at all? I later convinced myself that, in history, the way debt ratios get reduced is primarily through the denominator (GDP) rather than the numerator (the level of debt). Periods of long, sustained growth are what have enabled countries to durably reduce their debt ratios.
That was one thought in the back of our minds. The other was that it couldn’t possibly be right that the advice to pay down the debt through fiscal effort (a larger surplus) would apply equally to countries with a lot of fiscal space and to countries with very little fiscal space. Countries where markets are already giving you strong signals that you need to get your fiscal house in order are going to have a much greater need to have large government surpluses to pay down the debt. But for countries where there is very little real prospect of a fiscal crisis on the horizon, the case for fiscal efforts to pay down the debt seems much less compelling.
What we tried to do was put together a framework that might illustrate those two points. There is an analogy to monetary policy. When you have a lot of monetary policy credibility, you can afford to be more aggressive in combating deflationary risks even if it may look somewhat irresponsible. Sometimes it is responsible to do irresponsible things. Likewise, I think countries that have an excellent track record of fiscal responsibility can afford not to pay down their debt in short order, especially in periods like the one we are going through.
Q: Yet paying down debt has dominated economic thinking over the past five years.
A: When you talk about the virtues of paying down the debt, two arguments are normally made. One is that high debt is bad for growth, so low debt is good for growth. I have no argument with that. I accept that. The other is that low debt is needed as a kind of insurance to enable you to have the elbow room if something bad happens to you tomorrow. So it’s insurance. Low debt has both an insurance value and it is good for growth.
The problem is not with those two points, the problem is that you somehow imagine that you can get to low debt costlessly and you ignore the transitional cost of getting to low debt. If there is waste in the government, and you cut that waste, there is indeed a costless way of getting debt down. But if there is little or no waste, getting debt down involves either cutting productive spending, which has a cost, or raising distortive taxes, which has a cost. What we showed is that those costs are important and you can quantify them. And under very reasonable assumptions, for countries with ample fiscal space, the costs of bringing down the debt are going to be larger than the benefits in terms of insurance and future growth. The insurance and growth benefits of lower debt are going to be smaller than the transitional costs of getting to that lower debt.
It was a surprising finding. I believe that it is right. I can say that [Nobel laureate] Tom Sargent bought the argument, as did others. There was an intensive review of this line of reasoning here at the fund. I’m confident the results are right. What is the implication? The implication for countries with ample fiscal space, of which there are actually a number in the world today, is you should not sweat the debt. You should not obsess about the debt. There is a degree of debt obsession in some countries, which is not appropriate. The better strategy for countries with a high debt but ample fiscal space is to live with the debt, and allow the debt ratio to decline organically through growth.
Q: How have your conclusions gone down with your alma mater at the University of Chicago?
A: I haven’t presented it at Chicago. People will disagree about the politics. People may think you might tend to underestimate the insurance benefit of low debt. My view is that if you really take that argument to its logical conclusion, there really is no limit to how far you would want to go. Extreme bad shocks, like a Great Depression or the global financial crisis, might happen every 80 years or so, or maybe more frequently in countries like Japan, given its post-bubble blues. But if your perspective is that tomorrow’s bad shocks are all you should focus on, then why stop at bringing down your debt from 100 per cent to 60 per cent of GDP? Why not go to zero debt? In fact, why not go negative, that is have the public sector accumulate positive net assets? Some countries with large sovereign wealth funds have a positive net asset position. And indeed there are academic papers that suggest that, just like for the private sector, a precautionary saving motive is appropriate for the public sector, which should accumulate assets rather than debt. There is a spectrum of views out there. But these perspectives ignore the costs of bringing down the debt, and the opportunities forgone in increasing debt, such as improving infrastructure, a pressing issue in many countries. The debt-obsession perspective is too narrow, and we need some balance in the debate.
Q: Is all investment created equal?
A: When you listen to some commentators, you almost feel like there is no bad public investment project. Basically, interest rates are very low, we are in a deficient demand situation, fiscal multipliers are very high, infrastructure spending is super efficient, and so closing large infrastructure gaps is a no-brainer and may even bring down the debt ratio, i.e., the public spending projects may more than pay for themselves. I don’t disagree strongly with those points. There is an interesting parallel. Many decades ago, supply side economics, sometimes called “voodoo economics,” said that if you cut taxes, the debt will actually go down because there will be such a boost to growth that the debt more than pays for itself. That was on the right of the political spectrum.
Today, on the centre-left of the political spectrum, people say that if you increase public spending, say, on infrastructure, it will more than pay for itself. It’s the same mechanism, though: the economic boost will bring more money into the treasury and decrease the debt ratio as a result. Probably one side, the left or the right, would deride the other, given where it is coming from.
My question would be more, ‘Are these unusual economic conditions? Or are they normal economic conditions?’ I would say they may be unusual. Probably, today there is a very strong case for a buildup of public infrastructure in a lot of countries. But one should not forget the lessons of earlier time periods where there were bridges to nowhere and roads to nowhere and in countries with weaker political and economic institutions there was a lot of waste. I am not saying that is the message for today, but it should be kept in the back of one’s mind. There always is a danger that we become excessive cheerleaders for a policy and forget lessons from earlier periods. Again, we need some balance.
Q: How have your findings on debt been received by the global political community? There still is some resistance. Are you disappointed that the message hasn’t been as widely embraced as Christine Lagarde, the IMF managing director, would have hoped by now?
A: There are radically different perspectives on this issue. You can guess what the different players would say. I can’t really say more than that. My work has spawned a debate and that’s the most one can hope for. I think the concept of fiscal space that we developed is an important one; the G20 and others are calling for countries with fiscal space to do certain things. So we need to know what the concept of fiscal space means, and how it should be applied. I am somewhat disappointed that we haven’t yet agreed on a concept of fiscal space. Some people think that the concept will never be agreed upon. I would rather see the glass as half-full than half-empty, and I believe my work is a reasonable starting point.
Q: What would hold back agreement?
A: In our paper, fiscal space is the distance between your current level of debt and the point at which markets cut you off. Clearly, you never want to get near the point at which markets cut you off. You never are shooting for zero fiscal space; zero space is not an “optimum.” You want to be well away from the point of market cutoff when spreads start to rise fast; you want to maintain a considerable buffer of fiscal space as we define it. One reason to keep your distance is that markets are notoriously bad at giving you early warning of impending problems. They tend to be, as Greece discovered, very fast moving: one day you can borrow at close to the risk-free rate and the next you may be pretty much shut out from markets as risk premia go sky high.
Part of the difficulty is to define how far from the fiscal cliff is the right distance. Moody’s [the credit-rating agency] has used the apparatus we developed to separate countries into green, yellow and red zones. The international community needs to agree on something akin to these zones and say, for countries in the green zone, they should behave in a certain way, using their available fiscal space to boost their economy and strengthen infrastructure, while in the yellow or red zones, caution or consolidation are needed. Moody’s has cut the data in one particular fashion, based on our approach. It doesn’t mean it’s the right way to cut the data, but the concept we developed remains useful.
The problem today is that we treat the whole world as if it’s in the red zone, or at least do not question the need to bring down the debt. But the green zone is not the empty set. In a world where we are worried about secular stagnation and deficient demand and deficient infrastructure, there is a cost to treating everybody like they are on the verge of experiencing a crisis. That is not healthy advice for the global economy.
Q: Is the Washington Consensus dead? And have you killed it?
A: There are very valuable things in the neo-liberal, Washington Consensus agenda. I think we’ve gained a lot from the growth of trade, for example, spurred by successive rounds of multilateral trade liberalization. We’ve gained a lot from bringing about an environment of low and stable inflation through appropriate monetary policies and inflation targeting. I wouldn’t want to throw these parts of the neo-liberal agenda out. But I think we have learned that the Washington Consensus is an incomplete agenda at best, and may have got some things wrong. Many people associate that agenda with, for example, open international capital markets, low levels of public debt, a high tolerance of economic inequality. These aspects are worrisome because they have not delivered the sustained economic growth which is the raison d’etre of the neo-liberal agenda. And to the degree that these policies have increased inequality, which I believe they have, they have made growth more fragile, and less sustainable. So even on the terms that are valued by the proponents of the neoliberal agenda, the rise of inequality is a huge problem, as some of my other work has shown.