Late January sees the annual global World Economic Forum meeting of politicians, businesspeople and the great and the good at Davos in Switzerland. Global economic, political, social and environmental issues are discussed and, sometimes, agreements are reached between world leaders. The 2019 meeting was somewhat subdued as worries persist about a global slowdown, Brexit and the trade war between the USA and China. Donald Trump, Xi Jinping, Vladimir Putin and Theresa May were all absent, each having more pressing issues to attend to at home.
There was, however, a feeling that the world economic order is changing, with the rise in populism and with less certainty about the continuance of the model of freer trade and a model of capitalism modified by market intervention. There was also concern about the roles of the three major international institutions set up at the end of World War II: the IMF, the World Bank and the WTO (formerly the GATT). In a key speech, Angela Merkel urged countries not to abandon the world economic order that such institutions help to maintain. The world can only resolve disputes and promote development, she argued, by co-operating and respecting the role of such institutions.
But the role of these institutions has been a topic of controversy for many years and their role has changed somewhat. Originally, the IMF’s role was to support an adjustable peg exchange rate system (the ‘Bretton Woods‘ system) with the US dollar as the international reserve currency. It would lend to countries in balance of payments deficit to allow them to maintain their rate pegged to the dollar unless it was perceived to be a fundamental deficit, in which case they were expected to devalue their currency. The system collapsed in 1971, but the IMF continued to provide short-term, and sometimes longer-term, finance to countries in balance of payments difficulties.
The World Bank was primarily set up to provide development finance to poorer countries. The General Agreement on Tariffs and Trade (GATT) and then the WTO were set up to encourage freer trade and to resolve trade disputes.
However, the institutions were perceived with suspicion by many developing countries and by more left-leaning developed countries, who saw them as part of the ‘Washington consensus’. Loans from the IMF and World Bank were normally contingent on countries pursuing policies of market liberalisation, financial deregulation and privatisation.
Although there has been some movement, especially by the IMF, towards acknowledging market failures and supporting a more broadly-based development, there are still many economists and commentators calling for more radical reform of these institutions. They advocate that the World Bank and IMF should directly support investment – public as well as private – and support the Green New Deal.
- What was the Bretton Woods system that was adopted at the end of World War II?
- What did Keynes propose as an alternative to the system that was actually adopted?
- Explain the roles of (a) the IMF, (b) the World Bank, (c) the WTO (formerly the GATT).
- What is meant by an adjustable exchange rate system?
- Why did the Bretton Woods system collapse in 1971?
- How have the roles of the IMF, World Bank and WTO/GATT evolved since they were founded?
- What reforms would you suggest to each of the three institutions and why?
- What threats are there currently to the international economic order?
- Summarise the arguments about the world economic order made by Angela Merkel in her address to the World Economic Forum.
With the UK parliament in Brexit gridlock, the Labour opposition is calling for a general election. Although its policy over Brexit and a second referendum is causing splits in the party, the Labour party is generally agreed that pubic expenditure on health, education and transport infrastructure needs to increase – that there needs to be an end to fiscal austerity. However, to fund extra public expenditure would require an increase in taxes and/or an increase in government borrowing.
One of the arguments against increasing government borrowing is that it will increase public-sector debt. The desire to get public-sector debt down as a percentage of GDP has been central to both the Coalition and Conservative governments’ economic strategy. Austerity policies have been based on this desire.
But, in the annual presidential address to the American Economics Association, former chief economist at the IMF, Olivier Blanchard, criticised this position. He has argued for several years that cutting government deficits may weaken already weak economies and that this may significantly reduce tax revenues and potential national income, thereby harming recovery and doing long-term economic damage. Indeed, the IMF has criticised excessively tight fiscal policies for this reason.
In his presidential address, he expanded the argument to consider whether an increase in government borrowing will necessarily increase the cost of servicing government debt. When the (nominal) interest rate (r) on government borrowing is below the nominal rate of economic growth (gn), (r < gn), then even if total debt is not reduced, it is likely that the growth in tax revenues will exceed the growth in the cost of servicing the debt. Debt as a proportion of GDP will fall. The forecast nominal growth rate exceeds the 10-year nominal rate on government bonds by 1.3% in the USA, 2.2% in the UK and 1.8% in the eurozone. In fact, with the exception of a short period in the 1980s, nominal growth (gn) has typically exceeded the nominal interest rate on government borrowing (r) for decades.
When r < gn, this then gives scope for increasing government borrowing to fund additional government spending without increasing the debt/GDP ratio. Indeed, if that fiscal expansion increases both actual and potential income, then growth over time could increase, giving even more scope for public investment.
But, of course, that scope is not unlimited.
- What do you understand by ‘fiscal illusion’?
- What is the justification for reducing government debt as a proportion of GDP?
- What are the arguments against reducing government debt as a proportion of GDP?
- Explain the significance of the relationship between r and gn for fiscal policy and the levels of government debt, government borrowing and the government debt/GDP ratio.
- Under what circumstances would a rise in the budget deficit not lead to a rise in government debt as a proportion of GDP?
- Does Blanchard’s analysis suggest that a combination of both loose monetary policy and loose fiscal policy is desirable?
- Under Blanchard’s analysis, what would limit the amount that governments should increase spending?
The IMF has just published its six-monthly World Economic Outlook. This provides an assessment of trends in the global economy and gives forecasts for a range of macroeconomic indicators by country, by groups of countries and for the whole world.
This latest report is upbeat for the short term. Global economic growth is expected to be around 3.9% this year and next. This represents 2.3% this year and 2.5% next for advanced countries and 4.8% this year and 4.9% next for emerging and developing countries. For large advanced countries such rates are above potential economic growth rates of around 1.6% and thus represent a rise in the positive output gap or fall in the negative one.
But while the near future for economic growth seems positive, the IMF is less optimistic beyond that for advanced countries, where growth rates are forecast to decline to 2.2% in 2019, 1.7% in 2020 and 1.5% by 2023. Emerging and developing countries, however, are expected to see growth rates of around 5% being maintained.
For most countries, current favorable growth rates will not last. Policymakers should seize this opportunity to bolster growth, make it more durable, and equip their governments better to counter the next downturn.
By comparison with other countries, the UK’s growth prospects look poor. The IMF forecasts that its growth rate will slow from 1.8% in 2017 to 1.6% in 2018 and 1.5% in 2019, eventually rising to around 1.6% by 2023. The short-term figures are lower than in the USA, France and Germany and reflect ‘the anticipated higher barriers to trade and lower foreign direct investment following Brexit’.
The report sounds some alarm bells for the global economy.
The first is a possible growth in trade barriers as a trade war looms between the USA and China and as Russia faces growing trade sanctions. As Christine Lagarde, managing director of the IMF told an audience in Hong Kong:
Governments need to steer clear of protectionism in all its forms. …Remember: the multilateral trade system has transformed our world over the past generation. It helped reduce by half the proportion of the global population living in extreme poverty. It has reduced the cost of living, and has created millions of new jobs with higher wages. …But that system of rules and shared responsibility is now in danger of being torn apart. This would be an inexcusable, collective policy failure. So let us redouble our efforts to reduce trade barriers and resolve disagreements without using exceptional measures.
The second danger is a growth in world government and private debt levels, which at 225% of global GDP are now higher than before the financial crisis of 2007–9. With Trump’s policies of tax cuts and increased government expenditure, the resulting rise in US government debt levels could see some fiscal tightening ahead, which could act as a brake on the world economy. As Maurice Obstfeld , Economic Counsellor and Director of the Research Department, said at the Press Conference launching the latest World Economic Outlook:
Debts throughout the world are very high, and a lot of debts are denominated in dollars. And if dollar funding costs rise, this could be a strain on countries’ sovereign financial institutions.
In China, there has been a massive rise in corporate debt, which may become unsustainable if the Chinese economy slows. Other countries too have seen a surge in private-sector debt. If optimism is replaced by pessimism, there could be a ‘Minsky moment’, where people start to claw down on debt and banks become less generous in lending. This could lead to another crisis and a global recession. A trigger could be rising interest rates, with people finding it hard to service their debts and so cut down on spending.
The third danger is the slow growth in labour productivity combined with aging populations in developed countries. This acts as a brake on growth. The rise in AI and robotics (see the post Rage against the machine) could help to increase potential growth rates, but this could cost jobs in the short term and the benefits could be very unevenly distributed.
This brings us to a final issue and this is the long-term trend to greater inequality, especially in developed economies. Growth has been skewed to the top end of the income distribution. As the April 2017 WEO reported, “technological advances have contributed the most to the recent rise in inequality, but increased financial globalization – and foreign direct investment in particular – has also played a role.”
And the policy of quantitative easing has also tended to benefit the rich, as its main effect has been to push up asset prices, such as share and house prices. Although this has indirectly stimulated the economy, it has mainly benefited asset owners, many of whom have seen their wealth soar. People further down the income scale have seen little or no growth in their real incomes since the financial crisis.
- Clouds gather over global economy, casting long shadow on Europe
Politico, Pierre Briançon (18/4/18)
- IMF warns rising trade tensions threaten to derail global growth
Reuters, David Lawder (17/4/18)
- IMF outlook contains cause for celebration but a horrendous hangover is looming
The Guardian, Greg Jericho (18/4/18)
- World trade system in danger of being torn apart, warns IMF
The Guardian, Larry Elliott (17/4/18)
- IMF Warns of Rising Threats to Global Financial System
Bloomberg, Andrew Mayeda (18/4/18)
- IMF issues warning on global debt
BBC News, Andrew Walker (18/4/18)
- The IMF has a simple message: the global recovery will peter out
The Guardian, Larry Elliott (17/4/18)
- Global growth is built, alas, on shaky foundations
The Irish Times, Martin Wolf (18/4/18)
- Government debt
The Economist (19/4/18)
- This Is How Much Money the World Owes
- For what reasons may the IMF forecasts turn out to be incorrect?
- Why are emerging and developing countries likely to experience faster rates of economic growth than advanced countries?
- What are meant by a ‘positive output gap’ and a ‘negative output gap’? What are the consequences of each for various macroeconomic indicators?
- Explain what is meant by a ‘Minsky moment’. When are such moments likely to occur? Explain why or why not such a moment is likely to occur in the next two or three years?
- For every debt owed, someone is owed that debt. So does it matter if global public and/or private debts rise? Explain.
- What have been the positive and negative effects of the policy of quantitative easing?
- What are the arguments for and against using tariffs and other forms of trade restrictions as a means of boosting a country’s domestic economy?
The latest edition of the IMF’s Fiscal Monitor, ‘Tackling Inequality’ challenges conventional wisdom that policies to reduce inequality will also reduce economic growth.
While some inequality is inevitable in a market-based economic system, excessive inequality can erode social cohesion, lead to political polarization, and ultimately lower economic growth.
The IMF looks at three possible policy alternatives to reduce inequality without damaging economic growth
The first is a rise in personal income tax rates for top earners. Since top rates have been cut in most countries, with the OECD average falling from 62% to 35% over the past 30 years, the IMF maintains that there is considerable scope of raising top rates, with the optimum being around 44%. Evidence suggests that income tax elasticity is low at most countries’ current top rates, meaning that a rise in top income tax rates would only have a small disincentive effect on earnings.
An increased progressiveness of income tax should be backed by sufficient taxes on capital to prevent income being reclassified as capital. Different types of wealth tax, such as inheritance tax, could also be considered. Countries should also reduce the opportunities for tax evasion.
The second policy alternative is a universal basic income for all people. This could be achieved by various means, such as tax credits, child benefits and other cash benefits, or minimum wages plus benefits for the unemployed or non-employed.
The third is better access to health and education, both for their direct effect on reducing inequality and for improving productivity and hence people’s earning potential.
In all three cases, fiscal policy can help through a combination of taxes, benefits and public expenditure on social infrastructure and human capital.
But a major problem with using increased tax rates is international competition, especially with corporation tax rates. Countries are keen to attract international investment by having corporation tax rates lower than their rivals. But, of course, countries cannot all have a lower rate than each other. The attempt to do so simply leads to a general lowering of corporation tax rates (see chart in The Economist article) – to a race to the bottom. The Nash equilibrium rate of such a game is zero!
Raising Taxes on the Rich Won’t Necessarily Curb Growth, IMF Says Bloomberg, Ben Holland and Andrew Mayeda (11/10/17)
The Fiscal Monitor, Introduction IMF (October 2017)
Transcript of the Press Conference on the Release of the October 2017 Fiscal Monitor IMF (12/10/17)
Higher taxes can lower inequality without denting economic growth The Economist, Buttonwood (19/10/17)
Trump says the US has the highest corporate tax rate in the world. He’s wrong. Vox, Zeeshan Aleem (31/8/17)
Reducing inequality need not hurt growth Livemint, Ajit Ranade (18/10/17)
IMF: higher taxes for rich will cut inequality without hitting growth The Guardian, Larry Elliott and Heather Stewart (12/10/17)
IMF Fiscal Monitor
IMF Fiscal Monitor: Tackling Inequality – Landing Page IMF (October 2017)
Opening Remarks of Vitor Gaspar, Director of the Fiscal Affairs Department at a Press Conference Presenting the Fall 2017 Fiscal Monitor: Tackling Inequality IMF (11/10/17)
Fiscal Monitor, Tackling Inequality – Full Text IMF (October 2017)
- Referring to the October 2017 Fiscal Monitor, linked above, what arguments does the IMF use for suggesting that the optimal top rate of income tax is considerably higher than the current OECD average?
- What are the arguments for introducing a universal basic income? Should this depend on people’s circumstances, such as the number of their children, assets, such as savings or property, and housing costs?
- Find out the details of the UK government’s Universal Credit. Does this classify as a universal basic income?
- Why may governments reject the IMF’s policy recommendations to tackle inequality?
- In what sense can better access to health and education be seen as a means of reducing inequality? How is inequality being defined in this case?
- Find out what the UK Labour Party’s policy is on rates of income tax for top earners. Is this consistent with the IMF’s policy recommendations?
- What does the IMF report suggest about the shape of the Laffer curve?
- Explain what is meant by tax elasticity and how it relates to the Laffer curve?
According to Christine Lagarde, Managing Director of the IMF, the slow growth in global productivity is acting as a brake on the growth in potential income and is thus holding back the growth in living standards. In a recent speech in Washington she said that:
Over the past decade, there have been sharp slowdowns in measured output per worker and total factor productivity – which can be seen as a measure of innovation. In advanced economies, for example, productivity growth has dropped to 0.3 per cent, down from a pre-crisis average of about 1 per cent. This trend has also affected many emerging and developing countries, including China.
We estimate that, if total factor productivity growth had followed its pre-crisis trend, overall GDP in advanced economies would be about 5 percent higher today. That would be the equivalent of adding another Japan – and more – to the global economy.
So why has productivity growth slowed to well below pre-crisis rates? One reason is an ageing working population, with older workers acquiring new skills less quickly. A second is the slowdown in world trade and, with it, the competitive pressure for firms to invest in the latest technologies.
A third is the continuing effect of the financial crisis, with many highly indebted firms forced to make deep cuts in investment and many others being cautious about innovating. The crisis has dampened risk taking – a key component of innovation.
What is clear, said Lagarde, is that more innovation is needed to restore productivity growth. But markets alone cannot achieve this, as the benefits of invention and innovation are, to some extent, public goods. They have considerable positive externalities.
She thus called on governments to give high priority to stimulating productivity growth and unleashing entrepreneurial energy. There are several things governments can do. These include market-orientated supply-side policies, such as removing unnecessary barriers to competition, driving forward international free trade and cutting red tape. They also include direct intervention through greater investment in education and training, infrastructure and public-sector R&D. They also include giving subsidies and/or tax relief for private-sector R&D.
Banks too have a role in chanelling finance away from low-productivity firms and towards ‘young and vibrant companies’.
It is important to recognise, she concluded, that innovation and structural change can lead to some people losing out, with job losses, low wages and social deprivation. Support should be given to such people through better education, retraining and employment incentives.
IMF chief warns slowing productivity risks living standards drop Reuters, David Lawder (3/4/17)
Global productivity slowdown risks social turmoil, IMF warns Financial Times, Shawn Donnan (3/4/17)
Global productivity slowdown risks creating instability, warns IMF The Guardian, Katie Allen (3/4/17)
The Guardian view on productivity: Britain must solve the puzzle The Guardian (9/4/17)
Reinvigorating Productivity Growth IMF Speeches, Christine Lagarde, Managing Director, IMF(3/4/17)
Gone with the Headwinds: Global Productivity IMF Staff Discussion Note, Gustavo Adler, Romain Duval, Davide Furceri, Sinem Kiliç Çelik, Ksenia Koloskova and Marcos Poplawski-Ribeiro (April 2017)
- What is the relationship between actual and potential economic growth?
- Distinguish between labour productivity and total factor productivity.
- Why has total factor productivity growth been considerably slower since the financial crisis than before?
- Is sustained productivity growth (a) a necessary and/or (b) a sufficient condition for a sustained growth in living standards?
- Give some examples of technological developments that could feed through into significant growth in productivity.
- What is the relationship between immigration and productivity growth?
- What policies would you advocate for increasing productivity? Explain why.