Why Is The IMF Pushing Fiscal Consolidation in the Eurozone in 2017?

The eurozone collectively has a substantial external surplus, and its economy is operating below potential. In the framework set out in the IMF’s external balance assessment, that pretty clearly calls for fiscal expansion:

"Surplus countries that have domestic slack need to rely more on fiscal policy easing, which would address both their output gaps and their external gaps... Meanwhile, deficit countries should actively use monetary policy, where available, to close both internal and external gaps."

But is the IMF following its own advice (for a currency union that has an external surplus and domestic slack, I am well aware of the fact that the eurozone is not a single country with a single fiscal policy) and actually recommending a fiscal expansion in the eurozone?

Best I can tell, no. Not for 2017.

The IMF of course is for more fiscal stimulus at the European level. But that is a hope, not a reality. The capacity for a common eurozone fiscal policy conducted through borrowing by the center doesn’t currently exist, and it realistically isn’t going to materialize next year.

That means the eurozone’s aggregate fiscal impulse is the sum of the fiscal impulses of each of its main economies. What does the IMF recommend there?

In Italy the IMF seems to want about a half a point of structural fiscal consolidation (see paragraph 35 of the staff report).

In France, the same (see paragraph 33 of the staff report).

In Spain, the last IMF article IV called for a half a point of consolidation as well (see paragraph 33). That though is likely to be ratcheted up, as Spain hasn’t done much consolidation over the past two years and now will need to engage in a major consolidation to get to the Commission’s 3 percent of GDP fiscal target in 2018.

Spain, Italy, and France collectively account for a bit more of the eurozone’s GDP than Germany and the Netherlands.

So, is the IMF recommending enough fiscal expansion in Germany and the Netherlands to assure a positive fiscal impulse for the eurozone as a whole? No.

The IMF is now advocating that Germany avoid returning to a structural surplus, and invest any windfall savings from higher than expected revenues or lower interest rates. But the IMF isn’t advocating Germany do any more on net than it already had done. Germany delivered a significant stimulus is 2016, but it was a one and done stimulus. Germany isn’t projected to generate a positive fiscal impulse in 2017.*

The Netherlands needs stimulus on purely domestic grounds given persistent weakness in household demand and an ongoing output gap (see the "Tricky Balance" chart in the IMF’s external balance assessment). And the IMF did recommend a modest fiscal expansion in its last assessment of the Dutch economy. But also it didn’t protest too much when the Dutch government politely declined. See paragraphs 14 and 15 of the 2015 staff report.

Bottom line: Germany’s 2017 fiscal impulse is projected to be neutral. The fiscal expansion the IMF recommended in the Netherlands for 2017 is not likely to be adopted and even if adopted it would be too small to offset the fiscal consolidation the IMF is recommending in Spain, Italy, and France. Given the weight of France, Italy and Spain in the eurozone, this implies the IMF is recommending that the eurozone as a whole consolidate next year. And in the IMF’s global framework, that implies the IMF is currently recommending policies that would tend to raise the eurozone’s external surplus.

That goes to a larger global problem. The IMF’s framework for looking at external balances says, more or less, that intervention in the foreign exchange market has only a modest impact on external balances.** The policies that matter are healthcare spending, and of course, fiscal policy. The IMF always lives up to its mostly fiscal reputation.

The implication, if the IMF wants to be symmetric and worry about global demand as well as global balance of payments adjustment, is that the IMF needs to be as aggressive in recommending fiscal expansion in surplus countries as it is in recommending fiscal consolidation in deficit countries.

Judging by its recommendations in Europe, it still has a way to go.

In addition to watching the IMF’s aggregate recommendation for the eurozone, I also will be watching the IMF’s 2017 fiscal recommendation for Korea—which has a German-sized current account surplus and, broadly speaking, a German fiscal policy (counting the off-budget surplus in Korea’s social security fund, Korea ran a general government surplus in 2015).*** And its last stimulus package seems to lack what the Japanese would call fresh water.

There is of course a second, more straight forward argument for why the IMF might want to encourage Germany to do a bit more public investment in 2017: It offers the most obvious way to help insulate Germany from a slowdown in British demand.

The IMF’s initial analysis of Brexit suggested it might knock 20 basis points off eurozone growth in 2017. The hit to Germany, though, was bigger—more like 40 basis points. Logical, given Germany’s greater dependence on exports. Germany’s 2017 nominal wage growth—judging from the contracts agreed this spring—also looks to be slower than in 2016.

All in all, it would seem like there is ample reason for the IMF to encourage Germany to offset the impact of the drag expected from Brexit with a looser fiscal policy in 2017 and 2018, even if that means Germany would need to run small structural fiscal deficits for a time. It would support German growth in the face of an expected external shock. It would help ease the pressure on monetary policy when the ECB is at the zero bound. It would make it easier for Italy, Spain, and France to offset the demand drag from fiscal consolidation through exports, and thus facilitate the eurozone’s internal rebalancing. And it would help reduce the eurozone’s contribution to global current account imbalances.

Note: edited slightly after publication; I had "internal" when I meant "external" in the last paragraph

* Germany did provide a solid (around 1 percent of GDP) fiscal stimulus in 2016 in response to the migrant crisis, as the IMF estimates it moved from a 70 basis points of GDP general government surplus to a 30 basis point of GDP general government deficit. But now that Germany no longer has a surplus, the politics of further stimulus get complicated. The IMF’s staff report emphasized that any further public investment needs to be Within the fiscal rules ("Fiscal resources available within the envelope defined by the fiscal rules, including in case of overperformance, should be used to finance additional public investments...") and the debt brake doesn’t leave much space (see paragraph 49 of the 2016 staff report; the fiscal impulse is from table 2 of the staff report.

** This gets technical. In the IMF’s analytical framework, the intervention variable is interacted with the capital controls variable, reducing its impact. The capital controls variable is never “1.” For China, for example, it was 0.5 last year. So a percentage point of GDP in Chinese intervention could not have more than a roughly 17 basis point impact on the current account (the 0.45 intervention coefficient is multiplied by capital controls, which are now rated at 0.38 on a 0 to 1 scale. For Korea, a percentage point of GDP intervention could not have an impact of more than 6 basis points, given the 0.13 intensity of Korea’s controls. This is well below the impact that the Peterson Institute’s Joe Gagnon has estimated. And the impact is further reduced by the fact that the relevant variable is the gap between a country’s current level of controls and the optimal level of controls. So if the IMF (wisely) believes China isn’t ready yet to liberalize its financial account, the impact of intervention in generating a “policy gap” falls further. Right now, given the size of the capital controls gap for China, a dollar of intervention in China results in only a ten cent change in the current account. It doesn’t matter much now, as emerging markets sold reserves in 2015 and so far in 2016. But the net effect is that in the IMF’s framework, intervention never had much of an aggregate impact even back when there was a lot of intervention.

*** The IMF is recommending medium-term fiscal consolidation in Japan, China, and the eurozone. Fairly substantial consolidations too (see table 3 of this report, look at what the IMF calls P* or "optimal" policies and compare that with the current estimated fiscal balance; the full underlying analytics are here). It is recommending a small medium-term fiscal expansion in Sweden and Korea. Both countries ran general government surpluses in 2015, and the IMF is calling them to bring those surpluses to zero or run a small (10 basis points of GDP) general government fiscal deficit. But the resulting swing in the fiscal balance is modest relative to the size of the Swedish and Korean current account surplus. For Germany, the IMF is recommending a fiscal expansion relative to its 2015 surplus; but, as noted above, that stimulus occurred in 2016, and the IMF isn’t currently calling for more stimulus. I should note here that the recommended fiscal stance in the IMF’s external balance assessment is for the medium term; just because the Fund recommends a medium term on-budget consolidation for say China doesn’t mean it recommends an immediate on-budget fiscal consolidation. That said, given China’s extremely high national savings rate and the need for corporate deleveraging, I personally do not see why China could not sustain on-budget fiscal deficits of around 2 percent of GDP in the medium term.