The Troika changes its mind

International Monetary Fund (IMF) calls to increase public investment to boost the recovery. The European Commission, World Bank and OECD representatives are saying the same. There is a change in the opinions of Troika and other institutions.

Angel Gurria, OECD Secretary-General, said: “Countries should not repeat the mistakes we made after the last crisis, and try to cut spending or raise taxes too early.” Carmen Reinhart, the chief economist at the World Bank (WB) and a well-known debt critic, adds: “First fight the war, then figure out how to pay for it”. At the same time European Commission (EC) prepares the historically large investment package – EU’s recovery fund.

Greek tragedy

Let’s look back at Greece and problems it had (and still has). The Troika – EC, IMF and European Central Bank (ECB) – had one solution: austerity. Cutting spending, raising taxes and selling assets as the only way to achieve a budget balance.

In 2011-2013, Greece had implemented an extremely restrictive fiscal policy. The average annual discretionary fiscal effort (DFE) reached 5.8 per cent of GDP, the highest level in the EU, over 4 times higher than at that time the EU’s average (1.3 per cent of GDP). The public investment declined from 5.7 per cent of GDP in 2009 to 2.5 per cent in 2011. In 2011, the real GDP decreased by over 9 per cent. In 2013, unemployment rate reached 27.5 per cent. As a result of the Troika plan the public debt increased significantly, from 146 per cent of GDP by the end of 2010 to 177 per cent by the end of 2013.

The same happened in other southern European countries: Italy, Portugal and Spain. All of them introduced restrictive fiscal policy right after the financial crises (average annual DFE in 2011-2013 amounted to 1.9, 2.9, 3.3 per cent of GDP respectively). None of them succeeded in reducing the public debt.

Government is not a household budget

It’s extremely hard to reduce the public debt when the GDP is falling. And austerity usually has a negative impact on GDP. It’s a vicious circle – countries implement the restrictive fiscal policy to reduce the debt to GDP ratio, but it deteriorates GDP growth. So despite the effort the debt does not decrease. The task of lowering the debt to GDP ratio after current expansionary state’s policies should be on to-do-list in a long-term strategy. Some economists say that we will have to implement severe public policy to pay off the debt and it will take years to do so. However, this is not necessarily true.

In fact, the temporarily, expansionary fiscal policy usually does not bear the fiscal cost, i.e. does not result in the need for severe tax increases or spending cuts in the future. This thesis, although it is not popular in a public debate, is well-established in economics (e.g. Ball, Elmendorf and Mankiw, 1998, or, more recently, Blanchard, 2019). That’s what mathematics and history teaches us. The reduction of public debt happens automatically when the GDP growth rate is higher than the government bond rate, and the primary balance of public finance is close to zero.

The first is a historical norm, at least in developed economies. The opposite situation occurs rarely and only for a short time. It is also unlikely to happen in the coming years, as the interest rates may remain low. If economies come back to their long-term growth levels the second will not be a difficult challenge. It means that countries can keep a deficit of a few per cent of GDP (equal to the amount of debt servicing costs).

This leads to a conclusion: the key challenge of the coming years would not be to reduce the public debt, but to return to growth levels. This should be a main goal of the fiscal policy, as it is the precondition for debt reduction.

Lack of democracy

In this context the exhortations of IMF and other institutions not to implement austerity too quickly seem to be right. Still I have doubts. Firstly, why none of the Troika members have the courage to say straightforwardly: “A decade ago we were wrong”. Or at least to say “We are sorry”. That’s a basic problem – the international organizations, unlike national, are not accountable. Southern Europeans cannot fire them. If they could, probably they would.

Secondly, do we have a proper definition of what is called “public investment”? Generally, we understand them as construction of buildings, highways, power plants, etc. IMF’s recommendations also suggest this understanding. However, scientific researches show that these are not necessarily the highest return rate investments. It would be much more profitable to invest in human capital – education and science. For example, researches show high return ratios of public spending on early childhood education, sometimes exceeding 10 per cent annually (Garcia et al., 2016). Also other spending we classify as social and often the first to cut may bring significant benefits in the future (Hendren and Sprung-Keyser, 2020).

The experience from a decade ago shows us that mistakes cost a lot. This time we should not repeat them by keeping to the old definitions.

Jakub Sawulski, PhD, is the Head of Macroeconomics Team at Polish Economic Institute and Assistant Professor at Warsaw School of Economics.