IMF hands Osborne a headache

An acknowledgment by an IMF report that fiscal cutbacks are having a negative effect on output supports the findings of those who warned about the damage of austerity politics

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The IMF’s World Economic Outlook will make for grim reading for investors as global growth forecasts were downgraded. Yet the biggest headache may be saved for the Treasury.

One of the key passages in the report was a surprising admission by the Fund. Having long been supporters of sharp fiscal adjustment for states with high public debt as a percentage of GDP the report acknowledged that, having reviewed the figures, “fiscal cutbacks had larger-than-expected negative short-term multiplier effects on output”.

That is, government spending cuts have had a greater impact on economic performance than were forecast. In fact the report goes even further:

“Fiscal problems can be rooted in structural problems that take time to address, and sharp expenditure cutbacks or tax increases can set off vicious cycles of falling activity and rising debt ratios, ultimately undercutting political support for adjustment.”

The findings pose a problem, not only for the credibility of George Osborne’s Plan A but also for investors looking for areas of growth amidst the gloom. If spending cuts are likely to have a significant negative impact on the economy then Osborne’s speech at the Conservative Part Conference last week could be a serious cause for concern.

“Our public spending plans were designed to give us flexibility and credibility,” the Chancellor announced. “The flexibility to respond to the economic conditions in the world around us. The credibility that each day earns us record low interest rates in the world’s bond markets…Our published plans already require us to find £16bn of further savings.”

His message reflected a doubling-down on Plan A-usterity as the deficit reduction target the government set itself looks set to be missed by a wide margin. If the Fund is to be believed, however, this approach could have severe consequences on the prospects for growth.

Writing on his blog Jonathan Portes, a director of the National Institute of Economic and Social Research (Niesr) and former chief economist at the Cabinet Office, said the findings vindicate the work of Brad Delong and Paul Krugman who have long been warning of the damage of austerity politics.

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“Why does this matter? Everyone agrees growth since 2010 in the UK has been very disappointing. But there has been much debate about why – was it cutting the deficit too quickly, was it the spike in inflation resulting from commodity price rises, was it the impact on confidence from the eurozone?…The IMF has now definitively sided with those who think that tightening fiscal policy quickly and sharply had a very large and negative impact.”

The UK economy is now forecast to shrink by 0.4 per cent over the whole of 2012, a downward revision of 60 basis points. Moreover growth in 2013 is predicted to be a modest 1.1 per cent and given the trajectory of recent revisions even that looks vulnerable.

Falling confidence in a recovery may already have begun filtering into business sentiment. The composite index of Purchasing Managers’ surveys fell from 52.2 to 51.1 in September indicating only a slim chance of growth.

This leaves investors in something of a quandary. As the graph shows, so-called “safe haven” assets have rallied sharply in recent years – particularly government bonds with benchmark 10-year gilts up over 60 per cent over the past five years.

Unfortunately this sharp rally has also depressed yields with 10-year UK government debt yielding 1.76 per cent, well below CPI inflation that currently stands at 2.5 per cent.

“I do not know who is still buying gilts but someone is. I can only presume it is institutions that are being forced to for regulatory reasons,” says Ben Willis, the head of research at Whitechurch Securities. “There has been a lot of money going into corporate bonds and equity income but at the safer end a lot of the gains may already have been had.”

Despite these fears the appeal of safe havens remains potent. According to the IMA the top three sectors by net retail sales in August were £ Sterling Strategic Bond, £ Corporate Bond and Global Equity Income. Yet are investors buying into these assets at their peak?

The IMF report states that downside risks have grown but notes that upside potential has also increased. The majority of these risks centre on understandable doubts over the ability and/or will of politicians to meet their commitments to prevent a euro collapse and avert hitting the fiscal cliff in the US.

Yet if these dangers are avoided risk assets that are being forced to discount uncertainty could see a significant rally. That, however, relies on politicians moving past party political sparring to acknowledge the scale of the challenges and the importance of being seen as sufficiently competent to deal with them.

Conference season has provided precious little in this regard. Perhaps the only highlight was the reiteration of the Liberal Democrat’s commitment to the Coalition after an unsteady period with their Conservative partners. This at least offers the potential of a functional government.

The World Economic Outlook demonstrates the value of evidence-based research rather than political invective. Austerity, whether in the UK or Southern Europe, should never be allowed to become an article of faith. Perhaps we should once again borrow from John Maynard Keynes and ask the Chancellor:

“When my information changes, I alter my conclusions. What do you do, sir?”

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