The U.S. Economic Debate Gets a Failing Grade at the IMF

At the private conference this week convened by the International Monetary Fund (IMF), 30 world-class economists talked for two days about “Macro and Growth Policies in the Wake of the Crisis.” Their discussions provided a reality test for the current economic debate in Washington, and the last decade of U.S. policymaking flunked. Economic ideology not only blinded American policymakers to the seeds of a financial crisis that never had to happen; it also has led to wrong-headed responses for both the short-run and the long-term.

While the United States and other advanced countries embraced large-scale stimulus in 2008 and 2009 to avoid a global depression, the panelists pointed out that the world’s advanced economies are now moving in the opposite direction, without regard for the consequences. Across a group of economists who normally argue over every assumption and decimal point, a genuine consensus emerged that the American and European economies remain too fragile today to successfully absorb major deficit cuts.

While congressional Republicans wield a meat axe over the budget, and many Democrats would apply a scalpel, nearly all of the economic notables gathered at the IMF concluded that additional spending and tax breaks would be much more sensible. The 2009 and 2010 stimulus programs came in for plenty of criticisms, especially for their emphasis on tax breaks for households:  The financial meltdown and deep recession left most households with so much debt relative to their incomes that much of the stimulus just went to reducing their debt loads. Household debt today is considerably lower; but it hasn’t fallen as far as most people’s assets, because the value of their principal asset, their homes, has kept on declining month after month. This time, the experts agreed, any stimulus should be better targeted, for example through investment tax breaks and spending on education and infrastructure.

To be sure, there were repeated calls for a long-term “fiscal consolidation” program, which is how economists describe entitlement reforms and other measures that can limit a nation’s public debt to a reasonable share of its GDP. But they weren’t encouraged by what they’re hearing out of Congress, where politicians regularly conflate the need for long-term deficit reduction with a short-term opportunity to roll back the size of government. Nowhere is this confusion more obvious, several noted, than in a misguided focus on cutting current discretionary appropriations. And particular scorn was heaped on calls for cuts in education and infrastructure investments, which economists have long promoted as the best way to support future expansion and provide a lifetime of healthy social returns.

The most stinging critique, however, was reserved for the years of policy and business misjudgments which brought on the financial crisis and ultimately triggered the worst recession in 80 years. Starting with the opening remarks by Dominique Strauss-Kahn, the head of the IMF, a long line of economic luminaries laid out how policymakers here and in Europe misunderstand the very nature of modern financial capitalism. Again, there was rare unanimity for the view that markets today, which work so well in allocating resources, lack the means and the information to recognize bubbles and evaluate the economic risk of complex financial instruments.

Nor do policymakers have the excuse that this challenge represents something new. Hundreds of savings and loans went under in the 1980s, because financial markets couldn’t evaluate risk very well. Moreover, the 1990s saw three bubbles slowly take shape and then explode, first in Japan, then across much of East Asia, and finally in the Nasdaq tech sector. Yet, policymakers at the White House, the Federal Reserve, the Treasury and their counterparts across Europe sat by placidly, just a few years later, as leading financial institutions recklessly accumulated enormous leverage for financial instruments based on an obvious bubble and whose riskiness they couldn’t begin to assess.

Yet, these misjudgments weren’t universal: The financial meltdown was limited to the advanced economies, while much of the developing world learned the painful lessons of the 1997-1998 Asian financial crisis. So, their policymakers imposed new limits on leverage, and their financial institutions passed on investing in the toxic assets that brought down the U.S. and European economies. That’s why, at least for now, the developing economies have become the engine of global growth.

The Great Depression produced a large sheaf of institutional reforms which have helped the world avoid a repeat ever since. Yet, the Nobel Laureates and other experts gathered this week by the IMF also agreed that the United States and Europe have yet to undertake comparable reforms that would make another global financial crisis less likely. If we don’t, they warned, another financial crisis almost certainly will befall America and Europe in the foreseeable future.

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