After three and a half demanding and fulfilling years at the International Monetary Fund, I’ve had a chance to see, up close, countries trying to cope with the global economy in the same way a cook might operate a blender without the lid on—carefully, while creating as little mess as possible.
As I step down from my position as Director of the IMF’s Western Hemisphere Department, I would like to share some reflections on one of the central issues facing many countries—adjustment under fixed exchange rates. It goes without saying that these reflect a personal and not an institutional view.
A lot of ink has been spent over the question of why you would lend money to a country trying to bring down its government debt and deficit. The answer is simple: to give the reforms needed to make economies competitive again time to kick in.
In the old days, fixed exchange rates were the norm rather than the exception. A body of literature and a wealth of country experience have accumulated on how to adjust under such exchange rate regimes, mostly in emerging economies. The expression “adjustment and financing” came to summarize what economies should do when faced with severe funding constraints brought on by high borrowing costs for government debt in financial markets.
Financing stress prevents an economy from maintaining its spending plans. With creditors unwilling to extend financing, reductions in government spending become unavoidable.
Spending above the level of production, the root cause of debt accumulation and financing stress, needs to be reversed for financing to start flowing again. But what is produced must be sold—without demand to make up for spending cuts, production will fall too. If adjustment is to work, then producers of goods need to find new buyers to replace financing-constrained ones.
Where can those new buyers come from? If, as is the case in a number of European economies nowadays, the excess debt and ensuing financing constraints affect both the public and private sector, then new buyers need to be found abroad through exports.
However, exports will not appear just because goods produced at home find fewer domestic buyers; goods need to have a combination of quality and price that is attractive to foreigners. When domestic debt was increasing, home goods became less attractive: excess spending harms the trade balance, and inflates the prices of non-tradable goods and services—including wages. In turn, higher wages make exports less competitive.
When governments have a hard time financing themselves, the economy is no longer competitive enough to automatically capture foreign demand. Part of the problem arises from the high costs of non-traded inputs. But, sometimes the competitiveness problem is more deeply entrenched, as booms in nontradables—typically housing—may have masked the underlying lack of competitiveness in exports, fostering complacency about the reforms needed to revive productivity.
Adjustment―the process of reducing government debt and deficits while restoring competitiveness―typically entails austerity and structural reforms. Austerity is needed to fit spending to the amount of available financing and bring down non-tradable prices to restore competitiveness, since currency devaluation is not an option.
A coordinated reduction of non-tradable prices including wages, agreed between labor unions and businesses, would be best, as it would mitigate the shrinkage in spending needed to realign non-tradable prices. But such agreements are often difficult to achieve.
Structural reforms typically include measures to facilitate the downward adjustment of non-traded goods prices. Reforms in labor and product markets achieve this by increasing flexibility and competition. But, if competitiveness is very weak, other reforms may be needed to spur comparative advantages in new sectors.
By their very nature, structural reforms take time to kick in and boost exports. In the meantime, if austerity is the only response to financial stress, the economy will experience a severe downturn or worse. As domestic spending shrinks, with the pull from exports still to occur, output will contract. Government revenue will also contract, feeding creditors’ fears of default and crimping financing.
In the private sector, contracting output will push down asset values, and affecting firms’ ability to borrow. Banks, typically overexposed to the non-tradable sector, will face sizable loan losses. If they respond, as is likely, through defensive deleveraging, this will exacerbate the contraction of private demand. In turn, deflationary pressures will increase the real value of debts, further adding to the malaise.
Eventually, the downturn would end as falling non-tradable prices make exports profitable again and boost import-competing home goods. But the output loss would be needlessly large. As structural reforms mature, the economy will once again become competitive, with the ensuing surge in exports boosting domestic demand and partially reviving the non-tradable sector. The trade surplus will allow the country to reduce foreign debt, and the recovery in tax collection will repair the balance sheet of the government, restoring access to market financing.
Why will the output loss be needlessly large? With prices slow to adjust until structural reforms kick in, the exchange rate inflexible, and financing tight, the up-front burden falls on output and employment. This excess output loss can be so severe that it strains the social fabric, a deep loss in itself, and introduce the perception of political and default risks.
Official financing―for instance in the form of an IMF-supported program―during the economic transition while structural reforms mature will help avoid this fate, supported by steps to reduce non-tradable prices. To be certain, conditionality will be needed to prevent structural reforms from stalling. These reforms are usually difficult and require governments to spend a significant amount of political capital. Hence, the risk of backsliding will be present for some time.
The European Union and the International Monetary Fund are now trying to provide financing to many besieged economies in Europe and avoid excessive output losses. Adjustment without financing may fail and, even if it succeeds, it will impose needless sacrifice, often the more vulnerable segments of the population.
But also, no one should believe in the mirage that the problem could be solved without adjustment and sacrifice. As markets sometimes indulge countries by financing unsustainable expansions, all too often when they respond they overshoot and over-penalize. By then, the reality of austerity has arrived to stay.
