Central banks are incubating a crisis the IMF is disinclined to see

By Jeremy Warner

IMF chief Christine Lagarde has urged central banks to launch more QE, which has only succeeded in putting a rocket under asset prices Christine Lagarde has implied that the world, and particularly Europe, needs a bit more inflation Photo: AP According to the old saw, forecasting is difficult, especially when it’s about the future. It’s a truism that the International Monetary Fund – focused, perhaps inevitably, on the rearview mirror rather than the road ahead - has been repeatedly forced to take to heart. Famously, it failed to see the financial crisis coming, despite a chief economist at the time, Raghuram Rajan, who came as close as any to identifying the risks of excessive credit expansion. Later, it blamed its blind spot on “group think”. A similar problem seems to have coloured the IMF’s view on Britain’s fiscal consolidation, which as little as a year ago the current IMF chief economist, Olivier Blanchard, characterised as “playing with fire”. This spectacularly ill-timed judgment, just as the UK economy was beginning to turn, again reflected a kind of “group think”, certainly among many academic economists, where received wisdom was that growth and austerity were incompatible, if not among less theoretically-minded applied economists. At the time, UK Treasury officials attributed the way the IMF singled out the UK for criticism as an indirect warning to the US, where a fierce fiscal squeeze was also being applied. If so, it was an odd way of going about it. Nor did it work. Not only did the US squeeze proceed as demanded by Congress, but it didn’t obviously have a great deal of impact on growth. Both the US and Britain grew relatively strongly last year and are expected to grow by even more this year. George Osborne, the Chancellor, is entitled to take some satisfaction in the IMF’s discomfort, though he promises not to rub it in when he gives a speech on Britain’s apparent “economic miracle” at the IMF’s spring meeting in Washington this week. All this raises an obvious question; having been far too upbeat about prospects for the world economy ahead of the crisis, then too sanguine about its impact, and then, realising its mistake, far too downbeat, is the IMF again missing the big picture? With past errors ringing in its ears, the IMF tends these days to hedge its forecasts with lots of caveats. The list of potential “risk factors” that could derail the IMF’s central forecasts grows with the publication of each passing World Economic Outlook. The biggest cause of concern this time around, according to the IMF, is again that of persistently low European growth. In a speech last week, Christine Lagarde, managing director of the IMF, said she wasn’t referring to the threat of outright “deflation” when she cited these concerns. This was a word previously used only “to catch everyone’s attention”. Actually, the more potent threat was simply that of a prolonged period of “low inflation” and therefore low growth. More monetary easing, including unconventional measures, were needed, she insisted, to the obvious irritation of the European Central Bank’s Mario Draghi, who pointed out that she would never dare offer policy advice to the US Federal Reserve. Ms Lagarde’s clear implication, also apparent in pre-released papers from the IMF’s World Economic Outlook, due to be published on Tuesday, is that the world, and particularly Europe, needs a bit more inflation. I don’t necessarily disagree with this, but I would be very wary about doing it in the manner Ms Lagarde suggests – through further central bank money printing. The big fear about quantitative easing when the US and Britain first started doing it was that it would be inflationary. Images of Weimar Germany’s hyperinflation were quickly brought to mind. Yet so far it has proved nothing of the sort. One thing it has done, however, is put a rocket under asset prices. Rising asset prices are only the flip side of the same coin as falling yields, and they are phenomena that long precede the financial crisis. Basically, it’s been going on ever since the late 1970s. Both inflation and long-term interest rates have fallen dramatically since then, driving a spectacular long-term bull market in asset prices. There is a huge and very varied volume of academic research on the causes of this phenomenon, which I don’t intend to rehearse here. Suffice it to say that the effect of QE has been to prevent the sort of adjustment that would normally take place after such a prolonged period of asset price growth. The concern about QE has therefore shifted from initial fears of an inflationary meltdown, which proved groundless, to that of its long-term consequences for financial stability and wealth distribution. The rich have got richer, but it is not apparent that QE has done much for ordinary wage inflation or productivity-enhancing investment. Those with assets have generally done well out of QE, those with cash have been very badly hurt by it. Renewed search for yield has also generated scope for further financial crises. We already see this in the panicked reaction of some emerging markets to Federal Reserve tapering. The greatest risk to the world economy, therefore, is not so much Europe’s failure to grow as that the world economy is simply returning to the way it was, with few, if any, of its underlying imbalances adequately addressed. It is as if we have failed to learn the mistakes of the pre-crisis world, and are therefore damned to repeat them. This is at its most obvious in Britain itself, where the economy is beginning to look indistinguishable from the pre-crisis model invented by Gordon Brown – highly reliant on debt, household consumption and rising house prices. The IMF’s immediate concern is simply to get robust growth going again, in Europe and elsewhere, so that decent inroads can be made into unemployment. Britain has proved that unconventional monetary policy can be helpful in this process. Ultimately, however, the printing press can be no more than a sticking plaster solution, and if underlying structural deficiencies aren’t addressed, then it may end up producing an even bigger muddle. The IMF is unlikely to have made one of its big misjudgments this time around. The world economy has stabilised since its near-death experience in the financial crisis, and it is hard to disagree with Ms Largarde’s central prognosis of continued, but weak, recovery. It seems unlikely we are about to plunge into renewed crisis. But nor have the “fault lines” at the heart of the world economy, brilliantly articulated by Raghuram Rajan in his book of the same name, been anywhere near corrected. Further crises are inevitable; we cannot know when, but one thing we can be sure of is that the IMF won’t see them coming when they do.

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