Time for a Rethink

Stephen Pursey

By Stephen Pursey, Director of the ILO Policy Integration Department





The Spanish philosopher, George Santayana, famously said that, “those who cannot remember the past are condemned to repeat it,” which is probably why the IMF’s latest report on the state of the world economy asks the question, “does the history of government debt give us any lessons of how to handle the current situation?”

Given the polarized and often confusing nature of the arguments about austerity versus stimulus, the answer to the question is surprisingly clear. It is a ‘yes’.

Back in the 1920s, the report reminds us, when the post-war British government pushed through tough austerity measures, growth suffered, debt rose, as did unemployment – despite the pain. The parallel with the Eurozone crisis is obvious.

After the near crash of the global financial system in 2008, governments initially increased spending and reduced taxes and in 2010 the recovery got going.  Then governments and the financial markets became jittery about the level of debt and switched from stimulus to austerity.

Like an echo from the British experience of the 1920s, since the second half of 2011, the IMF has had to reduce its forecasts for global growth in every update of its World Economic Outlook. Despite the pain, particularly in southern Europe, the targets for reducing the debts and deficits are being missed. The latest report predicting that growth in 2012 will be 3.3 per cent instead of 4 per cent means unemployment will continue to rise.

So what went wrong?  The IMF now says that the mistake is in the maths: Whereas governments thought that a one per cent cut in the deficit would reduce growth by half a per cent, it has actually led to a cut in growth of around three times as much. This is because cuts reduce growth faster than debt, which then has a negative ‘multiplier effect’ that slows growth even further.

History – and maths it seems – is always open to interpretation and the new message coming out of the IMF is being challenged by economists and political leaders who do not believe in the new arithmetic and who still see government debt as the main problem to be tackled.

By contrast, the reaction at the recent IMF/World Bank meeting in Tokyo, judging by comments in the press and in the blogosphere, is that the IMFs findings make sense, not least because a number of governments adopted austerity measures at the same time and the effects spilled over and were amplified.

The urgent question now is: Can the G20 work out how to coordinate a shift in policy to stop the slide and get the recovery going again?

Related story from the ILO Newsroom: ILO calls on G20 to live up to its promise to tackle the crisis