Guest Post: Dear IMF, It's Not *Only* Fiscal
IMF veteran Christopher Marsh explains how the balance of payments, the domestic financial system, and the fiscal accounts should be linked together when determining sustainability.
I have followed Christopher Marsh’s writings for years, starting with when he blogged anonymously as The General Theorist. He was in the trenches at the International Monetary Fund (IMF) in 2005-2012 and has since been working in macro investing. He is now the Chief Economic Advisor at Exante Data and contributes to their excellent Money: Inside and Out blog. I am very pleased to be hosting this guest post from him on how to improve the IMF’s sustainability analysis, which in his view (and mine) has pivoted too far towards concerns about public debt sustainability at the expense of other risks. While there are a fair amount of equations, none of the math is more complicated than Please Excuse My Dear Aunt Sally.
There is some confusion about how fiscal policy should be thought of in the design and implementation of International Monetary Fund (IMF) programs.
This confusion may originate in the belief that fiscal slippage was the key to the crisis in Argentina at the turn of the millennium. As expressed by Michael Mussa as Economic counsellor amongst others, such concerns evolved into the formalisation of the debt sustainability analysis (DSA) framework at Fund over twenty years ago.
Since then, Fund programs now focus excessively, perhaps exclusively, on the public sector DSA—and fiscal policy is now seen through that lens, to the detriment of balance of payments (BOP) analysis. This was notably the case during the Eurozone Crisis.
It is important to distinguish the role of fiscal policy in BOP analysis, therefore, and the possibility that meeting public debt sustainability thresholds does not automatically deliver the BOP adjustment that is the purpose of Fund programs.
We here recall the essence of the IMF’s traditional approach to balance of payments analysis and the role of fiscal policy in this adjustment.
Fiscal Sustainability
Consider the standard expression for the evolution of public debt:
Primary budget surpluses relative to Gross Domestic Product (p) cause the debt-to-GDP ratio (b) to fall. But if nominal interest rates on outstanding debt (i) are higher than the growth rate of nominal income (g), then the debt-to-GDP ratio rises based on how much debt there was before. The minimum condition for sustainability therefore relates the primary balance to the growth adjusted nominal interest on the existing debt stock:
Formally, this condition, when i is higher than g, ensures that the net present value of future primary surpluses in the steady state is equal to the existing debt stock—Ponzi schemes are ruled out as the debt is “serviced” rather than capitalized. This justifies investors holding the debt today; debt is “sustainable” in a forward-looking sense.
Suppose this condition is met. What about the balance of payments?
Balance of Payments Analysis
Write the fiscal dynamics equation instead as:
where ΔbD is the change in debt by locals vs. GDP and ΔdbE is the change in debt held by foreigners vs. GDP. The difference is determined by the residency of the owners rather than the currency in which the debt is denominated.1
Suppose that the central bank balance sheet evolves so that the change in international reserves-to-GDP (r) is equal to the change in base money-to-GDP (m) minus the change in domestic credit of the central bank-to-GDP (c):
Subtracting the fiscal expression from this, we get an expression for the consolidated government’s change in net external assets—liquid foreign assets in the form of international reserves net of long-term external debt of the government:
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