Outlook: In defence of IMF fiscal austerity

WHAT RESPONSE should policy-makers adopt in a recession or slump? The textbook answer is still the classic Keynsian one of more public spending, reduced taxes, lower interest rates, and a devalued currency.

Broadly speaking, this is how the UK authorities are responding to the present economic slowdown.

Interest rates are falling, though not as quickly as the Government would like, sterling is being allowed to weaken - making our goods more internationally competitive - and public spending is rising. The only missing element is tax cuts, but no doubt the Chancellor could even be persuaded into these too if the economic slowdown translated into a slump in consumer spending.

So what on earth is Brazil doing by responding to its own economic crisis with an austerity programme of such heroic proportions? Public spending is being slashed and taxes are being raised. The effect will be to reduce the budget deficit by about a half in a single year. Meanwhile interest rates are being kept at levels that here in Britain would be regarded as suicidal, this in an effort to defend an exchange rate which looks equally unjustified by the economic wreckage that lies behind it. Once again, why adopt such a hair shirt response to economic difficulty when there are so much more appropriate and comfortable alternatives? Nobody in the developed world would even think about such an approach, would they?

Well actually that's where you are wrong, for this is the medicine being foisted on Brazil by our very own International Monetary Fund. If the Brazilian Government doesn't carry out the austerity programme, the IMF insists, Brazil won't get its $30bn of emergency credits and the country will go bankrupt. Broadly, but with some differences, this has also been the IMF's prescription for the former Asian tigers and Russia in return for emergency loans. Some of them have taken the money and are now refusing to swallow the medicine, but that was certainly the intention.

So is not the IMF imposing a wholly inappropriate policy response on these downtrodden emerging markets, one, moreover, which it would never dream of enacting in more developed economies? Certainly it is becoming the height of fashion to think in these terms. Some of America's best known free market economists, including Jeffrey Sachs of Harvard University and Paul Krugman of MIT, have joined this growing backlash against the rule of global capital markets. Self fullfilling speculative attacks helped prompt these crises in the first place, they argue; now we are making a bad situation worse by insisting on austerity programmes we would never impose on ourselves.

Like a lot of economic theory, the argument is compelling and eloquent. But it is also poppycock. There is a lot wrong with the IMF, starting perhaps with its very existence, but these programmes are not part of it. Virtually all these countries have been living beyond their means, Brazil included. That Western bankers and investors were prepared to finance such uneconomic spending for so long is one of the abiding mysteries of the whole affair. But the fact is that they did and the eventual and inevitable reckoning was as a consequence that much worse.

To compare the policy response required in these circumstances with that used by Western economies to deal with the comparatively minor recessions seen in recent years is a false and bogus one. When Britain spent and devalued its way out of recession in the early to mid 1990s, it was against the backdrop of a well capitalised banking system that could absorb the worst of the bad debts thrown at it, a deregulated and essentially healthy economy, and a public finance balance sheet that was among the strongest in the world.

The economic and fiscal reforms demanded by the IMF will barely begin the process of bringing these emerging economies up to the same standards. All these countries desperately need international capital, but in order to attract it they must abide by its rules. We can all dream of a world where capital is allocated according to social and national need, but that's not the one we wake up to every morning. Capital chases the highest and most sustainable returns. It's an ancient and lasting rule and it doesn't look likely to be overturned.

Brazil is showing great bravery, realism and courage by adopting such an austerity package, which is being pushed through at great political and social cost. But the upside potential is much greater. If the Brazilian government can hold its nerve, it will be rewarded with a sustained inflow of foreign capital.