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This chart in a new IMF staff working paper caught my eye:

IMF tax expenditures

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A new IMF Working Paper on the role of inequality in generating financial crises has some interesting findings:

[The paper] explore[s] the nexus between increases in the income advantage enjoyed by high income households, higher debt leverage among poor and middle income households, and vulnerability to financial crises. This nexus was prominent prior to both the Great Depression and the recent crisis. In our model it arises as a result of increases in the bargaining power of high income households.

The key mechanism, reflected in a rapid growth in the size of the financial sector, is the recycling of part of the additional income gained by high income households back to the rest of the population by way of loans, thereby allowing the latter to sustain consumption levels, at least for a while. But without the prospect of a recovery in the incomes of poor and middle income households over a reasonable time horizon, the inevitable result is that loans keep growing, and therefore so does leverage and the probability of a major crisis that, in the real world, typically also has severe implications for the real economy.

More importantly, unless loan defaults in a crisis are extremely large by historical standards, and unless the accompanying real contraction is very small, the effect on leverage and therefore on the probability of a further crisis is quite limited. By contrast, restoration of poor and middle income households’ bargaining power can be very effective, leading to the prospect of a sustained reduction in leverage that should reduce the probability of a further crisis.

In recent days the IMF has publicly argued that “markets need to end their addiction to credit ratings”. They suggest:

[t]he real solution lies in reducing the reliance on credit ratings as much as possible. This should start with removing the mechanistic use of ratings in rules and regulations, which some countries are already beginning to do. Investors must be weaned off credit ratings too. Policymakers should persuade the larger ones, at least, to perform their own risk assessments as part of deciding what to buy or sell.

I wonder what our State governments will make of this advice, given that they behave as if their sole task is to maintain the public balance sheet in a state that will please Standard and Poors.

The IMF has also examined the evidence in favour of fiscal austerity, assessing when and to what extent governments should begin to repair their balance sheets in the wake of a recession. They end up finding that fiscal contractions are contractionary, and fiscal expansions are expansionary, a vindication of Keynes. This might seem obvious, but it’s far from the ‘Washington Consensus’ view imposed on various nations throughout the 1990s.

The results suggest that recessions associated with financial crises tend to be unusually severe and their recoveries typically slow. Similarly, globally synchronized reces- sions are often long and deep, and recoveries from these recessions are generally weak. Countercyclical monetary policy can help shorten recessions, but its effectiveness is limited in financial crises. By contrast, expansionary fiscal policy seems particularly effective in shortening recessions associated with financial crises and boosting recoveries.

I’m not sure what has happened to the IMF, but this sudden rash of common sense is definitely a good sign.