Leaked IMF Report Shows Dangers For US Economy

By Daniel R. Amerman, CFA

A confidential internal International Monetary Fund report was recently leaked to the Wall Street Journal, with the contents later being made public by the IMF. The contents of this report have major implications for Europe, but even greater implications for the United States.

Most of the press attention is being paid to the legalities associated with the report, and revolve around what the International Monetary Fund knew, when it knew it, and whether it properly acted within its charter at various points.  However, what is being overlooked is the truly explosive information that comes in the form of what the IMF admitted (in this internal report to itself) when it came to miscalculations about "austerity", and closing budget deficits.

Briefly, the International Monetary Fund and European Union did not force balanced budgets upon Greece, but only a reduction in the level of deficits.

The IMF's economists estimated that this reduction in deficits would lead to a 5.5% reduction in the size of the Greek economy. But they were horrified to discover that in practice they were dead wrong, as it instead resulted in a 17% contraction in the Greek economy, or just over three times the damage that they were estimating.

They were also badly mistaken, as they belatedly came to realize, when it came to the impact of these deficit cuts on the official unemployment rate.

That is, the IMF had expected unemployment to rise to 15%, which was unpleasant, but a necessary part of the belt-tightening associated with austerity and reducing the levels of government deficit. In practice, however, unemployment jumped to 25%, a level grossly in excess of IMF estimates, and which also placed the entire economic theory underlying the austerity approach in jeopardy.

For the decrease in tax revenues associated with a 17% contraction in the economy, combined with an official unemployment rate of 25%, is of such magnitude that the government deficit reduction targets can no longer be met.

A loop was created in which the economic damage associated with reducing government spending - even while increasing tax rates - was so great that it offset the enhanced revenues expected from this combined "austerity" strategy.

The issue is what economists refer to as the fiscal multiplier– and this is what the IMF so badly underestimated. What they failed to fully take into account is that when all those beneficiaries of government spending lost their income -  whether they be government employees, private contractors or transfer beneficiaries - they would stop spending their income.

So when the corporations, and municipalities, and waiters, and cooks, and convenience store employees whose jobs were dependent on that spending saw a contraction in their own revenues, they spent less as well.  Which led to reduced employment, and a  further reduced economy that spiraled down in a multiplier effect, causing the Greek economy to contract three times more than expected, even as unemployment levels grew to a level that was almost twice as high as expected.

Bigger Problems In The United States

Greece is not the only nation that has what could be called an "artificial" economy, if we define an artificial economy as being one where both economic output and employment levels are each materially dependent on the government borrowing money that it can't possibly pay back under normal circumstances.

And arguably the globe's largest "artificial" economy is also the globe's largest economy – which is that of the United States of America.

As I have previously covered in detail in a series of articles which includes, "The Economic Deception At The Heart Of The Fiscal Cliff", linked below, the economic situation in the United States is in fact much worse than what can be seen at the surface level of government statistics and the financial media's reporting thereof. 


And this can be established quite easily by going directly to the government's own statistics themselves, and looking underneath the headline statistics, to the next level below.

The government share of the United States economy has been growing for many decades now, fundamentally transforming the country as a result. And by 2007, the United States economy had reached the extraordinary point (outside of a major war) where the government was consuming a full 35% of the economy. That is, government spending amounted to 35% of the economy, and 65% was the private sector.

Then something remarkable happened. At the height of the Financial Crisis of 2008, the private economy imploded by $1.3 trillion per year when it came to the real private production of goods and services. This was a catastrophic decline that if left untouched, would have pushed the United States straight into an overt Depression.

But this implosion, while confirmed in the government's own statistics and very real, is not what the government's surface level reporting of GDP shows at all. Instead, what the official statistics indicate on that top level is that there was "only" a $300 billion contraction in the economy, with the recession officially having ended in June 2009.

Wait, what? How could it be that if the private sector within the economy plummeted by $1.3 trillion, that the total economy only fell by $300 billion?

Well, when it comes to desperate governments in a time of economic collapse, there turns out to be a bit of a loophole.  And that is that when GDP is reported by the media, what is reported is almost always total GDP - which is the sum of economic activity by the private sector and the public sector.  So in looking only at total GDP then, any catastrophic  declines in private economic activity can be effectively masked by equally extraordinary increases in public spending - at least temporarily.

That obscure little loophole is the hidden-but-real story behind 2009, and every year since.  In practice, the difference between the actual government-reported $1.3 trillion collapse in the private sector, and the officially reported $300 billion decline in the total economy, came from federal, state and local governments increasing their spending by a staggering $1 trillion between 2008 and 2009.

This resulted in a massive and unprecedented shift in spending as the government soared in size, even as simultaneously the private sector was collapsing in size. So the economy nearly instantly shifted from being 35% government and 65% private, to being 43% government and 57% private – a level which remains in approximate terms true today.

So when we look at these fantastic levels of deficits that have been consistently coming in at well over $1 trillion per year, what we have in fact been seeing is the increase in the size of the government from 35% to 43% of the overall economy, in order to maintain the facade of an intact economy.

In other words, since the fall of 2008, a substantial chunk of the US economy has been "artificial". The private-sector imploded. It has not recovered to this day. And the great majority of damage containment has been dependent on the United States government running unsustainable deficits, of which it lacks the ability to pay back under ordinary circumstances.

Dire Lessons For The US From Greece

Here are some questions that may be worth considering: what happens to economic output and employment if we were to unwind the crisis-averting "artificial" economy in the United States, and bring the ratio between private sector-created wealth and government spending back to pre-2009 levels, and thereby return deficits to sustainable levels?

What might the real price be of returning to "normal"? And can we get there at all in the near future?

The size of fiscal multipliers for government spending has been a highly controversial question within economics for many years now. 

In previous articles, I chose to neutralize the fiscal multiplier controversy by taking the analytically conservative approach of assuming the fiscal multiplier to be 1.0. So if we reduced government spending as a percentage of the economy to a pre-2008 level, then we would see exactly proportionate reductions in the size of the economy, as well as proportionate increases in unemployment rates.

However, the dire lesson to take away from Greece is that if the United States government were in fact to abandon its "artificial" economy and return to spending no more than it could afford to pay, based upon tax revenues and a much reduced level of annual deficits to a more historical level, then a likely higher fiscal multiplier could translate to a change in the economy that is much more drastic than even that.

If the lessons of Greece do indeed apply to the US economy, then the unfortunate implications are that reducing government spending as a percentage of the economy to let's say 2007 levels might cause the economy to drop not by 5-6%, but by 8% to 10%. This would take the United States straight into an overt depression.

And unemployment could go from our current headline rate of 7.6% -  with the real full unemployment rate (adjusting for U-6 unemployment and workforce participation rate changes) of roughly 19% - soaring up to a real full unemployment rate of 25-30% or more, which would be a higher level than during the Great Depression.

Now whether those numbers would actually occur - or whether they'd be something else altogether  - would be a massive experiment, and nobody can really know at this point.

But what we do now know, based upon real-world data from this leaked IMF report on their experience with Greece, is that the consequences may be much worse than what even some of the leading economists in the world anticipated they might be, because the fiscal multiplier in practice has proven in these circumstances to be much higher than previously thought.

IMF Discovery & False Dichotomy

When we look at the results of the EU and IMF austerity experiment in Greece, what we learn is that the budget deficits in the United States likely can't just be suddenly stopped in their tracks in an act of fiscal responsibility, without triggering major economic changes that are also likely to lead to a political earthquake.

The surface-level picture of the US economy that's generally presented via the government and the media is that while we went through a very tough time, we're right on the verge of everything getting better and returning to normal. The consistent message that comes out is not to worry, because happy days will be here again, the former economy is just a little ways away from kicking in and generating more jobs and economic growth, and that's why you need to buy stocks again for long-term investment.

That is the mainstream narrative, and it fits very well into what I've termed the false dichotomy that's described in my article, "Political Economy Collapses False Dichotomy Of Mainstream vs Doomers".


The problem with this perspective is that it is demonstrably not true, as can easily be shown. For here we have $1.3 trillion of the private economy that disappeared in 2008-2009, and it hasn't returned on a percentage basis. And if we were to stop running fantastic budget deficits and instead, in a measure of newfound fiscal responsibility, try to impose Greek-style austerity on the US government and its people, we're liable to trigger a massive contraction in the US economy that could then trigger a major upwards spike in unemployment.

Ironically, the overarching issue is that the very act of covering over the damage creates a situation where it becomes extremely difficult for the real, private economy to recover. That is because there is no "free lunch". The entire economy has been distorted, with 43% of it now dependent on government spending. Thus there is less money to go around to the private sector, and indeed, much of the former wealth of the private sector – and that of retirement investors in particular – has been redistributed to, and consumed by, the government, through a process of Financial Repression that is not understood by the general public.

Now on the other side of this false dichotomy are those who many consider to be in the "gloom and doom" camp. They look at the economic statistics, they see what the US government is doing, and they conclude that the United States must be on the verge of collapse. Well, while that could certainly happen and with surprising speed, there is something else going on as well that is not being taken into account.

That hole in the economy has been there for going on five years now, with the government not being able to pay its bills in any way shape or form if we look at things from a fiscal responsibility perspective – and with the private economy not being strong enough to support the spending that's necessary to keep the fiscal multiplier from kicking in.

Yet here we are and the world hasn't ended. To the contrary, the shopping malls are full, real estate is soaring, the stock market is jumping, and interest rates are still quite low even with a nearly openly "bankrupt" country.

Now perhaps the single most important financial question a person can ask then becomes, if the United States appears to be going through catastrophic economic problems, but we're not seeing it in the financial markets, and we're not seeing it in bread lines and massive open unemployment – then what the heck is actually going on?

What is going on has to do with massive changes that have absolutely transformed this country, and which are the only reason we're still afloat four and a half years later.

But these are not fiscal changes. These are not based on the way money used to work. These are not based on the way investments used to work.

The US economy is still afloat, despite what's going on behind all the headlines and underneath the surface, because of unprecedented monetary and political changes that have already occurred, with even bigger changes likely to come.

The implications for US citizens and others around the world, whether we're looking at workers or investors, are extraordinary.

And let me suggest that the best chance that an investor has to come through this turmoil with their assets intact – other than happenstance – is to first understand what has actually happened, along with what is occurring right now, so that one can anticipate what some likely paths for the nation and world might be in the future. Which will require looking at the world through a quite different prism than either the mainstream or contrarians do, which is that of monetary and political risk.