Do we believe IMF boffins or markets?

The IMF's latest World Economic Outlook, out today, provides a dose of reality and highlights the key dilemma for the global economy: how do nations rebuild their balance sheets while stimulating growth?

The reality dose is that, according to the IMF, the central bank actions of the past few months, since the last WEO in July, have not improved the economic outlook one bit – in fact it has continued to deteriorate.

As the IMF says: "In many advanced economies, injections of liquidity are having a positive impact on financial stability and output and employment, but the impact may be diminishing.”

What's more, the IMF includes a big warning with its latest forecast, which is still for growth to pick up again later this year and next year. Global activity is clearly in decline again but the IMF economists are not sure whether it's because of another bout of turbulence "or whether the current slowdown has a more lasting component”.

"The answer depends on whether European and US policymakers deal proactively with their major short-term economic challenges. The WEO forecast assumes that they do…”

Right … well, that's a big assumption, especially in the midst of a US election campaign with the clock on the fiscal cliff, and another clock ticking on Greece and Spain doing enough to stay in the eurozone.

And it's worth noting that between the July and October WEOs, the reduction in growth for China and other emerging nations has been greater than that for advanced economies. China's 2012 and 2013 forecasts have both been cut 0.3 per cent by the IMF to 7.8 and 8.2 per cent respectively, while the United States' is up 0.1 per cent for 2012 and Europe's is down 0.1 per cent.

So China is decelerating more quickly than either Europe or the US, and that's despite the IMF's expectation that activity will be boosted by an acceleration of public infrastructure projects.

But broadly the world is stuck in a vicious circle of fiscal austerity and weak confidence, and the IMF has now concluded that it may have underestimated the "fiscal multiplier”, which refers to the impact of fiscal consolidation of the economy.

In previous WEO reports, the IMF has assumed a fiscal multiplier of close to 1. But having crunched the numbers some more, the IMF researchers now reckon the multipliers have recently been more than 1 – as much as 1.9 in fact.

This has prompted the IMF chief economist Olivier Blanchard to suggest that some nations might have to put the brakes on budget deficit reduction – not go into reverse and take on more debt, but to make "gradual and sustained” fiscal adjustments.

"Fiscal problems can be rooted in structural problems that take time to address, and sharp expenditure cutbacks or tax increases can set off vicious cycles of falling activity and rising debt ratios, ultimately undercutting political support for adjustment.” In other words the IMF is joining the Keynesians like Paul Krugman.

Despite the deceleration evident in China, the IMF says the euro crisis remains the most obvious threat to the global outlook. Unless action is taken soon to establish a banking union and fiscal integration, "the recent improvements in financial markets could prove fleeting”.

All pretty gloomy stuff, but for the moment, markets are happy to go with "not fleeting”, as the Australian index hits a new 14-month high this morning.

Markets are usually to be believed ahead of IMF boffins. Let's hope that holds this time as well.

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