Consider it a mea culpa submerged in a deep pool of calculus and
regression analysis: The International Monetary Fund’s top economist
today acknowledged that the fund blew its forecasts for Greece and other
European economies because it did not fully understand how government
austerity efforts would undermine economic growth.
The
new and highly technical paper
looks again at the issue of fiscal multipliers – the impact that a rise
or fall in government spending or tax collection has on a country’s
economic output.
IMF
chief economist Olivier Blanchard writes that the fund misjudged the
impact of austerity on European economies. (Stephen Jaffe/IMF)
That it comes under the byline of fund economic counselor and
research director Olivier Blanchard is significant. Fund research is
always published with the caveat that it represents the views of the
researcher, not the institution itself. But this paper comes from the
top, and attempts to put to rest an issue that has been at the center of
debate about how fast countries should move in their efforts to tame
large debts and deficits.
If fiscal multipliers are small, countries can cut spending faster or
raise more in taxes without much short-term damage. If they are large,
then the process can become self-defeating, at least in the short run,
with each dollar of government spending cuts, for example, costing the
economy more than a dollar in lost output and thus actually increasing
debt-to-GDP ratios.
That is what has been happening with a vengeance in Greece, where
fund forecasters, as part of the country’s first bailout program in
2010, predicted that the nation could cut deeply into government
spending and pretty quickly bounce back to economic growth and rising
employment.
Two years later, the Greek economy is still shrinking and unemployment is at 25 percent.
Of course no two circumstances are alike. Shut out of international
bond markets, Greece had little choice but to begin bringing its public
finances into line or face a catastrophic default. Financing wasn’t
available to sustain prior spending levels. For an economy that has been
reeling for several years, however, a billion or two in extra
government programs or investment could have kept a few small businesses
open and kept a few more families employed and spending.
“Forecasters significantly underestimated the increase in
unemployment and the decline in domestic demand associated with fiscal
consolidation,” Blanchard and co-author Daniel Leigh, a fund economist,
wrote in the paper.
That somewhat dry conclusion sums up what amounts to a tempest in
econometric circles. The fund has been accused of intentionally
underestimating the effects of austerity in Greece to make its programs
palatable, at least on paper; fund officials have argued that it was its
European partners, particularly Germany, who insisted on deeper, faster
cuts. The evolving research on multipliers may have helped shift the
tone of the debate in countries like Spain and Portugal, where a slower
pace of deficit control has been advocated.
But the paper includes some subtle and potentially troubling insights
into how the fund works. Blanchard – effectively the top dog when it
comes to economic science at the fund – writes in the paper that he
could not actually determine what multipliers economists at the country
level were using in their forecasts. The number was implicit in their
forecasting models – a background assumption rather than a variable that
needed to be fine-tuned based on national circumstances or
peculiarities.
Heading into a crisis that nearly tore the euro zone apart, in other
words, neither Blanchard or any one of the fund’s vast army of
technicians thought to reexamine whether important assumptions about the
region would still hold true in times of crisis.
That, it turns out, was a big mistake. Multipliers vary over time:
They may be low in a country where the economy is growing, interest
rates are normal and the banking system is sound. As this research
showed, they get larger if interest rates are low, output is falling and
the banking system is creaky – conditions that make everyone, from
households to investors, less likely to spend, and thus makes the role
of government-generated demand that much more important.
Blanchard and Leigh deduced that IMF forecasters have been using a
uniform multiplier of 0.5, when in fact the circumstances of the
European economy made the multiplier as much as 1.5, meaning that a $1
government spending cut would cost $1.50 in lost output.
What are the implications for the future?
This paper may not be an official position of the IMF, but coming
from the agency’s top economist, it is bound to change how the agency
generates forecasts.
As for fiscal policy – an issue of interest as the U.S. debate
turns towards austerity – Blanchard and Leigh said a better understanding of multipliers does not produce any definitive conclusions.
Many countries still need to cut their deficits – some faster, some slower, depending on a host of other factors.
“The results do not imply that fiscal consolidation is undesirable,”
the two write. “Virtually all advanced economies face the challenge of
fiscal adjustment in response to elevated government debt levels and
future pressures on public finances from demographic change. The
short-term effects of fiscal policy on economic activity are only one of
the many factors that need to be considered in determining the
appropriate pace of fiscal consolidation for any single country.”
