It was disguised as a technical appendix, but it turned out to be an act of insurrection. The International Monetary Fund has published results from a study, which show that the impact of fiscal policy on growth is higher than previously estimated. The policy conclusion of a large fiscal multiplier is obvious: excessive austerity defeats itself. It must end.
One has to be clear about what this statement says, and what it does not. The IMF does not say that austerity is too hard, too unfair, causes too much pain in the short term or hits the poor more than the rich. It says simply that austerity may not achieve its goal of reducing debt within a reasonable amount of time.
The technical article makes two observations. The first is that most standard fiscal multipliers used in ordinary forecasting models, including the IMF’s own, is roughly 0.5. That means for each additional dollar or euro in reduced public spending, the economy contracts by 50 cents. This is not a realistic assumption for a time like this. Even intuition tells us that the multiplier must be at least one - simply because the fiscal tightening is not compensated for by lower interest rates. Nobody takes up the slack caused by austerity.
The second claim is that most forecasting models underestimate the multiplier by 0.4 to 1.2. This implies that it must be in a range between 0.9 and 1.7. The estimate for the Eurozone periphery is nearer the higher end of this range. So, let us assume that it is 1.5. That means a fiscal adjustment of 3 per cent of gross domestic product would translate into a GDP contraction of 4.5 per cent. This is roughly what Spain needs to do to reach its fiscal target for next year. The multiplier thus tells you what kind of recession Spain can expect. And it tells us that the Spanish government’s forecast of a 0.5 per cent fall in GDP in 2013 is delusional.
What are the policy implications of this analysis? At the very least, one would hope, it would persuade the European authorities to switch from a relentless and ultimately futile pursuit of nominal deficits to a structural target. If they did only this - which I believe is not nearly enough - they would at least end the vicious cycle where governments have to heap one austerity programme on another merely to meet an arbitrary nominal target; one that has no intrinsic rationale other than that it exists.
One could go further than this if one assumes hysteresis, the idea that the recession will cause long-term damage that will not be reversed in the ensuing recovery. For example, if cyclical unemployment becomes structural. Italy recently reported that the rate of female employment in the south has fallen back to 2004 levels. When a decade of efforts to increase the employment of women is reversed by a single recession, then you have hysteresis. In a recent paper, the economists Brad DeLong and Lawrence Summers* started with the observation that the fiscal multiplier increases when monetary policy hits the zero bound. Then they added the hysteresis effect, and made a number of reasonable assumptions about the state of the world, and found that stimulus spending can become self-financing. The corollary is that austerity becomes self-defeating. In other words: austerity turns into a cause of a deteriorating debt crisis.
The IMF does not go that far. But even the more modest assertions that arise out of the IMF’s analysis have come as a bit of a shock to the Europeans, who reacted with profound irritation in Tokyo last week. They said it was “not helpful” that the IMF would dare to challenge the pro-austerity consensus, given how hard it was to achieve in the first place.
This leaves the question: why does the IMF do it? My guess is that the IMF must have realised that the present policy is not working. The IMF has raised an important question, and deserves credit for doing so, especially as it implies self-criticism. Of course, nobody is under any illusion that the Eurozone will dump its policies as a result of an econometric analysis. As hordes of frustrated European economists know only too well, macroeconomic analysis in general does not play a role in Eurozone policy making.
The most one can expect from the IMF’s challenge is that it might shift the discussion in the long run. It will have no impact on the 2013 fiscal year. European policy makers are paranoid about their credibility, and I expect them to hold on to austerity until the bitter end, when the policy implodes. An age of economic enlightenment will arrive eventually, but not quite yet.
You could say it is highly symbolic that all this happened in Japan. Unfortunately, we are making more profound policy mistakes compared to what the Japanese did in the 1990s. Unless we heed the IMF’s advice, our experience will be worse.
Financial Times
