Has the effect of austerity policies on economic activity been underestimated? The working paper by Olivier Blanchard and Daniel Leigh published in January 2013 shows that the measures taken were based on economic forecasts that underestimated the multiplier effect of fiscal reforms.
In the abstract of this research paper, which reflects only the authors’ views and not those of the IMF, the two authors explain that fiscal consolidation (measures aimed at increasing tax revenues and reducing public spending) has led to a sharper-than-expected decline in GDP growth. « We find that, in advanced economies, stronger planned fiscal consolidation has been associated with lower growth than expected, with the relation being particularly strong, both statistically and economically, early in the crisis. »
The main question regarding the impact of austerity measures on growth lies in the choice of the fiscal multiplier, which represents the change in GDP in response to a change in public spending. For example, if the fiscal multiplier considered in the model is equal to 0.5, this means that a €10 billion reduction in public spending will lead to a €5 billion decline in GDP. If the fiscal multiplier is set at 2, this means that a €10 billion reduction in public spending will lead to a €20 billion decline in GDP.
The choice of the fiscal multiplier level has a crucial impact on the change in GDP. All other things being equal, the higher the fiscal multiplier, the greater the impact of austerity on economic growth. However, the significance of the impact remains relative to the conditions imposed on the economy (effect on economic sectors, agents affected by fiscal measures).
How can the size of the fiscal multiplier be determined?
The fiscal multiplier is calculated empirically, i.e., by looking at how GDP has varied over different periods and in different countries following a change in public spending. As Blanchard and Leigh point out in the conclusion of their paper, there is no single value for the fiscal multiplier that is applicable in all countries for all periods. The IMF’s inaccurate forecasts are therefore due to a change in the value of the fiscal multiplier between before and after the crisis.
« However, our results need to be interpreted with care. As suggested by both theoretical considerations and the evidence in this and other empirical papers, there is no single multiplier for all times and all countries. Multipliers can be higher or lower across time and across economies. In some cases, confidence effects may partly offset direct effects. As economies recover and exit the liquidity trap, multipliers are likely to return to their pre-crisis levels. Nevertheless, when considering fiscal consolidation, it seems safe for the time being to assume higher multipliers than before the crisis. »
According to the IMF’s October 2008 economic outlook, covering the period from 1970 to 2007 for the 21 most advanced economies, the fiscal multiplier averaged 0.5. In fact, it has been above 1 since 2007, which means that for a country that planned fiscal consolidation of €100 billion, and while the IMF predicted a GDP decline of €50 billion (multiplier of 0.5), the actual GDP decline was around €100 billion (multiplier equal to 1).
The IMF, like the European Commission and the OECD, therefore underestimated the value of the fiscal multiplier. The graph below summarizes this, showing the growth forecast error per point of fiscal consolidation. Only the OECD, in a December 2010 report, had mentioned a fiscal multiplier close to 1.
Just two years ago, the IMF forecast GDP growth of 2% for France in 2012 and 2.2% in 2013 (World Economic Outlook, April 2010). In October 2012, French GDP growth was forecast at 0.1% in 2012 and 0.4% in 2013. Similarly, Spain experienced a recession of 1.4% compared with GDP growth of 1.5% forecast in April 2010.
Three reasons for underestimating the fiscal multiplier
The first reason relates to weak production and income, which affects consumption and investment. Consumers would thus have non-Ricardian effects, since their consumption, in the context of a tax increase, would depend on their current income and not their future income (no « smoothing of consumption »). Similarly, investment would depend on current profits rather than anticipated profits. These two factors would justify a fiscal multiplier greater than 1 (Eggertsson, Krugman, 2012).
The second reason relates to the recessionary nature of economies. An economy in recession with high public spending causes the multiplier coefficient to change from 0 to 2.5 (Auerbach, Gordonichenko 2012). There would therefore be a multiplier effect dynamic depending on the severity and duration of the economic recession in a country.
The third justification concerns zero interest rate monetary policies. If monetary policies are conventional and interest rates are low, then the multiplier effect is correctly assessed. On the other hand, in an unconventional scenario where interest rates are abnormally low for reasons unrelated to economic activity, the multiplier effect would reach a coefficient of 1.6 (Christiano, Eichenbaum, Rebelo, 2011).
Conclusion
Basing economic growth forecasts on ex-ante relationships prior to the crisis assumes that ex-post relationships after the crisis will remain stable. The paper by Olivier Blanchard and Daniel Leigh will therefore involve essential learning effects that will be used in the development of future aid plans. In addition, the degree of symmetry between economic and financial shocks, particularly in the eurozone, has played a major role: the Greek economic crisis is one of the main sources of the Cypriot economic crisis. This is an additional parameter to be included in the calculation of the multiplier for the development of the fiscal consolidation program in Cyprus, which should result in the fifth aid package granted by the IMF to a eurozone country.
Article co-authored with Arthur Jurus
References
Alan Auerbach, Yuriy Gorodnichenko, « Fiscal Multipliers in Recession and Expansion, » Fiscal Policy after the Financial Crisis, University of Chicago Press.
Gauti Eggertsson, Paul Krugman, “Debt, deleveraging, and the liquidity trap”, Quarterly Journal of Economics, pp. 1469-513.
Lawrence Christiano, Martin Eichenbaum, and Sergio Rebelo, “When is the government spending multiplier large?”, Journal of Political Economy, Vol. 119, pp. 78-121.
Olivier Blanchard and Daniel Leight, “Growth Forecast Errors and Fiscal Multipliers,” IMF
Working Paper, January 2008.
IMF, “World Economic Outlook,” October 2008.
IMF, « World Economic Outlook, » October 2012.
