2012-10-30 11:47:51
Oct 27th 2012 | from the print edition
IT IS among the hoariest of film clich s. The hero subdues one foe and turns his attention to another only to find that the first villain is still alive and bent on destruction. Two years ago the rich world thought that the global recession was over, vanquished by a wave of fiscal and monetary stimulus. Policymakers turned their backs to clean up the government debt that had been left behind. In 2011 and 2012 structural deficits across the rich world will have been reduced by about 0.75% of GDP, a pace that is forecast to rise in 2013. But economic gloom has not gone; indeed, fiscal consolidation seems to have deepened it.
Solvency worries drove the turn from stimulus to austerity. Markets started losing their appetite for Greek debt in late 2009. Many governments feared they might be next. In October 2010 the IMF called for belt-tightening and turned to gauging its probable impact. Yet controversy surrounded this switch. The IMF argued that austerity would be painful but necessary; some academics reckoned that cuts could do more harm than good.
The debate centred on the value of an economic variable called a multiplier . A fiscal multiplier describes the change in GDP that is due to a change in tax-and-spending policy. A multiplier of 1.5, for instance, means that $1 in government-spending cuts reduces GDP by $1.50; a multiplier of 0.5 means a $1 cut in spending only reduces GDP by 50 cents. Multipliers work both ways: during the recession experts bickered over the extra economic bang to be expected from a given stimulus buck. But it is the impact of austerity that now preoccupies people.
A simple example illustrates the multiplier s importance. Take an economy growing at 1.5% a year and with a government budget deficit of 1% of GDP. If the multiplier is 2, spending cuts big enough to close the deficit produce a drop in GDP in the year the cuts take effect. For its pains the economy ends the year with a higher debt-to-GDP ratio than it started with. A multiplier below 1.5 means slow growth and a lower debt burden at year s end.
Estimates of fiscal multipliers are all over the map. Some, like Alberto Alesina and Silvia Ardagna of Harvard University, argue that fiscal consolidation may actually raise growth, even in the short run. But the loose consensus a couple of years ago was that multipliers were typically around 1, or perhaps a bit below. In their 2010 analysis IMF economists reckoned that governments cutting deficits by 1% of GDP could expect a short-run hit to GDP growth of about half a percentage point: a multiplier of about 0.5.
This view was predicated on the idea that other factors can offset the blow from budget cuts. Spending cuts may crowd in private-sector activity: if governments are using up scarce capital and labour then austerity creates room for private firms to expand. In open economies, austerity s bite can be passed on to other countries through reduced imports. Most important of all, monetary policy can act as a counterweight to fiscal policy. Spending cuts that threaten to drag growth below a desired level should prompt monetary easing, limiting the multiplier.
What that means is that austerity may hurt much more at some times than others. In a 2010 paper Alan Auerbach and Yuriy Gorodnichenko of the University of California, Berkeley argued that the fiscal multiplier may be negative during booms, meaning that spending cuts actually raise growth. In recessions, by contrast, it could be as high as 2.5. A study by Lawrence Christiano, Martin Eichenbaum and Sergio Rebelo of Northwestern University suggested that although the multiplier may hover at around 1 normally, it could rise to more than 3 when interest rates fall to near zero, leaving the central bank with less room to act.
The timing of post-crisis austerity could hardly have been less auspicious. First, with many economies cutting budgets at once, the impact of austerity on growth couldn t easily be deflected elsewhere. That is a big problem in the euro zone where trade links are tight and countries are unable to devalue their currencies. Second, whereas cuts in government spending might normally be expected to free up resources for private use, that mattered far less when unemployment and saving were high. Third, with borrowing costs already at rock bottom in safe havens like Britain and America, there was less room for them to fall further to offset the impact of austerity on demand. Finally, as many interest rates neared zero, monetary-policy action had less scope.
Slasher movie
To be fair, the IMF cautioned in 2010 that austerity might be more painful than normal for just these reasons. Even so, it underestimated the hit from budget cuts. In the fund s latest World Economic Outlook , released this month, Olivier Blanchard, its chief economist, and Daniel Leigh study how well their past forecasts turned out. They analyse the IMF s 2010-vintage forecasts for 28 rich economies and find that planned fiscal cuts of 1% of GDP generally led the IMF to overestimate a country s subsequent growth by about a percentage point. Fiscal multipliers since the recession seem to have been between 0.9 and 1.7, they write, rather than the 0.5 figure used in initial forecasts. That meant more economic hardship for less improvement in public finances.
Given the small sample size, these conclusions should also be treated cautiously. Yet a battery of tests conducted by Mr Blanchard and Mr Leigh shows that the fund s new results hold when controlling for things such as banking crises, and remain statistically meaningful when countries on IMF programmes, such as Greece and Portugal, are excluded. Rapid belt-tightening may bring down deficits, but it hurts growth more than the fund anticipated. The IMF has seen this film before, say critics of austerity: it should have seen this coming.
Sources
"The design of fiscal adjustments", by Alberto Alesina and Silvia Ardagna, NBER Working Paper #18423, September 2012
"Measuring the output responses to fiscal policy", by Alan Auerbach and Yuriy Gorodnichenko, NBER Working Paper #16311, August 2010
"When is the government spending multiplier large?", by Lawrence Christiano, Martin Eichenbaum and Sergio Rebelo, NBER Working Paper #15394, October 2009
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