The IMF's world-changing U-turn
The IMF has completely changed its view on the fiscal multiplier and now believes austerity is counterproductive. The Keynesians are back on top.
That’s because it was at this meeting in Tokyo that the IMF admitted it had got the fiscal multiplier wrong. It is twice to three times what was previously thought, and certainly more than 1. As a result, the IMF is now arguing for an end to fiscal austerity in Europe.
The fiscal multiplier measures the impact on economic growth of a given change in the government budget balance. If it’s 1, then a 1 per cent reduction in the deficit will cut growth by 1 per cent.
In 2010, the IMF concluded that: "Fiscal consolidation typically lowers growth in the short term. Using a new data set, we find that after two years, a budget deficit cut of 1 per cent of GDP tends to lower output by about ½ per cent and raise the unemployment rate by ⅓ percentage point.”
But in a special box in last week’s annual report for the Tokyo conference, the fund reported that it had been doing further research, and concluded that: "…our results indicate that multipliers have actually been in the 0.9 to 1.7 range since the Great Recession.”
In 2010, as a result of the IMF’s insouciance, European economies moved decisively towards austerity, pushed by Germany with the support of the IMF, which was then under the leadership of managing director Dominique Strauss-Kahn.
Now, with Christine Lagarde in charge following Strauss-Kahn’s resignation, as a result of rape charges in New York in May 2011 that were later dropped, the IMF and Germany are at odds.
It has been a full intellectual U-turn by the IMF from its habitual pushing of fiscal austerity since it was set up in 1944 at the Bretton Woods conference to reconstruct the world’s payments system after World War II and stabilise exchange rates.
At the same time as lowering its forecasts for global growth, the IMF is now pushing for debt forgiveness for Greece and more time for other European countries to get their debt down. The IMF and Germany are now at odds.
In Tokyo, Lagarde said that countries should not blindly stick to budget deficit targets if growth weakens more than expected – they should instead allow "automatic stabilisers” (increases in welfare and reductions in tax revenue) to work if growth falls short.
Also in Tokyo, the German finance minister Wolfgang Schauble accused the IMF of contradicting its own stance on fiscal austerity, saying that the fund had "time and again” warned that high debt levels threatened economic growth.
Keynesian economists the world over, led by Princeton University’s Paul Krugman, are crowing.
Krugman wrote in his blog on Saturday: "It wasn’t just a contrast between the wishful thinking of the expansionary austerity types and those who didn’t buy it.
"There was also a distinction between those who looked at the historical record and concluded that fiscal contraction would have only modest contractionary effects, and those — including Martin Wolf, Wren-Lewis, Brad DeLong, and me — who argued that historical experience from countries that were not up against the zero lower bound, had flexible exchange rates, and were pursuing austerity amidst a strong global economy was likely to greatly understate the effects of austerity in the current environment.
"Our position was, if you like, that times like this are different.
"At some level…the vindication of this position is also a vindication for the whole enterprise of Keynes/Hicks macroeconomic theory…”
The Financial Times’ Lex column joined in yesterday with a column headed: "Austerity in Europe – enough already”.
The IMF is now squarely in this camp. It is significant because the fund is not just a spectator on the sidelines like those economists, but a player in the European drama – a member of the so-called rescue troika with the EU and the ECB, as a lender to Greece and other debtor countries.
The EU has already shown some flexibility, giving Spain and Portugal another year to hit their deficit reduction targets. And now that it has won the Nobel Peace Prize it might suddenly be overcome by finer feelings and start to dispense even more philanthropy.
The ECB, meanwhile, has announced its latest plan for Outright Monetary Transaction, or its version of quantitative easing in which it will buy sovereign bonds as long as the country concerned applies for help and agrees to the European Stability Mechanism rules on deficit reduction.
No one has asked for some OMT yet, which is getting to be a bit embarrassing, especially since it is clear that Spain will have to do so eventually. It’s also clear that Greece is not going to meet its debt reduction target of 120 per cent of GDP, with debt now at 181.8 per cent, and blowing out.
In fact Societe Generale’s economists argue that for Greece the fiscal multiplier is more than 2, which means deficit reduction at this point is entirely self-defeating.
More broadly, the basic reason that the fiscal multiplier is now thought to be above 1 rather than below 1 is because interest rates are "zero bound”, as Paul Krugman says. That means monetary policy can’t offset the fall in confidence that results from the cut in government spending or the increase in taxes.
And by the way, it’s worth noting that The Australian reports this morning on a report from the head of investment market research at Perpetual, Matthew Sherwood, who says that the Reserve Bank of Australia might soon hit its own version of zero bound if the cash rate is cut much more.
That’s because the banks will not cut deposit rates to below inflation. "After this, banks may not pass on any further stimulus to borrowers, regardless of how low official interest rates go," he says.
That’s important because while the Australian Government might not be in the same sort of fiscal mess as Greece, there is a political consensus around the need for fiscal austerity to get the budget back into surplus.
If monetary policy in Australia is effectively "zero bound” and therefore not working, the fiscal multiplier in this is likely to be more than 1 as well.
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