Free exchange


Fiscal policy

A supposedly fun thing we shouldn’t have done

Oct 25th 2012, 16:27 by R.A. | WASHINGTON

IN 2008 and 2009, leaders across advanced economies did a pretty good job cooperating to prevent a global financial meltdown and survive a global recession. In 2010, they surveyed the scene, pronounced the crisis safely in remission, and set about cleaning up the resulting fiscal mess. Gross government debt-to-GDP ratios rose from 74% to 101% from 2007 to 2010. There was just one problem with this strategy, as this week’s Free exchange column explains: it was not an ideal time for sweeping fiscal consolidation:

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.

The most recent World Economic Outlook contained the punchline: fiscal multipliers since 2009 seem to have been significantly larger than previously assumed. In a box in the WEO, IMF chief economist Olivier Blanchard and staff economist Daniel Leigh looked at 2010 vintage forecasts and found that planned fiscal cuts of 1% of GDP generally led the IMF to overestimate an economy’s subsequent growth by roughly one percentage point. The fiscal multiplier seemed to be in the 0.9 to 1.7 range rather than the previously estimated 0.5.

Critics have challenged the IMF’s conclusions as insufficiently robust; the Financial Times‘ Chris Giles ran his own regression and reportedly found that dropping Greece from the sample left the findings statistically insignificant. While I appreciate his effort, I don’t find it particularly convincing. Mr Blanchard and Mr Leigh ran their own battery of robustness tests, and found that excluding several different subsets of outliers—including economies on IMF programmes—did not affect significance. The relationship remained robust to inclusion of other control variables (like initial debt stock and the incidence of banking crises) and to broadening the sample. My strong suspicion is that further rigorous testing is underway and is likely to support the initial findings.

Moreover, the result is consistent with other key research results on the impact of cuts in environments like the present. Frankly, given the behaviour of governments and central banks over the past two years it would be truly bizarre not to observe fairly substantial fiscal multipliers.

And that is the key point: policymakers suffered from a striking lack of perspective in opting to pursue broad austerity* beginning in 2010. It was clear at the time that some economies needed to begin cutting debts immediately and that lots of economies would need to bring debt down eventually. But a look at global conditions should have indicated that the normal cushions against fiscal cuts were weaker than normal or absent. And so the decision by countries not facing immediate market pressure to start cutting alongside those that were seriously undermined the consolidation efforts of economies in truly dire straits and threatened recovery.

At the same time, central banks seriously underestimated the impact of a broad pivot to austerity and their own role in raising fiscal multipliers. A look at prevailing market conditions and the wholesale move toward deficit reduction across the advanced world should have convinced central banks that aggressively expansionary policy was likely to be necessary and was much less likely to carry inflationary risks.

The result was a process of fiscal consolidation that was more economically painful and dangerous and less successful than it needed to be. The past two years simply didn’t need to be as economically difficult as they have been.


* The broad move toward austerity is real, despite what you may have heard. Cyclically-adjusted deficits across advanced economies declined from 5.9% of GDP to 4.3% from 2010 to 2012, including a drop of 1.9 percentage points in America, 2.6 percentage points in the euro area, and 2.7 percentage points in Britain. Japan is the sole outlier among major advanced economies.