We have seen quite a few peripheral eurozone countries chasing their own tail. That is, they embark on austerity (raising taxes and cutting public expenditure), even heavy austerity:
(click to enlarge)
But the end result, rather than solving the public finance sustainability, is a seemingly bigger mess with 1930s style collateral damage in the form of 25%+ unemployment rates and 50%+ youth unemployment rates in Greece and Spain. Portugal and Italy aren't quite that bad (yet?), but the situation is hardly encouraging even there. And we're not even mentioning France yet.
What's going on? Well, for years, a few economists have warned for the possibility that embarking on heavy austerity in countries that do not enjoy the possibility of using any offsetting policy levers, such as monetary stimulus or depreciation of the currency, growth could suffer to such an extent as for austerity to yield little results even in terms of improving public finances.
And now, after collecting data in the years following the Great Recession, the IMF concedes (pdf) that fiscal multipliers are probably considerably larger than previously thought. Coming from the IMF, the institution that insists on austerity at basically every crisis it is called to, this is a big deal.
As Antonio Fatás points out, the earlier IMF assumptions about the size of the fiscal multiplier seem at odds with a host of previous studies:
About eleven years ago there was a series of academic papers that estimated fiscal policy multipliers. The conclusion of the earlier papers is that multipliers were somewhere in the range 1-1.5. In other words, a 1% increase in government spending raised GDP by somewhere between 1% and 1.5%. This was the conclusion I reached together with my co-author back in 2001 (paper is available at my web site pdf). This was also the conclusion of the paper written by Oliver Blanchard and Roberto Perotti written around the same time and available here. (pdf)
This might all seem like an arcane academic debate with little relevance, but it actually matters a great deal for policy makers. There are those (German policy makers, Niall Ferguson, etc.) that argue that in the face of big public deficits and debts, countries should embark on austerity.
There are others, like Richard Koo from Nomura or Paul Krugman, who argued the opposite, when the private sector is deleveraging (like in Spain and the U.S.), the public sector should step in and fill the demand gap left by the private sector in order to keep output close to capacity. In the eurozone periphery, where there are no offsetting policy levers (monetary stimulus, devaluation), one should be especially careful with the pace of austerity.
This issue is a big rift in the eurozone, and in case you haven't been paying attention, it is also a rather large contrasting issue in the U.S. elections. Well, after studying the data, the IMF now basically agrees that austerity has had a much bigger (negative) effect on growth than previously thought. It's a big deal, but is it a surprise? Anyone observing what has been going on in the eurozone periphery would probably have arrived at the same conclusion.
Lawrence Summers and Brad DeLong published a paper arguing that under certain circumstances austerity, rather than improving public finances, could even worsen them. At least some of the eurozone countries seem to be trapped by this kind of vicious cycle. Below we see the relation between the level of austerity and the level of growth, where there is a clear negative correlation.
Now, correlation doesn't imply causation, but as the IMF pointed out, there is a clear positive relation between the size of austerity and the economic growth forecast error. That is, the larger the austerity measures are, the more economic growth tends to surprise negatively, a clear indication the IMF was underestimating the size of fiscal multipliers.
What can explain this? Here are a few candidates:
- Liquidity trap makes monetary policy quite impotent, households are paying off debt no matter how low interest rates are, so there is little scope for austerity to be at least partly offset by monetary expansion
- In the eurozone, the periphery is also subject to monetary contraction as a result of the euro itself, that is, bank depositors and bond holders can easily shift their money elsewhere without incurring any currency risk. This capital and deposit flight exerts a further contraction
- Coordinated austerity; most countries are at it, reinforcing the impact. A single country embarking on austerity could at least export some of the negative demand effects to the rest of the world.
What to do?
For countries that do have offsetting policy levers, like the U.S. and the UK, they can at least mitigate the impact of austerity to some extent. Also, unlike the eurozone periphery, these countries enjoy record low interest rates.
There has also been some contrast between the U.S. and the UK. The US embarked on fiscal stimulus in the immediate aftermath of the financial crisis, and that almost certainly stopped the rot:
there is voluminous evidence that the stimulus did provide real stimulus, helping to stop a terrifying free-fall, avert a second Depression, and end a brutal recession. America's top economic forecasters -- Macroeconomic Advisers, Moody's Economy.com, IHS Global Insight, JPMorgan Chase, Goldman Sachs, and the Congressional Budget Office -- agree that it increased GDP at least 2 percentage points, the difference between contraction and growth, and saved or created about 2.5 million jobs. [Foreignpolicy]
In the light of the findings of the IMF concerning the size of fiscal multipliers, this isn't at all a surprise. Where there is ample spare capacity, zero interest rates, and the government able to borrow at record low interest rates fiscal stimulus is a powerful tool to compensate for private sector deleveraging. This is what kept Japan afloat, after suffering from a much bigger financial crash.
The UK chose a different path, especially after the election of the Cameron government it embarked on austerity. The IMF has argued that austerity is costing an extra 76B pounds ($123 B). How is that? Yes, it's those same multipliers again:
The independent Office for Budget Responsibility used a "fiscal multiplier" of 0.5 to estimate the impact of the coalition's tax rises and spending cuts on the economy. That meant each pound of cuts was expected to reduce economic output by 50p. However, after examining the records of many countries that have embraced austerity since the financial crisis, the IMF reckons the true multiplier is 0.9-1.7. Calculations made for the Observer by the TUC reveal that if the real multiplier is 1.3 - the middle of the IMF's range - the OBR has underestimated the impact of the cuts by a cumulative £76bn, more than 8% of GDP, over five years. Instead of shaving less than 1% off economic growth during this financial year, austerity has depressed it by more than 2%. [The Guardian]
After watching many countries chasing their own tails with austerity for years, perennially disappointing on growth forecast and thereby not getting much traction with regard to improving public finances, can this all be a surprise? Not quite:
Former monetary policy committee member Danny Blanchflower said: "In a way, the surprise is that it's taken everybody so long to work it out: Keynes knew it in the 1930s. This is the 'long, dragging conditions of semi-slump', and the multipliers are likely to be larger when you've got banks that aren't lending and you're coming out of the longest recession in 100 years."
It's why the IMF wants to go a little easier on austerity, giving the likes of Greece more time. These lessons don't seem to have been learned by some though. We have consistently attached more importance to structural reforms and warned for excessive austerity. While many fear hyperinflation, we side with Adair Turner, the chairman of the British Financial Services Authority, who argued:
"The recovery from recession has been far slower than most commentators and all official forecasts anticipated in 2009," he said. "That reflects our failure to understand just how powerful are the deflationary effects created by deleveraging in the aftermath of financial crises."
Japan, not Weimar or Zimbabwe is the reference point for understanding our economic predicament.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.