A simple, but very clever, bit of analysis from the IMF in its latest WEO has changed the debate on fiscal policy, especially as it relates to the developed world. It is an admirable about face as the mounting evidence of recent years has challenged the underlying assumptions of fiscal multipliers that informed the IMFs forecasts.
What is the fiscal multiplier?
The fiscal multiplier is the change in GDP, or economic output, which results from a change in government spending or taxation. By way of example, if we imagine $1bn of spending cuts and the multiplier is assumed as 1, then GDP will be reduced by $1bn. If the multiplier if 0.5, then $1bn of spending cuts will reduce GDP by only $500mn. Conversely, if the multiplier is 1.5 then $1bn of spending cuts will reduce GDP be by $1.5bn.
What did they find?
For reference, the crucial result of the IMF analysis is summarised in this section:
In line with these assumptions, earlier analysis by the IMF staff suggests that, on average, fiscal multipliers were near 0.5 in advanced economies during the three decades leading up to 2009. If the multipliers underlying the growth forecasts were about 0.5, as this informal evidence suggests, our results indicate that multipliers have actually been in the 0.9 to 1.7 range since the Great Recession. This finding is consistent with research suggesting that in today’s environment of substantial economic slack, monetary policy constrained by the zero lower bound, and synchronized fiscal adjustment across numerous economies, multipliers may be well above 1.
How did they do it? They examined the recent episode of widespread fiscal consolidation and analysed forecast errors for 2010/11 from forecasts that were made in early 2010. By looking at forecast errors versus austerity they are ensuring that the causality goes from austerity policies enacted now to the errors in the forecast in the future. So the causality question is addressed.
Context matters: there is not one fiscal multiplier
As Isabella Kaminska says , it is becoming clearer that the fiscal multiplier is variable. This implies that the multiplier effect should be very different in an economy that is at full employment and has positive/normal interest rates, compared to an economy that is at the zero lower bound with large output gaps. From a theoretical standpoint, some economists had this right, but not many. Simon Wren-Lewis noted that these economists “recognised that a world where nominal interest rates were fixed, either because they cannot go below the Zero Lower Bound (ZLB), or because the rate is determined for the Eurozone as a whole, is very different to a world where monetary policy is unconstrained.”
What this says about policy: Expansionary fiscal contractions?
Negligible fiscal multipliers underpinned the belief in expansionary fiscal contractions (EFC) that became a serious policy point of view in 2010. This was the view that contracting government spending could actually increase economic growth. Hence, the multiplier would be negative: a $1bn cut in spending actually increases GDP by some amount. Diagrammatically, this is shown in a simple AS-AD diagram.
Paul Krugman refers to this view as the belief in the ‘confidence fairy’. In a study at the time, the IMF found few examples of EFC’s. Ireland in 1987 and Denmark in 1983 were highlighted as successful cases of fiscal consolidation, but again, the context is very important. The IMF concluded that any possible EFC needs support from low or falling interest rates, a depreciating currency and falling bond yields. This empirical analysis only serves to strengthen the theoretical views of Wren-Lewis et al. These three conditions are not in play now with weak external demand, interest rates at the zero lower bound and bond yields at record lows.
Questions for theory and policy in the future?
Theoretically, as Wren-Lewis points out, it is relatively straight forward to achieve fiscal multipliers of more than one in New Keynesian modelling. These models involve effects on real interest rates, hysteresis effects and possible supply side effects if government spending is focused on investment. Moreover, as Krugman points out the context of leverage and deleverage is also crucial “The crucial thing from a macroeconomic point of view is that leveraging and deleveraging are not symmetric in their effects. Leveraging up, other things equal, leads to high aggregate demand — but this can be and is in practice offset by the central bank, which can always raise rates. Deleveraging, on the other hand, can’t be offset equally easily; the central bank can cut rates, but only to zero, and unconventional monetary policy is both controversial and an iffy proposition (which doesn’t mean that it shouldn’t be tried). So a large leveraging/deleveraging cycle is likely to be followed by a persistent shortfall in aggregate demand that can’t be cured using ordinary monetary policy; what I consider depression economics.” This extension to fiscal policy and aggregate demand would be very interesting for Geanakoplos’ Leverage Cycle and the Cubic IS curve model .
On the policy front, Portes makes the crucial point: “the first relates to the current debate about how large the UK “output gap” is and hence how much scope there is for expansionary policy (both fiscal and monetary). The UK economy has essentially seen zero growth for the past two years. Some analysts – Chris Giles being the most credible, but the OBR has also taken this line – have argued that given the sort of multipliers assumed by the OBR and IMF, fiscal consolidation can’t explain much of this growth shortfall, so it must be something else: supply side weakness, commodity prices, and so on, meaning that changing fiscal policy might not do much good. If, however, multipliers were in fact much higher, then fiscal consolidation is indeed the main reason for weak growth; and correspondingly, the scope for boosting growth through expansionary policy is much greater”
Overall, it can easily be seen why one IMF box has created such a reaction. It is far from resolved, both in terms of policy and theory, but it could turn out to be the most crucial lesson of the Great Recession.