In its October World Economic Outlook, the IMF stunned those espousing the Washington Consensus when it said the fiscal multiplier—percentage reduction in total output for every unit of spending-cut—may have been severely underestimated. In other words, the IMF underestimated the impact of a cut in government deficits on economic output even as it was recommending countries, such as Greece, frontload their deficit reductions. Last week, Olivier Blanchard, the Director of the IMF’s Research Department, and Daniel Leigh, an economist in the Research Department, released a detailed working paper that argues that the rise in fiscal multiplier during balance sheet recessions was very much a fact—the paper has the usual disclaimers but when it is the chief economist’s paper, it’s fair to see it as a major shift in IMF thinking. Turns out, the new research paper says, the under-estimation during the early part of the European crisis, for instance, may have been three times. That is, while economists were projecting that a cut in, say Greece’s, government spending by 100 basis points would result in a 50 bps fall in GDP, the actual fall in GDP growth was more likely to be 150 basis points. That is the reason why the IMF now tends to be more favourably inclined to more back-loaded structural reforms instead of front-loaded expenditure cuts—the problem, in Europe, of course is that the Germans are still to come around to this view.
The reason for the multipliers being far higher than previously thought—0.5 versus the reality of 0.9-1.7—has to do with what economists call the liquidity trap. Under normal circumstances, a cut in government expenditure would lower interest rates as demand for money reduces and this, in turn, encourages private consumption to rise—combined, this reduces the contractionary impact on the economy. In a liquidity trap situation, where interest rates are already at zero, there is no scope for interest rates to further fall; also, with households already over-leveraged, they are not in a position to raise consumption even though interest rates may be falling. The only viable solution then is to try to keep growing the economy with government spending while attempting longer-term structural solutions and giving both households and government time to fix their balance sheets.
Blanchard and Leigh’s thesis is borne out by the contrast between the performance of the UK and US—the former pursued vigorous austerity, while the latter engaged in a $700 billion stimulus. Two years into the policies, the UK is heading for a triple-dip recession, with a less impressive deficit reduction record; and the US safely out of recession, albeit with slow and lagging growth. The end result has British output 3.3% below pre-Lehman output and American output at least 2% more than its pre-Lehman output. Britain’s deficit, thanks to its poor growth, is projected at 6.9% for 2013 as opposed to the US’s 6.8%. That’s a warning for Europe which continues to value austerity above all else and a pat on the back for Shinzo Abe who is fighting a battle against austerity as he once again leads Japan.