Austerity made GDP fall 3 times more than projected
You have to admire the IMF’s gall. After admitting it underestimated the impact of its austerity programme for Greece by a factor of 3, it asks, “should the fiscal adjustment path have been more gradual?” And just in case you think such a monumental error would chasten the IMF, it makes it clear the question is rhetorical since, in the intro to the section it says “it is difficult to argue that adjustment should have been attempted more slowly.” Even more interesting is the IMF’s explanation for what went wrong. In January itself, its head of research Olivier Blanchard wrote a detailed working paper arguing the fiscal multipliers—the impact of a cut in government expenditure on economic growth—were wrong by between 2 to 4 times; instead of the multiplier being the 0.5 assumed, it was more likely to be between 0.9 and 1.7 due to what economists call the liquidity trap. Under normal circumstances, a cut in government expenditure lowers interest rates and this stimulates private consumption to rise—in a liquidity trap situation, where interest rates are already at zero, interest rates can’t fall further and, with households over-leveraged, they are not in a position to raise consumption. As a result, while the IMF originally thought Greek GDP would fall 5.5% between 2009 and 2012, it contracted 17%; unemployment rates rose to 25% against the projected 15%; ironically, the collapse in the economy make the financial sector even more vulnerable.
In retrospect, the IMF says, had the Greek public debt been restructured in the sense creditors were told to take a big haircut, this “could have eased the burden of adjustment on Greece and contributed to a less dramatic contraction in output.” So why wasn’t this done? Because, since the bulk of Greek debt was held by eurozone banks, this would have worsened their balance sheets, exposing them to a greater risk—in other words, Greece had to be collateral damage in the attempt to save Europe since, at that point, the Germans were not agreeable to less austerity and Europe had not taken enough risk mitigation exercises were the sovereign crisis to spill over to the banks. The EFSF, ESM and the OMT were not in place at that point, and certainly not as capitalised as they are today. Someone needs to tell the Greeks that their suffering has made it possible for other countries not to have to face the same fate.