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IMF: Austerity is much worse for the

economy than we thoughtBy Brad Plumer , Updated: October 12, 2012

Earlier this week, the International Monetary Fund made a striking admission in its

new World Economic Outlook. The IMFs chief economist, Olivier Blanchard, explained

that recent efforts among wealthy countries to shrink their deficits through tax hikes and

spending cuts have been causing far more economic damage than experts had assumed.

How did the IMF figure this? That was the tricky part. Blanchard could have just plotted a

simple graph showing that countries undertaking heavy austerity measures, such as Greeceand Portugal, are faring more poorly than their peers. But that doesnt actually prove

anythingperhaps those countries are undertaking austerity because theyd run into

economic trouble.

So, instead, Blanchard did something more subtle. He studied the IMFs previous economic

forecasts. If a country is already struggling for other reasons, the forecasters are likely to

have taken that into account. And what Blanchard found was surprising: IMF forecasts have

been consistently too optimistic for countries that pursued large austerity programs. This

suggests that tax hikes and spending cuts have been doing more damage to those economies

than policymakers expected. (Conversely, countries that engaged in stimulus, such as

Germany and Austria, did better than expected.)

This all comes down to a long-standing debate over whats known as the fiscal multiplier.

Economists tend to agree that tax increases and spending cuts hurt growth. The question is

how much they hurt growtha variable that usually changes at different points in time.

This matters a lot for policy. If tax hikes and spending cuts only hurt growth a little bit, then a

government with debt problems will want to enact some austerity measures. If a tax

increase, on average, raises $10 in revenue but reduces output by $6, that might be painful,but it will ultimately shrink the deficit. (Indeed, those are basically the numbers that

policymakers in Britain and elsewhere had been using.)

But if tax hikes and spending cuts hampergrowth significantly, then austerity could be ill-

advised. Indeed, if the fiscal multiplier is really, really high in certain situationssuch as

during a downturnthen austerity could prove counterproductive. Those higher taxes and

severe spending cuts will cripple growth so much that the nation will end up with an even

bigger deficit than it started out with.

Blanchard is now arguing that the fiscal multiplier appears to have been much higher over thepast few years than policymakers, including the IMF, had assumed. Its not 0.6. Its

somewhere between 0.9 or 1.7. If true, then countries in Europe and the United States

should have been pursuing stimulus measures to boost growthand not insisting on budget

cuts. (Not surprisingly, Paul Krugman is claiming vindication, since this was his view all

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7/31/2019 IMF: Austerity is much worse for the economy than we thought (The Washington Post)

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along.)

Yet its worth noting that not everyone is convinced by the IMFs results. Over at the

Financial Times, Chris Giles tried to replicate Blanchards calculations and found that the

analysis was heavily skewed by Greece and Germany. That is, austerity appears to have

kneecapped Greece much more forcefully than anyone expected over the past few years.

And Germany seemed to get an exceptional boost from its stimulus programs. But if you

remove those two countries from the equation (maybe theyre special cases), the results aremurkier:

For the countries where the full data is available on the IMF website, the results lose

statistical significance if Greece and Germany are excluded.

Moreover, the IMF results are presented as general but are limited to the specific time

period chosen. The 2010 forecasts of deficits are not good predictors of errors in growth

forecasts for 2010 or 2011 when the years are analysed individually. Its 2011 forecasts are

not good predictors of anything.

So there are some caveats here. Fiscal multipliers can change over time, depending on the

situation. Keynesians have often said as much: Stimulus is a good idea when the economy is

weak, but the returns diminish when the nation is at full employment. Similarly, as Blanchard

notes, economists still need a much better understanding of when, exactly, stimulus is

effective and when austerity can help shrink the deficit. How does monetary policy factor in?

Does the price of oil and other commodities matter? And so on.

For now, though, as both Kate McKenzie and Matt Yglesias point out, its quite significant

that the IMF has shifted its stance on austerity so dramatically. In the 1990s, the fund was

famous (or infamous, if you prefer) for ordering countries with debt troubles to tighten theirbelts. But now the IMF is urging countries in the euro zone, such as Netherlands and

France, to loosen up a bit. True, those countries do have high debts. But with Europe still

facing weak growth, budget-cutting might not be the answer just yet. For the IMF, thats a

big change in attitude.

The Washington Post Company

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