Is the IMF going through a paradigm shift in fiscal policy?

Cornel Ban

The Great Recession and especially the European crisis saved the IMF from its growing pre-crisis marginality. Yet things have been more awkward for the pride of its economists. Against a gloomy economic background, they bit the bullet in the Fund’s recent World Economic Outlook (WEO) report[1] and openly admitted that they have been wrong about some essential virtues of austerity. Three findings stood out: the size of the fiscal multipliers used for growth projections have been woefully underestimated, countries that engaged in more austerity had less growth than countries that did not and austerity failed to reduce public debt within a reasonable time span. Staff research that strays from the Fund’s policy line is tolerated but seldom makes it into the press conferences of the managing director. This time, however, it did. Christine Lagarde publicly upheld the self-criticism and demanded a recalibration of fiscal consolidation.

Prior to the crisis, in some quarters of the economic profession the research on multipliers settled around the consensus that fiscal multipliers should be around or slightly above 1.[2] During the recession, more papers found that fiscal multipliers are in fact even larger because of monetary policy stuck in the zero lower bound and the occurrence of a deep recession.[3] However, the chorus of voices demanding fiscal consolidation grew, silencing these insights.[4] The IMF lent legitimacy to this chorus when its staff used forecasting models using multipliers of 0.5 to measure the impacts of fiscal consolidation on growth prospects. That means that each 1 euro of cuts and tax increases shaves 50 cents off GDP growth.

In contrast, the October 2012 WEO found that in fact they ranged between .9 to 1.7 (the Eurozone periphery is closer to the higher end of the range), an error that explained the IMF’s extremely optimistic growth projections for countries who frontloaded fiscal consolidation.  Assuming the multiplier was 1.5, a fiscal adjustment of 3 percent of GDP-as much as Spain has to do next year- would lead to a GDP contraction of 4.5 percent. It was momentous finding and those who had been skeptical of the virtues of austerity felt vindicated.[5]

This recanting is certainly a big deal but does it mean that the Fund as a whole is backing off the austerity agenda in a big way? Indeed, is the October WEO the IMF’s road to Damascus moment? There was a real seismic tremor in Tokyo when Christine Lagarde defended the findings against the charge of the German finance minister, but an epiphany it was not. The mea culpa on multipliers may put to rest the expansionary austerity thesis, sow discord in EU-IMF relations[6] or send financial media analysts scrambling for critiques,[7] but it has had modest effects on the actual IMF line on austerity. Chief economist Olivier Blanchard rushed to declare in the German press that the IMF does not construe these findings as urging a shift to fiscal expansion.[8] The Fund’s managing director stressed that in fiscally constrained countries deficit cutting should continue, only at a slower pace and without nominal targets. Rather than go for stimulus, she insisted, countries with fiscal breathing room should abstain from both stimulus and cuts. [9]

The last WEO report may have recalibrated austerity in important ways, but was it truly surprising?  Not so much. Olivier Blanchard’s research used higher values for multipliers as early as 2001 and his appointment as the Fund’s chief economist during the crisis relaxed the fiscal policy skepticism of the institution, with staff authoring research stating that overly ambitious austerity programs implemented in economic downturns are self-defeating.[10] As early as December 2008 he co-authored a paper that made the frontloading of fiscal stimulus measures a centerpiece of crisis economics.

This entailed tweaking balanced budget rules to prevent cuts in existing programs, increasing the state’s share in public-private partnerships, increases in public sector employment, more transfers for those at the bottom end of the income distribution (the minimum wage workers, the unemployed, the foreclosed). Where the social safety net was narrow, the state had to step in to expand it. While it cautioned against industrial policies targeted at domestic firms, the paper urged governments to offer guarantees on new credit for firms whose fate was threatened by the credit crunch. This was hardly the bad cop material associated with the IMF medicine in the past decades.

But there was an important caveat to all this: fiscal activism was legit only as long as financial markets deemed it sustainable. At the time, it seemed that the entire Eurozone still benefited from “safe haven” status for bond investors so the IMF agreed to fiscal expansions there. But countries that faced pressures in the bond markets (Hungary, Latvia and Romania in 2008-2009) had to engage in fiscal consolidation in order to reduce debt and rebuild confidence. The same applied to Southern Europe and Ireland after 2010.

As a result, the Fund was in agreement with the European policy line on the “periphery” –including by marshaling models with low multipliers-but disagreed with them on the need for austerity in the eurozone’s “core. The last WEO changes a lot of things, but not the IMF’s prescription of austerity where it hurts the most. But as modest as these changes are in policy, given the hard line on coordinated contractions taken by those who matter politically in Europe, the IMF may be a better hope for those who want to save the euro from the scissors of its own designers.

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[1] http://www.imf.org/external/pubs/ft/weo/2012/02/index.htm

[2] http://fatasmihov.blogspot.com.au/2012/10/underestimating-fiscal-policy.html

[3] http://www.voxeu.org/article/spending-cuts-improve-confidence-no-arithmetic-goes-wrong-way

[4] https://europeaneconomics.wordpress.com/2012/10/01/five-reasons-why-the-keynesians-lost-the-battle/

[5] http://krugman.blogs.nytimes.com/2012/10/13/times-like-this-are-different/

http://notthetreasuryview.blogspot.co.uk/2012/10/more-on-multipliers-why-does-it-matter.html

http://mainlymacro.blogspot.co.uk/2012/10/multipliers-using-theory-and-evidence.html

[6] http://www.ft.com/intl/cms/s/0/09a54140-13ba-11e2-8260-00144feabdc0.html

[7] http://www.economist.com/blogs/freeexchange/2012/10/fiscal-policy

http://www.ft.com/intl/cms/s/0/85a0c6c2-1476-11e2-8cf2-00144feabdc0.html#axzz29Kgtrmtp

[8] http://www.forexlive.com/blog/2012/10/11/imf-blanchard-no-room-for-further-fiscal-stimulus-in-emu-us/

[9] http://www.ft.com/intl/cms/s/0/1bc1ed24-1441-11e2-8cf2-00144feabdc0.html#axzz29Kgtrmtp

[10] http://europeaneconomics.wordpress.com/2012/10/04/is-the-imf-turning-against-austerity/