Yesterday the IMF made a significant statement on fiscal policy, one that has already been picked up by Jonathan Portes, Paul Krugman and Simon Wren-Lewis but which may have even more important ramifications for the UK than many have yet realised.
The statement was about the size of fiscal multipliers, so it is worth very briefly recapping exactly what a fiscal multiplier is. Wikipedia defines the multiplier as:
In economics, the fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. More generally, the exogenous spending multiplier is the ratio of a change in national income to any autonomous change in spending (private investment spending, consumer spending, government spending, or spending by foreigners on the country’s exports) that causes it.
Simply put the fiscal multiplier is a measure of how changes in fiscal policy (spending and taxation) impact on the wider economy. If we imagine £10bn of spending cuts and the multiplier is assumed as 1, then GDP will be reduced by £10bn. If the multiplier if 0.5, then £10bn of spending cuts will reduce GDP by only £5bn and, alternatively, if the multiplier is 1.5 then £10bn of spending cuts will reduce GDP be by £15bn. In the context of a Government pursing over £100bn of fiscal tightening (spending cuts and tax rises), then the assumption made about the size of the multiplier is obviously crucial. This is why the IMF changing its views on the size of the multiplier (in the latest World Economic Outlook) is so important.
The new report states that:
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.
So the Fund initially thought that the multiplier was around 0.5 (i.e. £10bn of spending cuts will reduce GDP by around £5bn) whilst it now thinks they are between 0.9 and 1.7 (i.e. £10bn of spending cuts will reduce GDP by between £9bn and £17bn). That is quite a big change and, as Jonathan writes:
…the Fund deserve praise for going back, looking at their forecasts, analysing what went wrong, and saying very clearly “We thought the impact of fiscal consolidation on growth would be relatively small. We got it wrong. “
It is worth noting that the IMF has always been cautious on the size of multipliers. Back in the October 2010 World Economic Outlook it argued that whilst the multiplier might be 0.5, that assumed that interest rates had room to fall and the currency had room to depreciate, boosting exports and cushioning the blow to the economy. The Fund warned, 2 years ago, that if these cushions were not available then the multiplier was closer to 1. The Fund went further and argued that if a country’s trading partners were also committed to austerity and retrenching their spending then the multiplier might actually be closer to 2.
Overall, these results illustrate that changes in both the interest rate and the exchange rate are important to the adjustment process. When countries cannot rely on the exchange rate channel to stimulate net exports, as in the case of the global consolidation, and cannot ease monetary policy to stimulate domestic demand, due to the zero interest rate floor, the output costs of fiscal consolidation are much larger. Thus, in the presence of the zero interest rate floor, there could be large output costs associated with front-loaded fiscal retrenchment implemented across all the large economies at the same time.
In this regard, yesterday’s statement from the IMF is not so much of a volte-face. It may well be that in ‘normal times’ the multiplier is closer to 0.5 but when interest rates are already low, when the exchange rate cannot adjust further and when a country’s major trading partners are committed to austerity (as is the case for the UK now) then the multiplier was always likely to be much higher than 0.5.
But yesterday’s update from the IMF is especially important to the UK. Back in June 2010, the Chancellor set out a 5 year austerity drive (now extended to a 7 year one) based on a low estimate of the fiscal multiplier. The implicit assumption was that the economy was strong enough to take the pain and continue growing.
The multipliers as set out by the Office for Budget Responsibility (OBR) in June 2010 (paragraph C54 and table C8) were:
Change in VAT: 0.35
Change in personal tax and NICS: 0.3
Change in welfare spend: 0.6
Change in departmental spending: 0.6
Change in capital spending: 1.0
In other words, all roughly line in with the IMF’s 0.5. And that isn’t a surprise, as the primary source for the OBR’s own estimates was none other than the IMF. The OBR stated that its estimates were based on a range of empirical studies and cited:
A review of estimates for fiscal multipliers for different policy instruments and countries is available in Fiscal Multipliers, Antonio Spilimbergo, Steve Symansky, Martin Schindler (IMF Staff Position Note), May 2009. Further evidence was taken from papers including: Fiscal Policy Action in the Banking Crisis, National Institute Economic Review, January 2009; Fiscal Stabilisation and EMU, HM Treasury, 2003; Public Investment and the Golden Rule: Another (Different) Look, Roberto Perotti (IGIER Working Paper No 277), 2006; and Estimating Tax and Benefit Multipliers in Europe, Ali J Al-Eyd and Ray Barrell, Economic Modelling (Vol 22), 2005.
The primary source for the OBR when estimating the size of the multiplier was a 2009 staff study by the IMF. The IMF has now revised its view and argued that rather than being 0.5, the multiplier (at present) is actually between 0.9 and 1.7 – somewhere between twice and three and half times as big.
The question now is will the OBR follow the course set by the IMF, reassess its own use of multipliers and revise its view of the impact of spending cuts and tax rises?