Excessive austerity doesn’t pay, IMF economists show

It is probably one of the most important trips in Greece’s modern history. On Friday, the new Greek prime minister Antonis Samaras will travel to Berlin and ask the German chancellor Angela Merkel for more time. His stricken country, he will insist, needs  more years to meet the austerity targets. “All we want is a bit of ‘air to breathe’ to get the economy running and to increase state income”, he said in an interview with Germany’s tabloid “Bild Zeitung”.

A new research paper published by the research department of the International Monetary Fund (IMF) backs his claim. Countries trying to consolidate their public finances in the midst of a recession need patience and a steady hand, the paper entitled “Successful Austerity in the United States, Europe and Japan” concludes.

Given the fact that the IMF is part of the troika that insists on severe austerity programs in return for bailout funds, this  is quite a perplexing message.

A research team lead by IMF’s economist Nicoletta Batini analysed the history of austerity programs in industrial countries using state-of-the-art macro methods. They came to the conclusion that overly ambitious austerity programs implemented in economic downturns are self-defeating:

“The analysis in this paper shows that withdrawing fiscal stimuli too quickly in economies where output is already contracting can prolong their recessions without generating the expected fiscal saving.”

Without specifically discussing the Greek  case, the paper indirectly suggests  the excessive fiscal consolidation the troika forced upon the stricken country probably made things worse. According to figures published by the German Council of Economic Advisors, Greece has cut back its fiscal deficits rather vigorously.

From 2009 to 2012 the fiscal deficit shrunk by 9 percent of GDP and the structurally adjusted fiscal deficit was reduced by more than 14 percent. Simultaneously, however, economic output collapsed by more than 20 percent, and public debt exploded.

Excessive austerity measures in a recession can trigger a vicious circle, the IMF researchers warn in their paper. Declining output, diminishing tax revenue and expenditure cuts can reinforce each other – “a snowball effect”, as the economists call it. They advise governments to allocate consolidation measures evenly over several years.

“Frontloading” of cuts – a policy often demanded by the IMF – turns out to be especially damaging to growth:

“Smooth and gradual consolidations are to be preferred to frontloaded or aggressive consolidations, (…) because sheltering growth is key to the success of fiscal consolidation.”

This lesson seems to be especially important for countries that lost the confidence of the financial markets and have to pay high risk premia on public debt, the authors point out.

Their paper has been published as an IMF Working Paper and does not necessarily reflect the official view of the organisation. However, prior to publication, IMF Working Paper are subject to a stringent quality control process.

The results confirm an old hypothesis that dates back to the heydays of John Maynard Keynes. However, a lot of contemporary macro economists have been severely questioning the Keynesian view on fiscal policy and growth for decades. They suggest that fiscal retrenchment can boost economic prosperity even in the short run because it might foster confidence in the private sector.

In real life, however, this theory apparently does not hold the water.

“While it is plausible to conjecture that confidence effects have been at play in our sample of consolidations, during downturns they do not seem to have ever been strong enough to make the consolidations expansionary at least in the short run”, the researchers stress.

This observation supports the results of a different team of IMF economists who looked at the idea of “expansionary austerity” last year. In a paper entitled “Expansionary Austerity: New International Evidence”, Jaime Guajardo, Daniel Leigh and Andrea Pescatori came to the conclusion that previous academic literature on the subject has methodological weaknesses.

In the new paper Nicoletta Batini and her co-authors Giovanni Callegari and Giovanni Melina stress that the growth impact of austerity programs hinges on the economic climate. This is a distinction that most of the previous literature did not make but it turns out to be crucial. In good times, fiscal retrenchment does not do much damage to growth. If the economy is in a recession, however, things appear to be differently.

The results of the new paper are also stunning with regard to the optimal composition of austerity programs. Currently, most economists recommend cutting government expenditures rather than hiking taxes as the most growth friendly strategy. However, as Batini et al. point out, depending on the economic environment, this can turn out to be a dangerous piece of advice.

In a recession, cutting government outlays proves to be rather detrimental to growth. According to the results, the fiscal multiplier for so-called expenditure shocks varies between 1.6 and 2.6. This means that every Euro of cuts costs 1.60 to 2.60 Euro of GDP. Tax hikes are significantly less harmful: The fiscal multiplier only ranges between 0.16 and 0.35.

Unfortunately, however, most crisis countries in the Euro area heeded the prevalent economic advice and gave a higher priority to cuts rather than to tax hikes, as Laura Weymes, an economist with the Central Bank of Ireland, recently stressed in a paper:

“Currently, the composition of consolidation programs across the broader EU appear balanced slightly in favour of expenditure.”

This might have exacerbated Europe’s problems.

Angela, please listen.

11 Comments

Filed under Economic Policy, Financial Crisis

11 Responses to Excessive austerity doesn’t pay, IMF economists show

  1. TyBrentwood

    The use of Estimates and Likelyhoods based on assumptions and proven with mathamatical accuracy can only be viewed as aggregated snake oil. The proof of this statement is justified by history.
    To gain a “Real Fiscal Outcome” in reference to -; Consumer, Public, Bank and Government expenditure relationship the answer lies in the FALGAFT Plan = an Economic Platform.
    Perhaps it is time for a New Vision of Economic performance.

  2. It has been evident for some time that the IMF and the other members of the troika are out of sync on austerity, both in the bailout countries and in the eurozone generally. Back in 2010, the IMF produced evidence essentially debunking the expansionary fiscal contraction myth (http://www.imf.org/external/pubs/ft/weo/2010/02/pdf/c3.pdf). Ireland is often unfairly used as a poster child for this myth due to the successful austerity in the 1980s, but the success had more to do with Lawson boom in the UK than domestic factors. Even the original academic work supporting the expansionary fiscal contraction hypothesis admitted that confidence effects would likely only mitigate the negative impact of austerity. German politicians persist in advocating the expansionary fiscal contraction hypothesis, despite the lack of evidence to support it. The only conclusion is that it is an article of faith or an ideology.

    The difference of opinion between the IMF and rest of the troika has led to mixed messages here in Ireland. When questioned on what would be the correct response should Ireland miss its fiscal targets, the IMF said the best thing to do would be to stick with the original plan. The Commission on the other hand said that further austerity would have to be administered to ensure the next set of target are met.

    While Ireland is not only meeting but surpassing the fiscal targets laid down by the troika, the debate is academic. But should the situation change, my money would be on the Commission getting its way, as the IMF have repeatedly been shown up to be the weakest member of the troika. Which is a shame, because they appear to be the most on the ball.

  3. Mathieu P.

    I trust that Angela Merkel is fully aware of this. The flaw is to assume that her sole goal is to keep Greece on track. It seems that her objective function is rather to maximize the pain Greece has to bear under the constraint of keeping the eurozone (minus Greece) together.
    The pain maximization is, I suppose, there to deter other countries from ever treading the path Greece has gone.

    • Dan Asta

      @Mathieu
      I agree this may be the lesson Angela wants to deliver, but I fear it may have backfired. All we hear from Spain and Italy is a refusal to go the way of Greece. In other words, they will not become Angela’s whipping boys. We shall see if they are bluffing. I don’t believe Italy is.

  4. There’s a great book that says that too: 23 things they don’t tell you about capitalism. Well worth the read, promise! ;-)

  5. merijnknibbe

    The Baltic states Lithuania, Latvia and Estonia are trying to overcome the aftershock of the immense 2005-2007 boom by pursuing austerity. Estonia does, at the moment, least bad and is indeed the only of the three which increased taxes. But even Estonia seems to experience a double dip, right now: http://www.stat.ee/main-indicators

  6. Pingback: Hinweise des Tages | NachDenkSeiten – Die kritische Website

  7. Pingback: Trotz des eitlen Selbstlobs von Wolfgang Schäuble: Die Eurokrise ist massiv zurückgekehrt 111 | Klaus Gauger

  8. Have a look at the depression of 1920: US government almost cut expenditure in halve, decreased taxes and increased import duties to protect it’s own industry. In only 18 months the US economy was on the recovery path. And to add insult to injury, the Fed only started wit ‘Open Market Operations’ in 1922, well after the US economy had recovered. The unexplainable explained here: https://www.youtube.com/watch?v=czcUmnsprQI

  9. Pingback: Trotz des eitlen Selbstlobs von Wolfgang Schäuble: Die Eurokrise ist massiv zurückgekehrt 136 | A BLOG FOR NONCONFORMISTS

  10. I did some calculations on my new blog trying to analysis what the consequences of the high multipliers are for economic development in crisis countries examining the example of Spain. The results are pretty bad implying that Spain will have to endure another 15% loss of gdp due to fiscal cuts that would bring it back to the 3% Maastricht criterion (and that is is low goal). Here is the link to my blog and more detailed calculations: It is in German though: http://makrointelligenz.blogspot.de/2012/10/austeritatspolitik-bei-einem.html