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IMF: Austerity is much worse for the economy than we thought

Earlier this week, the International Monetary Fund made a striking admission in its new World Economic Outlook. The IMF's 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 Greece and Portugal, are faring more poorly than their peers. But that doesn't actually prove anything—perhaps those countries are undertaking austerity because they'd run into economic trouble.

So, instead, Blanchard did something more subtle. He studied the IMF's 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 what's known as the "fiscal multiplier." Economists tend to agree that tax increases and spending cuts hurt growth. The question is how much they hurt growth—a 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 hamper growth significantly, then austerity could be ill-advised. Indeed, if the fiscal multiplier is really, really high in certain situations—such as during a downturn—then 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 the past few years than policymakers, including the IMF, had assumed. It's not 0.6. It's 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 growth—and not insisting on budget cuts. (Not surprisingly, Paul Krugman is claiming vindication, since this was his view all along.)

Yet it's worth noting that not everyone is convinced by the IMF's results. Over at the Financial Times, Chris Giles tried to replicate Blanchard's 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 they're special cases), the results are murkier:

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, it's 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 their belts. 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, that's a big change in attitude.