More on multipliers: why does it matter?

The IMF's reassessment of the "fiscal multiplier" has sparked off multiple reactions in the economics blogosphere both in the US and UK. My initial reaction is here. Meanwhile, Chris Giles at the FT has weighed in, attempting to demonstrate that the IMF's analysis is not robust. I'd like to step back a bit now from the IMF piece (I'll return to it later) and explain why this matters.


As I discuss here, in mid-2010 the international economic policymaking community, led by the IMF, and very much influenced by the new Coalition governnment in the UK, executed what became known as the "pivot" to fiscal consolidation. Pretty much everyone agreed that it was necessary to reduce budget deficits; the question was how quickly, and what the damage, if any, to growth would be. As a reminder for those new to this debate, the "multiplier" measures this: it is the reduction in output resulting from a given reduction in the budget deficit (so if the multiplier is 1, then a reduction in the budget deficit of 1% of GDP reduces output by 1%). On this question, broadly, there were three camps.

First, a small group of economists argued both on theoretical and empirical grounds that fiscal consolidation wouldn't reduce growth at all - indeed it might even enhance growth (so the multiplier would be zero or positive). The doctrine of "expansionary fiscal contraction" argued that tightening fiscal policy could, through exchange rate and confidence effects, actually increase demand and growth; a paper by Alesina and Ardagna was particularly influential in this respect. While this was always a minority view among empirical macroeconomists, this research was quickly picked up on by those politicians who wanted aggressive deficit cuts, in both the UK and EU. For example, Matthew Hancock MP, formerly George Osborne's Chief of Staff (and now Minister for Skills), claimed:

"I discovered that research into dozens of past fiscal tightenings shows that, more often than not, growth doesn't fall but accelerates."

Somewhat more tentatively, the UK Treasury argued (although I doubt any Treasury official believed this for a moment) in the 2010 Emergency Budget that 

" These [the wider effects of fiscal consolidation] will tend to boost demand growth, could improve the underlying performance of the economy and could even be sufficiently strong to outweigh the negative effects".

So while this view was never very credible economically, it certainly influenced policy.

The second view was that taken by mainstream economic modellers and forecasters, including most importantly the IMF, but also the UK Office for Budget Responsibility, the Bank of England and indeed us here at NIESR. This was that the negative impact of fiscal consolidation on growth would be significant, but not disastrous. The IMF never believed the Alesina and Ardegna results; in October 2010 the Fund concluded that:

"Fiscal consolidation typically lowers growth in the short term. Using a new data set, we find that after two years, a budget deficit cut of 1 percent of GDP tends to lower output by about ½ percent and raise the unemployment rate by ⅓ percentage point."

These estimates were based on historical experience over the last three decades; using similar data, NIESR's model incorporate similar estimates. And when estimating the impact of the UK fiscal consolidation programme announced in June 2010, the OBR also used very similar estimates. This is hardly surprising: as Duncan Weldon points out in a neat bit of detective work, the OBR's multiplier estimates are based primarily on one IMF paper, as well as two papers from NIESR researchers. 

There was, however, a third view. This  was advanced most strongly by Paul Krugman and Brad Delong in the US, and here by Martin Wolf (in the columns of the FT) and Simon Wren-Lewis; it was that the experience of the last three decades (except, perhaps, in Japan) was not relevant to that of a world where monetary policy was limited by the zero lower bound on interest rates (or, for those like Scott Sumner who think that monetary policy could have been even more aggressive, by political or institutional constraints).  In such a world, multipliers would be significantly higher, and almost certainly greater than one.   Simon explains why here, concluding perceptively that this may be "an occasion where thinking about macroeconomic theory can be rather more useful than naively following the evidence of the past."  Meanwhile, Antonia Fatas and Ilian Mihov argued on empirical grounds that the Fund and others were consistently underestimating the size of the multiplier, as they explain here

So what then is the significance of the IMF analysis published this week?  For reference, I will repeat the key paragraph:

"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, in contrast to the Fund's 2010 view, multipliers are much larger than 0.5 - large enough to have a very substantial, and negative, impact on growth.  

Now, the IMF analysis, in isolation, is clearly not definitive "proof" that multipliers are now 0.9 to 1.7 - and even if it was, that would not "prove" anything about multipliers in a specific country. I won't attempt to arbitrate between the Fund and Chris Giles on econometrics, except to say that his detailed analysis confirms my view, which he also reports, that cross-country regressions are typically not very robust, and in general can be used to make pretty much any argument you like (indeed, this is precisely the same reason I never believed the Alesina and Ardegna result either).   So while I think the new Fund analysis does broadly support the view that in general terms one of the reasons the Fund's forecasts (in common with pretty much everyone else's) have been too optimistic is that they underestimated the negative impact of fiscal consolidation, I wouldn't place much weight on them in isolation. 

But what is clear  - particularly in the last sentence I quote above-  is that the Fund has now accepted that the balance of the argument, both theoretical and empirical, has tilted decisively in favour of the third group of economists above. It's not just about one set of regressions; these are simply a further piece of supportive and confirmatory evidence supporting those of us who argued that aggressive fiscal consolidation was an unnecessary and dangerous gamble, with very serious downsides.  The Fund is now squarely in this camp.  This is a major intellectual shift - as Isabella Kaminska writes, no wonder Paul Krugman is feeling "smuggish".  But leaving aside the economists' debate, how should this affect policy? In the UK, I can think of two key implications:

  • the first relates to the current debate about how large the UK "output gap" is and hence how much scope there is for expansionary policy (both fiscal and monetary). The UK economy has essentially seen zero growth for the past two years.  Some analysts -  Chris Giles being the most credible, but the OBR has also taken this line - have argued that given the sort of multipliers assumed by the OBR and IMF, fiscal consolidation can't explain much of this growth shortfall, so it must be something else: supply side weakness, commodity prices, and so on, meaning that changing fiscal policy might not do much good.  If, however, multipliers were in fact much higher, then fiscal consolidation is indeed the main reason for weak growth; and correspondingly, the scope for boosting growth through expansionary policy is much greater;
  • the second relates very specifically to the OBR.  As Duncan pointed out, the OBR's excessively optimistic forecasts were explicitly based on multipliers derived from IMF research. The IMF has now explicitly changed its mind; the OBR's position is no longer tenable.  If it wants to retain its credibility as an economic forecaster independent of government, it needs to examine its assumptions and methodology, both retrospectively and prospectively, on the impact of fiscal consolidation on growth.  The December OBR forecast should include at a minimum both a reassessment of its forecast record, in the light of the Fund's change of view, and an assessment going forward of the impact of different multiplier assumptions on growth. 

Arguably, however, far more important than the UK debate- and far more central to the concerns of the IMF - are the implication for the eurozone, and in particular for the current adjustment programmes in Greece, Spain, Italy, Ireland and Portugal.  Several months ago, I argued:

Clearly long-run solvency is also essential.   But, in Spain and Italy, trying to hit arbitrary short-run deficit targets, as proposed by the European Commission, is likely if anything to be counterproductive to the objective of long-run sustainability.   Spain’s long-term fiscal position, for example, is relatively strong; what it needs to ensure that remains the case is decent levels of economic growth, and what it needs for that is structural reform, especially labour market reform. Both politically and economically, such reforms will be both less painful and more effective if fiscal consolidation is much slower, as I argue here.   These arguments on timing hold good even if multipliers and hysteresis effects are relatively small; if such effects are large – and there is every reason to believe that in European labour markets hysteresis effects are of profound macroeconomic importance – then they are even more compelling, 

The IMF clearly now agrees with this, as Christine Lagarde has made clear in the case of Greece. They need now to point out to the European Commission and the German government as forcefully as possible that if they do not belatedly come to their senses, they will run the economies of Southern Europe - and possibly the euro itself - into the ground on the basis of an economic analysis that has now been discredited both theoretically and empirically.

Finally, what about us here at NIESR?  Well, we did produce this, examining why the multiplier might be larger in current circumstances, and examining the implications; precisely what the OBR should have done. But, more broadly, when presenting NIESR forecasts in 2011, I was frequently asked why we were rather pessimistic relative to most other forecasters, and certainly the OBR.  My response was often that what I worried about most was not that our model's predictions looked rather gloomy; it was that the economists I took most seriously - those listed above, who don't use quantitative models - thought our model was far too optimistic. And so it proved.    

Comments

Unknown's picture

Fascinating thank you, is there any way of calculating the gains on the supply side from fiscal contraction? Presumably there might be some - how and when those gains kick in would be doubtless difficult to ascertain but has any work been done on it.Phillip Blond

Sandwichman's picture

"I discovered that research into dozens of past fiscal tightenings shows that, more often than not, growth doesn't fall but accelerates."

Another one of Matthew Hancock's profound insights: "As an economist working in politics, I’m sometimes shocked at some of the arguments about the economy."

http://blogs.spectator.co.uk/coffeehouse/2011/02/milibands-economic-imma...

Of course, he's only "shocked" when those arguments don't conform to his ideological priors.

Robert's picture

This comment has been removed by the author.

Robert's picture

Any definition of "the multiplier" is misleading. In the IS-LM model, New Keynesian models and reality there are three fiscal multipliers. All existing theories in which the multipliers are not all zero and the data imply that the effect of a spending cut on output is greater than the effect of a tax increase. The difference is the balanced budget multiplier. By your definition this would be meaningless -- something divided by zero by definition. The evidence does not support the assumption that the balanced budget multiplier must be zero. \

Here a lot of the evidence is the one episode of the tax financed US war effort in Korea, but there is indirect evidence from differing estimates of the effects of deficit financed spending increases and of tax cuts.

I think it would be better to have provided no definition than to have presented only one. Recall the heated debate over the composition of the ARRA (US 2009 stimulus) which would be incomprehensible if it were agreed that there is one and only one fiscal multiplier)

Honestly, this comment has been edited to make it more nearly polite. Fans of rudeness can read my original effort here
http://rjwaldmann.blogspot.it/2012/10/ruder-comment-on-portes.html

(warning very safe for work, nasty, and pedantic).

Robert's picture

I have another objection. You claim without making the case that Spain needs "structural reform, especially labour market reform."

My impression is that Spain enacted quite radical labour market reform starting decades ago. In particular the extremely rigid Franco era firing restrictions were relaxed for newly hired workers by the Suarez government and then still more by the Gonzales government. This reform in Spain was enacted long long before the Shroeder reforms in Germany.

The timing is very important, since all the reforms preserved employment protection for those employed at the time of the reform (IIRC). Spain, unlike Germany, had a huge number of workers without strong employment security -- workers who had been hired since the reforms and not shifted to the protected employment relationship.

This made the extremely rapid increase in Spanish unemployment possible.

One might also argue that what Spain needs is deregulation of banking so that foreign banks can open offices in Spain and so the international flow of capital is not hindered by the highly regulated protected Spanish banking system. I don't think that you are one who would make that argument (it is a parody -- I've been in Spain and seen branches of UK based banks all over). However, I honestly don't see why the argument for labour market deregulation is so much stronger than the argument that Spain wouldn't be in such trouble if only they had been able to attract foreign financial investment (again this is a parody-- I am not suggesting that you (or indeed any sentient being) would make that argument).

Why do you think that Spain needs further labour market reforms ? It is an important question, yet you seem to consider the answer completely obvious ?

ejh's picture

The IMF clearly now agrees with this, as Christine Lagarde has made clear in the case of Greece

But not in fact in the case of Spain, where only last week she described the Rajoy programme as "very, very brave". I think people who, like myself, actually live in Spain, may be forgiven for waiting until there is a shift in actual policy, rather than an apparent intellectual shift, before considering that anything so "clear" has occurred.

(As for Spain needing further labour market reform - do me a favour. What we need is jobs.)

Postkey's picture

"Infrastructure investment spending is 3 times more effective in increasing 'growth' than tax cuts."
John Cridland of the CBI.

jck's picture

"...multiplier identities suffer from a ‘lack of any innate theoretical, or behavioural, content’ so that accounts of the underlying dynamic processes based on them ‘are at best misleading and often wrong’."
Charles Goodhart

Jonathan Portes's picture

In the context of a discussion of the Fund's analysis, the general political/policy debate, and the implications of both, I think my simple definition is clear and intuitive (it is after all what the Fund is talking about and what the debate is mostly about). Of course it's not that simple, and Simon and Ian Mulheirn have written a lot about balanced budget multipliers: anyone who wants a proper exposition of the theory can follow the very clearly signposted link to Simon

Jonathan Portes's picture

I do think it is completely obvious from looking at what's happened in Spain that the labour market needs radical reform; obviously it's not explained in this post. Try my El Pais article here: http://notthetreasuryview.blogspot.co.uk/2012/03/fiscal-policy-and-labou...

Essentially I am making the same point you correctly make above: misguided "reforms" in Spain created a two-tier labour market, with protected insiders (mostly white middle aged men) and unprotected outsiders (younger and more likely to be female or immigrants) who were very easy to fire in a downturn. They would have been much better off with a lower, but more uniform, level of protection, as in the UK.

Charles Butler's picture

A good deal of radical reform in Spain could be foregone merely by lowering the retirement age... instead of raising it.

Jonathan Hopkin's picture

Spain's labour institutions are obviously not ideal, but where is the evidence that wholesale liberalization would create jobs? There is very little geographical labour mobility in Spain, and some areas have quite low unemployment normally (the same goes for Italy). Do you really think investors will flood Andalusia with jobs if firing costs are slashed? The answer lies elsewhere, and the apparent correlation between labour protection and unemployment is probably driven by politics. Reducing labour protections when there are no alternative jobs for the potential firees is obviously going to lead to huge protests, which is why it hasn't happened until the crisis (and still hasn't really).

smarthomeman's picture

Why on earth does everyone seem to be making the simplifying assumption that the multiplier will stay fixed over the unfolding cycle? As a businessman my instincts tell me otherwise. I think that things are improving over time.

A possible explanation for this is that when the financial crisis first hit, the downturn was so severe that the private sector had no idea how to react. As time has gone on, lessons have been learned, and the effects of the belt-tightening have been more successfully mitigated.

Basing future economic policy on the historic data from the early years of the crisis may be a dangerous mistake.

Stephen Henderson's picture

that sounds similar to the idea that:
"OK I'm in a hole"
"Perhaps digging was the wrong plan before"
"But maybe if I dig now things will work out better"

somnus11258's picture

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