Thursday, January 31, 2013

IMF: Austerity Has Failed Europe
In a recently published working paper, IMF chief economist Olivier Blanchard acknowledged that the IMF under-estimated the size of the macroeconomic multiplier. The result is that the negative economic effects of austerity in the Eurozone have also been under-estimated.  Whereas, the IMF estimated a GDP contraction of $0.50 for every dollar of spending cuts, the real contraction was in fact $1.50 for every dollar of spending cuts. According to the Washington Post, this amounts to an earthquake in policy circles. The allegations are that the IMF intentionally under-estimated the negative effects that austerity would have on Greece and its Eurozone neighbors.

Notwithstanding, words of caution were first issued by the IMF in a 2011 study which contested the idea of expansionary austerity, calling studies that support the concept biased in favor of over-estimating the expansionary effects that brought on by expanded private consumption expected to result from spending reductions.

At the center of the IMF's under-estimation, is an overlooking of the fact that multipliers change over time. In its conclusion, the study cautions that, in general, multipliers grow during a crisis. "It seems safe for the time being, when thinking about fiscal consolidation, to assume higher multipliers than before the crisis." According to the study's conclusion, this change in multiplier size is due in part to changes in credit availability. Apparently, due to unexpected changes in the size of the multiplier, the paradox of thrift was - at least in this specific case - true after all.
This paper investigates the  relation between growth forecast errors and planned fiscal consolidation during the crisis. We find that, in advanced economies, stronger planned fiscal  consolidation has been associated with lower growth than expected, with the relation being  particularly strong, both statistically and economically, early in the crisis. A natural  interpretation is that fiscal multipliers were substantially higher than implicitly assumed by  forecasters. The weaker relation in more recent years may reflect in part learning by forecasters and in part smaller multipliers than in the early years of the crisis.
Max Berre is an economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.

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