A problem of multiplication
If Spain cuts public spending and raises its taxes more than it has already, will that worsen its recession, and if so how much? Should Barack Obama’s stimulus of 2009 have been bigger or smaller? Are David Cameron’s continuing efforts to cut Britain’s budget deficit helping or hurting? They’re variants of a question economists have been asking for years: How big is the “fiscal multiplier”?
The fiscal multiplier is a measure of the effect that cuts in taxes or increases in public spending will have on a country’s GDP. If a $1 billion increase in the budget deficit expands output by $1 billion, the multiplier is one. If output doesn’t change, the multiplier is zero. Many economists think the multiplier is one or more. Most think it’s positive, but a few think it’s negative—i.e., that austerity actually helps the economy rather than hurting it. Most of today’s arguments about budgetary policy boil down to this disagreement.
A section of the IMF’s new World Economic Outlook (pdf, p. 41), published last week, is causing a stir because it says the multiplier is higher than the Fund’s economists previously thought—somewhere between 0.9 and 1.7, rather than around 0.5. That’s a big deal. It would make tightening fiscal policy during a recession a lot more costly, implying that Spain and others are overdoing the austerity. It would imply that Obama’s $800 billion stimulus helped a lot, and that it would have worked even better if it had been bigger still.
Sadly, the IMF’s new estimate doesn’t settle anything. The statistical method is questionable (as statistical methods usually are). The Financial Times took more recent figures and a slightly different group of countries and found that when you crunch the numbers the same way as the Fund, 0.5 doesn’t look so wrong after all (paywall).
Actually, the problem goes deeper than that. First, economies aren’t all alike, so fiscal multipliers are bound to differ from country to country. Even in principle, there’s no one, true multiplier (and it’s hard to see what use an average would be). Second, economies change over time so estimates based on the past may be out of date. Third, economies have countless moving parts so identifying the influence of the budget deficit on its own is all but impossible. If monetary policy tightens in response to a bigger budget deficit, you’d expect the fiscal multiplier to be zero regardless.
Then again, what does “fiscal policy” mean? You can add $1 billion to the budget deficit by cutting income taxes, cutting payroll taxes, cutting sales taxes, creating new tax shelters, subsidizing investment, extending employment benefits, building bridges, buying munitions, or giving cash support to lower tiers of government—to name just a few. Nobody thinks the multiplier would be the same in each case, and that’s before you start thinking about second- or third-round effects.
The dismal “science”
In case you hadn’t noticed, economists have strong views on the subject despite the lack of statistical proof. (So much for economics being a “science”.) There’s a firm consensus that the short-term public-spending multiplier is well above zero. Most macroeconomists would put the number for increased public investment, say, at one or higher. Most believe the multiplier for tax cuts is lower than the multiplier for increased public spending. But often they base these opinions on what’s theoretically plausible and on casual observation (of Britain, for instance, which chose austerity and has a double-dip recession to show for it), not on rigorous analysis.
The same goes for the dissenters, of course. They have their own unprovable theoretical convictions and favorite examples. They can point to countries like Estonia, which bounced back strongly despite (or because of) tight fiscal control. But these dissenting “austerians” (as Paul Krugman calls them) are in the minority.
Most economists agree about something else too: Today’s circumstances are especially dangerous and likely make fiscal policy more powerful than usual. Managing an economy is usually a mix of fiscal and monetary policy, but right now little or no scope remains for straightforward monetary stimulus. Interest rates have already been cut almost to zero, so conventional monetary easing can’t be used to offset the effects of fiscal tightening. (Unconventional monetary policy—quantitative easing, i.e., in effect, printing more money—has its own drawbacks.)
Some studies point to cases where fiscal tightening, especially in the form of spending cuts rather than tax increases, hasn’t caused output to drop much. Austerity can even be expansionary—a negative multiplier—it’s argued, if done the right way (pdf). On closer examination (pdf), other factors usually turn out to have played a part: if not monetary accommodation, as just mentioned, then strong external demand (pdf). But exports aren’t buoyant when demand is down everywhere, and countries in the euro area can’t improve their competitiveness by devaluing their currencies.
No pain, no gain?
Overall, then, the conclusion stands: At the moment, fiscal tightening hurts more than usual, and shouldn’t be rushed. Even so, some countries still have to ask, what’s the alternative? At some high level of public debt—another crucial number, as hard to nail down as the elusive multiplier—financial markets will refuse to finance further borrowing except at punitive interest rates. If investors aren’t willing to extend more credit, belt-tightening is the only option, regardless of the impact on growth. (Well, there is another option, of course: default on the debt.)
Greece, yet again the focus of Europe’s anxieties, finds itself in that position. At last week’s meetings in Tokyo, IMF chief Christine Lagarde said Athens should be given more time to meet its fiscal targets—a position consistent with the view that Greece (a) has already tightened a lot, (b) is in a deep recession, and (c) has a big fiscal multiplier. But to consolidate more slowly Greece would need new credit or further write-downs of existing debt or both. Private investors have had enough, and Germany’s finance minister Wolfgang Schäuble, who sparred with Lagarde publicly in Tokyo, didn’t seem keen to help.
The IMF’s new view that fiscal consolidation needs to be done patiently, financial markets permitting, looks right and reflects the professional consensus, even if it can’t be proven. But Greece is still staring into the abyss, Spain’s not far behind, and Europe apparently has no plans to do anything about it.