In its recent six-monthly World Economic Outlook report, the IMF included a section examining why it, and just about all other economic forecasters, had been consistently too optimistic in its forecasts of economic growth over the last three years. This has been particularly painful for those governments undergoing austerity programmes, where the shortfall in growth relative to forecasts has meant larger deficits and the need for further austerity programmes.
The very clear conclusion is that their estimates of the fiscal policy multipliers have been far too low. The fiscal policy multiplier measures the degree to which the economy is impacted by a change in fiscal policy (either a tightening of policy created by raising taxes or cutting spending, or an easing of policy created by cutting taxes or boosting spending). For the 30 years up to 2007, economists had identified this multiplier to have a value of about 0.5, so that a fiscal tightening equivalent to 1% of GDP, could be expected to reduce the growth rate of the economy as a whole by about 0.5%. However since 2008 this previously stable relationship has changed and the multipliers now appear to range between 0.9 and 1.7. Further, it was those economies which underwent greater austerity which saw the higher multipliers on final economic demand.
For the UK, this is unfortunate news for Mr Osborne, since this is exactly what his Labour opponent, Mr Balls, has been saying for some time. It means that the steady approach to austerity at about a 1% rate of tightening per annum, that he adopted is having a greater effect on the overall economic growth than he envisaged.
The higher multipliers identified where there is greater austerity is probably due to an economic confidence effect, as the deep cuts in government spending and large increases in taxes will lead everyone to believe that recession is imminent and thus curtail their spending immediately. For Greece, Spain and Portugal this goes some way to understanding why their previous austerity plans have not worked – those who are bailing them out have demanded that they get their fiscal houses in order in a short space of time and this has resulted in even weaker economies and larger than expected budget deficits.
At the same time as the fiscal policy multipliers have risen, so the monetary policy multipliers appear to have fallen. Cutting interest rates from 6% to 5% has a far more dramatic effect on the economy than cutting the from 1% to 0% and Quantitative Easing policies are generally agreed to work best the first time they are used and have less effect with each repeated use. Keynes is often attributed with describing such policies as “pushing on a string”. Central Banks are now having to make significant monetary policy changes to have any effect on the economy.
So the world finds itself in a real policy bind. The area of policy being tightened (fiscal) is working too effectively on growth, and the area of policy being eased (monetary) is not working at all effectively on growth. This approach does help to provide an understanding of why economic growth is consistently disappointing the economic forecasters. The policy implications are at odds with conventional wisdom – governments should adopt a slow but sure approach to austerity, and a more effective form of Quantitative Easing needs to be adopted with the concept of the Modern Debt Jubilee (espoused here), appearing to be an increasingly interesting idea.