I’ve commented numerous times over the the last 3 years that I considered the IMF’s position on Europe dangerously misguided as I felt it was based more on ideology than evidential analysis ( see more here ). I have posted on a near-dialy basis over the last 2 years on the slow downfall of the euro-zone under what I considered to be a policy framework that was doing more harm than good due, in part, to the fact that it underestimated the feedback from on-going government sector austerity in an environment of private sector balance-sheet retrenchment. ( See more here )
Back in December 2011 I made the prediction that:
.. while there is no credible counter-balance for the effects of supra-European austerity any attempt to implement the new “fiscal compact” will make Europe’s economic issues worse. The continent is already on the way to recession and unless we see some additional action from the ECB, or a huge swing against this new framework, the push to implement the outcomes of the summit will simply accelerate that outcome. My assumption is that, if Europe does ratify this framework (there are a few stragglers), after 12-24 months of trying the effect will be so disastrous that they will eventually give up. But until then my base case for Europe is a significantly worse economic outcome.
Since Christine Lagarde took over as the head of the IMF I have noted a quite a few times that the organisation was slowly steering itself away from it’s previous position of “expansionary fiscal consolidation” and appeared to be finally taking notice of its own research that demonstrated its errors. Of note in recent weeks is that the IMF has been offering new guidance to the Eurozone which is in-line with my previous prediction.
The International Monetary Fund and European Commission officials have encouraged France and its eurozone partners not to fixate on deficit reduction targets if it would exacerbate the bloc’s debt crisis. The head of an IMF mission in France, Edward Gardner, urged officials in Paris last week to consider their 2013 budget targets “in a broader European context.”
The IMF and the EU Commission expect the French public deficit to amount to 3.5 percent of gross domestic product (GDP) next year. They do not believe France can reach its 3.0 percent goal, the eurozone limit, without additional measures that could aggravate an already tenuous economic situation.
“The credibility of the medium term orientation policy” was more important than a specific deficit target, Gardner told reporters.
Loosening the criteria would “be more effective, more credible in a coordinated fashion” across the 17-nation eurozone, he suggested.
Of greater note, however, is the latest research from the IMF and statements from their chief economist that appears to suggest that they simply didn’t know what they were doing.
Consider it a mea culpa submerged in a deep pool of calculus and regression analysis: The International Monetary Fund’s top economist today acknowledged that the fund blew its forecasts for Greece and other European economies because it did not fully understand how government austerity efforts would undermine economic growth.
The new and highly technical paper looks again at the issue of fiscal multipliers – the impact that a rise or fall in government spending or tax collection has on a country’s economic output.
“Forecasters significantly underestimated the increase in unemployment and the decline in domestic demand associated with fiscal consolidation,” Blanchard and co-author Daniel Leigh, a fund economist, wrote in the paper.
That somewhat dry conclusion sums up what amounts to a tempest in econometric circles. The fund has been accused of intentionally underestimating the effects of austerity in Greece to make its programs palatable, at least on paper; fund officials have argued that it was its European partners, particularly Germany, who insisted on deeper, faster cuts. The evolving research on multipliers may have helped shift the tone of the debate in countries like Spain and Portugal, where a slower pace of deficit control has been advocated.
A reading of the conclusion of the actual report ( available below ) is quite revealing as it shows that the IMF teams appear to have taken non-dynamic estimates of the outcomes of their programs under the assumption that even the most radical cuts to the government sector would always deliver a net economic positive.
What do our results imply about actual multipliers? Our results suggest that actual fiscal multipliers have been larger than forecasters assumed. But what did forecasters assume? Answering this question is not easy, since forecasters use models in which fiscal multipliers are implicit and depend on the composition of the fiscal adjustment and other economic conditions.
We believe, however, that a reasonable case can be made that the multipliers used at the start of the crisis averaged about 0.5. A number of studies based on precrisis data for advanced economies indicate actual multipliers of roughly 0.5, and it is plausible that forecasters, on average, made assumptions consistent with this evidence. The October 2008 WEO chapter on fiscal policy presents multiplier estimates for 21 advanced economies during 1970–2007 averaging 0.5 within three years (IMF, 2008, p. 177). Similarly, the October 2010 WEO (IMF, 2010d) chapter on fiscal consolidation presents multiplier estimates for 15 advanced economies during 1979–2009 averaging 0.5 percent within two years. This evidence, and our finding of no gap, on average, between assumed and actual fiscal multipliers before the crisis, would imply that multipliers assumed prior to the crisis were around 0.5. Relatedly, the March 2009 IMF staff note prepared for the G-20 Ministerial Meeting reports IMF staff assumptions regarding fiscal multipliers based on estimates from various studies. In particular, it contains an assessment of the impact of the 2008–10 fiscal expansion on growth based on assumed multipliers of 0.3–0.5 for revenue and 0.3–1.8 for government spending (IMF, 2009b, p. 32)
If we put this together, and use the range of coefficients reported in our tables, this suggests that actual multipliers were substantially above 1 early in the crisis. The smaller coefficient we find for forecasts made in 2011 and 2012 could reflect smaller actual multipliers or partial learning by forecasters regarding the effects of fiscal policy. A decline in actual multipliers, despite the still-constraining zero lower bound, could reflect an easing of credit constraints faced by firms and households, and less economic slack in a number of economies relative to 2009–10.
So they got it wrong and have now, in part, acknowledge that fact so we should see adjustments to their existing programs to take into account this new information and the fact that fiscal multipliers are 1 ) dynamic; and 2 ) capable of producing self-defeating economic outcomes. Let’s hope that is the case, and recent advice to the EU suggest that may be, but the outstanding question for me it whether the other members of Europe’s troika are willing to listen to them if they do.
Full report below.