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The IMF Weighs in on the Fiscal Multiplier Debate

In its latest World Economic Outlook (WEO), the International Monetary Fund (IMF) has added its own perspective on the current global slowdown.  However, unlike other policy makers and thought leaders who have focused on "things to do," the IMF has come up with "things not to do."

In its latest World Economic Outlook (WEO), the International Monetary Fund (IMF) has added its own perspective on the current global slowdown.  However, unlike other policy makers and thought leaders who have focused on "things to do," the IMF has come up with "things not to do.

Unlike the U.S. Federal Reserve and the European Central Bank, which are prepared to do "whatever it takes" to help boost markets, the IMF recommends that countries should limit austerity. It argues in the WEO that fiscal cut-backs have had a larger than expected negative short-term multiplier effects on output and that putting a brake on austerity is the best cure. Accordingly, they urge that Greece should be given more time to implement its austerity program and that other European countries should refrain from fresh budget cuts, or tax rises if growth weakens.

Based on evidence from 28 countries, the IMF warns the proponents of austerity the damage it has done to growth.  By applying the fiscal multiplier concept - the one-off impact of a given deterioration in the balance between revenue and expenditure - it concludes that the resulting fiscal multipliers have been much greater than normal; in the rage of 0.9 to 1.7%. Put in terms of real economic impact, multipliers in this range mean that even a 5% tightening of GDP would lower overall growth by between 4.5% and 8.5%.

I would argue that the only way to justify IMF's policy direction is in the context of the current state of affairs.  With interest rates near zero, the effectiveness of monetary policy is negligible, making fiscal policy the only option to boost struggling economies. In these circumstances, austerity would indeed be counterproductive.

However, I do not necessarily agree with IMF's view, and instead favor a sharper reduction in fiscal deficit, sooner than later. The effect of such a sharp adjustment on economic output would be temporary, a one-off occurrence in which an increase in the debt to GDP ratio would be short-term only. Taking into consideration crucial structural changes, (like tax reforms which can widen the tax net along with prudent spending by the government), the economy would more than likely recover soon after such an event. .. On the other hand, a more gradual adjustment implies a prolonged period of low or stagnant growth, with the short-term fall in debt ratios being only a temporary phenomenon and not sustaining for the years to come.

What is most important is the level of debt, and the decision for a gradual adjustment vis-à-vis a sharper adjustment can be contingent on this. High debt tends to have a negative impact on economy (generally in excess of 90% of GDP for developed economies and even lesser for emerging economies as argued by Reinhart and Rogoff). It impacts growth by distorting taxes and lower government investments as government has to arrange for higher debt service payments and principal, if any; or financial repression and distortion in the financial markets due to government interference in market functioning.

In case it defaults on any payments, or there is a chance of default, future interest rates on further borrowing rises, as investors charge a higher premium as compensation for higher risk taking. This starts a vicious cycle of increasing domestic interest rates, thereby crowding out private investment and economic activity, pushing down growth further.

In addition, high debt also implies shifting the debt burden on future generation, thus impairing future growth prospects. Therefore, for countries with a very high debt level, such as Greece and other EU nations, (the current countries in question, namely Europe), fiscal austerity is the cure, even though it comes with some short-term pains.

The optimal timing for all practical purpose however, depends on the patience of voters to confront a prolonged adjustment effort and the patience of financial markets to continue to finance the government's deficits.

IMF's warning on too much austerity is more to give a short-term respite to the struggling countries. In addition, it probably prepares the ground for the upcoming fiscal cliff in US where the Fund would likely urge the US congress to say no to austerity and continue with the current tax cuts. If there is an inherent structural deficit (read high debt levels) in the country, kicking the can is not the ideal solution. By that you would just be deferring your current problem to an even bigger one, but not solving it.


Well researched and do agree with your comments on ineffectiveness of the monetary policy and also fiscal deficit needs to be curtailed.
"This Time is Different" (Reinhart and Rogoff) provides good perspective on how each time establishment convinces its masses on how they are in control of situation. Given the complexity of such issues even though austerity may be recommended any measure in such direction will lead into a deflationary trap, as was witnessed in late 2008, this will potentially wipe out current establishment world over, therefore political bosses will try to generate inflation so as to reduce the general debt levels over period of time. Problem is that this did not work for Japan in last 25 years but that is what I guess establishment will try and do and one way I guess will be to keep political temperatures dangerously hot, no wonder this time is different.

Thanks Maninder. Japan indeed is the best example, but given the technical recession in Europe, even inflation can be ruled out in the recent months to come. Ineffectiveness of monetary policy can neither be a necessary and/or a sufficient condition for a fiscal stimulus induced growth. The growth in that case can only be temporary. All depends on the pile of debt you are sitting upon.

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