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Austerity Policy Leads to Low Economic Growth, 43pp
by IMF Working Paper
Monday Jun 24th, 2013 8:23 AM
This IMF Working Paper published on January 31, 2013 was co-authored by Olivier Blanchard, chief economist of the IMF. The IMF erred in estimating its fiscal multiplier and the effect of state spending cuts in deficit countries. The report was greeted by the silence of German and American media.
Austerity Policy Leads to Low Economic Growth
Working Paper of the IMF - January 31, 2013, 43 pp Olivier Blanchard and Daniel Leigh(summary published on Blatter website)

http://www.blaetter.de/archiv/jahrgaenge/dokumente/%C2%BBstrenge-sparpolitik-steht-in-zusammenhang-mit-geringerem-wachstum%C2%AB?print

I. Introduction With many economies in fiscal consolidation mode, there has been an intense debate about the size of fiscal multipliers. At the same time, activity has disappointed in a number of economies undertaking fiscal consolidation. A natural question therefore is whether forecasters have underestimated fiscal multipliers, that is, the short-term effects of government spending cuts or ta x hikes on economic activity.

In a box published in the October 2012 World Economic Outlook (WEO; IMF, 2012b), we focused on this issue by regressing the forecast error for real GDP growth on forecasts of fiscal consolidation. Under rational expectations, and assuming that forecasters used the correct model for forecasting, the coefficient on the fiscal consolidation forecast should be zero. If, on the other hand, forecasters underestimated fiscal multipliers, there should be a negative relation between fiscal consolidation forecasts and subsequent growth forecast errors. In other words, in the latter case, growth disappointments should be larger in economies that planned greater fiscal cutbacks. This is what we found.

In the box published in October, we focused primarily on forecasts made for European economies in early 2010. The reason was simple: A number of large multiyear fiscal consolidation plans were announced then, particularly in Europe, and conditions for larger- than-normal multipliers were ripe.

First, because of the binding zero lower bound on nominal interest rates, central banks could not cut interest rates to offset the negative short-term effects of a fiscal consolidation on economic activity. Christiano, Eichenbaum, and Rebelo (2011) have shown, using a dynamic stochastic general equilibrium (DSGE) model, that under such conditions, fiscal multipliers can exceed 3.[1] Since episodes characterized by a binding zero lower bound (also referred to as “liquidity trap” episodes) have been rare, only a few empirical studies investigate fiscal multipliers under such conditions. Based on data for 27 economies during the 1930s—a 4 year period during which interest rates were at or near the zero lower bound—Almunia and others (2010) have concluded that fiscal multipliers were about 1.6.[2]

Second, lower output and lower income, together with a poorly functioning financial system, imply that consumption may have depended more on current than on future income, and that investment may have depended more on current than on future prof its, with both effects leading to larger multipliers (Eggertsson and Krugman, 2012).[3]

Third, and consistent with some of the above mechanisms, a number of empirical studies have found that fiscal multipliers are likely to be larger when there is a great deal of slack in the economy. Based on U.S. data, Auerbach and Gorodnichenko (2012b) have found that fiscal multipliers associated with government spending can fluctuate from being near zero in normal times to about 2.5 during recessions.[4] If fiscal multipliers were larger than normal and growth projections implicitly assumed multipliers more consistent with normal times, then growth forecast errors should be systematically correlated with fiscal consolidation forecasts.

our findings that short-term fiscal multipliers have been larger than expected do not have mechanical implications for the conduct of fiscal policy. Some commentators interpreted our earlier box as implying that fiscal consolidation should be avoided altogether. This does not follow from our analysis. The short-term effects of fiscal policy on economic activity are only one of the many factors that need to be considered in determining the appropriate pace of fiscal consolidation for any single economy.

to read the full 43-page report/retraction by the chief economist of the IMF Olivier Blanchard published January 31, 2013 (and greeted with silence by the German and American media!), click on

http://www.imf.org/external/pubs/ft/wp/2013/wp1301.pdf