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Austerity Policy as Momentous Mistake
by Philipp Heimberger
Tuesday Jun 12th, 2018 5:16 PM
The IMF's austerity policy of the last years was misguided. That austerity policy led to intensified growth declines and increasing unemployment and did not reach its goal of permanently calming the financial markets. Public investments could raise economic growth both in the short- and long-term. State expenditures have a considerable influence on employment and growth.

By Philipp Heimberger

[This blog article published on November 20, 2014 is translated abridged from the German on the Internet,]

The demand for budget consolidation measures in the whole Euro zone from 2010 was a momentous mistake. A report on the political-economic recommendations of the IMF during the financial- and economic crisis published by the International Monetary Fund (IMF) came to that remarkable conclusion. The European Commission should take the IMF as an example and dismiss the one-sided austerity policy of the last years - especially through a coordinated expansion of public investments.


A comprehensive evaluative report (pdf) contains harsh self-criticism of the IMF's political-economic recommendations in the crisis years. The most important macro-economic critical points of the report could be briefly summarized:

• It was a momentous mistake that the IMF from 2010 promoted a policy of cutting state spending and tax hikes.

• The expectations of the IMF as to economic growth in 2010-2014 were systematically too optimistic. The reason for that is the misjudgment about the extent of the negative effects of the austerity policy on growth and employment.

• In the Euro zone, general institutional and macro-economic conditions prevailed in the last years where austerity policy had markedly negative consequences.

Given high economic unter-utilization, limited effectiveness of monetary measures and continuing rescheduling efforts of private households and businesses, the IMF should have been forced to expanded economic programs instead of urging austerity policy, particularly in countries with greater fiscal possibilities.

The IMF is commissioned with stabilizing international financial markets and awarding credits to countries with problems of refinancing on the financial markets. In the last years, the IMF was a central actor in the course of negotiating and converting crisis programs in the periphery-countries of the Euro zone.

The demands of the IMF for austerity policy all over the Euro zone are representative for the political-economic reaction to the crisis from 2010. The European Commission and the German government under Angela Merkel's leadership encouraged intensified austerity policy as the supposed European way out of the crisis.

The evaluations of the IMF's policy recommendations show the austerity policy of the last years was misguided. That austerity policy led to further growth declines and increasing unemployment and did not reach its goal of permanently calming the financial markets. The debt overload problematic in the Euro zone is unsolved and even worsened through the austerity policy. The poor growth development raised the state debt rates that are measured in percentages of the gross domestic product. Countries in the south of Europe impacted most severely by the crisis - Greece, Spain, Portugal and Italy - fell into a spiral of increasing indebtedness and decreasing inflation. The deflationary development now advancing in the Euro zone raises the real debt burden because the nominally fixed debts must be worked off with a rising Euro.


Like the European Commission, the IMF systematically estimated economic development in the Euro zone much too optimistically.

In April 2011 the IMF even predicted a better economic development in the Euro zone than in 2010. However the predictions afterwards had to be gradually revised downwards. After 2010 the economic situation in the Euro zone became more overcast than originally forecast by the IMF. According to the latest prediction from October 2014, the real 2014 gross domestic product will be below the 2011 level. For 2014, the forecast error amount to almost 6 percentage points compared to the predictions of April 2011 October 2014 which is equivalent to a reduced economic output of more than 550 billion Euros.

At the beginning of 2013, IMF chief economist Olivier Blanchard withy Daniel Leigh published the most regarded economic research paper of the last years (pdf). The authors show the IMF's forecast errors concerning economic growth were not accidental. Rather they were greatest in those countries that planned the most comprehensive austerity policy from 2010 - and conversely least where budget consolidation measures were hardly in the planning stage... The growth disappointments were greatest in those countries where the most extensive austerity policy was planned - and vice versa.


The economic debate on the height of the so-called fiscal multiplier is at the center. This indicates how much the gross domestic product changes in Euros when the state alters its spending- and revenue policies. The higher the multiplier, the more negative are the growth effects of the austerity policy.

In 2010 the expectation that austerity policy could even have a positive effect on growth and employment prevailed within the IMF, the European Commission and other organizations. Thus the belief that the fiscal multiplier could be negative or at least very low was accepted. This is based on the theoretical notion that budget consolidation measures lead to increasing the trust of households and businesses in the economic future and that would trigger a current boom in consumption and investments that would more than compensate for the direct negative effects of the austerity misadventure.

This notion of the salutary macro-economic nature of indirect effects proved totally misguided. The technical economic literature shows very clearly central conditions for high fiscal multipliers have been fulfilled since 2010. That is true for the general political-economic and institutional conditions in the Euro zone.

• Monetary policy can only partly compensate for the demand declines appearing on account of the austerity debacle because its effectiveness is very limited.

• High economic under-utilization predominates. Available production factors were not utilized on account of the bad economic situation. In such a plight, state revenue- and spending policy is especially effective. Public expenditures help in productively using unutilized production factors. They do not displace any private expenditures.

• Credit restrictions of the private sector play an important role as is typically the case during and after grave financial crises. The private sector is occupied in reducing its debts accumulated in the pre-crisis years and therefore spends less for investment- and consumer goods. The state has a special stabilizing function. If it is not observed, that is de-stabilizing.

On this background, it is not surprising that the fiscal multipliers in the last years were greater than one - and thus higher than in the models applied by the IMF and the European Commission for their economic predictions. This explains the connection between the forecast mistakes and the planned austerity policy.


In view of the experiences of the last years, the analysis published by the IMF comes to the conclusion that the demand for incisive budget consolidation measures was a momentous mistake. This must be recognized at the outset and not afterwards if the framing conditions in the Euro zone should be properly considered.

Nevertheless the ex-post-confession of the IMF was absolutely remarkable since it only very rarely happens among economists and in key political-economic institutions that theoretical positions are confronted with empirical evidence and reassessed if necessary. It is high time the European Commission takes the IMF as an example and critically examines its own political-economic action during the financial- and economic crisis.

The economy of the Euro zone needs an economic- or budgetary policy change of course, a turning away from the one-sided austerity policy of the last years. Public investments are urged above all. The demand in the Euro zone is weak while interests on long-term government bonds are extremely low. Public investments could catapult economic growth both in the short- and long-term as the IMF argues convincingly in its latest report on the world economy. Those countries with the greatest fiscal possibilities like Germany and Austria must be the investment trailblazers. The conversion of the golden investment rule of budgetary policy discussed by the IMF could help.


By Sebastian Gechert

[This blog-article published on June 6, 2014 is translated from the German on the Internet,]

During the financial- and economic crisis, states all over the world crafted economic packages to mitigate the deep recession before they turned to the austerity policy. Both led to lively discussions about the growth- and employment effects of active budgetary policy. This discussion should be welcomed because it has led to a multitude of serious academic studies analyzing the effect of changes in public spending and revenue. These studies concluded that spending cuts (or economic packages) have a substantial negative (or positive) effect on growth and employment - especially when they involve investments.


The so-called multiplier effect of fiscal policy on economic growth is a central measure in investigating economic- or austerity packages. The multiplier indicates how many Euros change the gross domestic product when the state changes its spending- or revenue policy. It measures the effectiveness of a fiscal stimulus or the harmfulness of a consolidation measure. For example, a multiplier of 1.5 means the GDP increases 1.5 billion Euros with an additional invested billion for the public infrastructure.

The spectrum of conclusions in the literature is immense. At the lower end, isolated studies find negative multipliers that suggest a shriveling effect through expansive measures or a growth effect through austerity measures. At the top end, there are very high positive multipliers that imply economic packages in large part finance themselves through their employment- and growth effects - and increasing tax revenues. Savings attempts run aground with high multipliers in the self-caused slowing down of growth while they are simultaneously associated with high social costs.


The multitude of conclusions should be systematically evaluated and facts deduced instead of selectively picking out individual ones. Obviously the question what measures have the strongest effect on the revenue- and spending sides of the state budget is central.

A so-called meta-regression analysis can bring light into the thicket. The conclusions and characteristics of a huge number of studies on this theme are collected and systematically evaluated with statistical methods. At the Institute for Macroeconomics and Economic Research (IMK), we have evaluated 104 studies. Most were published in technical international journals and include no less than 1069 multipliers (Gechert 2013, Horn 2014).

The multiplier effects reported in the studies refer back to different factors as for example the kind of fiscal impulse (investment cuts, tax cuts, reduced military spending) and constants (characteristics of like analyzed region or covered time period, applied methods, the manner of calculating the multiplier, etc). So the effect of different fiscal measures can be compared with each other.



The following conclusions can be drawn:

1. If the state increases its general spending 1 Euro, the economic activity on average rises the same amount. Thus the multiplier effect withy state spending is almost one. Conversely spending cuts slow down the gross domestic product in the relation of 1:1.

2. Of the expenditure measures, investments have the strongest effect. An additional Euro of public investment brings about an economic growth of 1.30 to 1.80 Euros. A so-called crowding-in-effect occurs here, the stimulation of private economic activity by increasing public investments.

3. Expenditure measures have significantly higher growth effects than revenue measures. The multipliers are 0.3 to 0.4 points lower. Thus tax cuts have less effect on economic growth and damaging tax increases influence economic activity less than assumed. Taken together, tax-financed increased spending has a positive net effect. The economic activity could increase (this is also called the Haavelmo effect, named after the Norwegian Nobel Prize winner). To top it all, spending measures take effect more quickly and longer than measures on the revenue side.


State expenditures have a considerable influence on employment and growth. Consolidation measures that are essentially at the expense of public investments are counter-active and therefore not means for stabilizing an economy in recession. Quite the contrary!

The state should save when it is most compatible with the private sector, namely in the upswing. European economic policy should reassess its strategy considering the continuing recession and the enormous unemployment in the crisis countries. The one-sided austerity course entails high costs and hardly helps in the recovery.