The Watcher Cat

The Watcher Cat

Tuesday, January 8, 2013

The Reports of the Death of J.M. Keynes Have Been Greatly Exaggerated

Olivier Blanchard and Daniel Leigh of the International Money Fund have released a paper in which they acknowledge that their expectations of growth underpinning the IMF's support for fiscal consolidation (austerity to you and me) was the right approach to take in Europe in the wake of the Great Recession of 2008 to the present were, um, wrong. As the WSJ Blog summarizes:
In a new paper published Thursday [January 3, 2013], IMF Economic Counsellor Olivier Blanchard and research-department economist Daniel Leigh show the IMF recommended slashing budgets too fast early in the euro crisis, starving many economies of much-needed growth.

In “Growth Forecast Errors and Fiscal Multipliers,” Messrs. Blanchard and Leigh calculate IMF and European economists underestimated the euro-for-euro effect of cutting government budgets. While economists expected that cutting a euro from the budget would cost around 50 cents in lost growth, the actual impact was more like 1.50 per euro.
In other words, the assumption was that austerity would hinder growth one third the amount it in fact did. The paper itself states that in the last similar period, the Great Depression, the actual impact of austerity was a similar 1.6 ratio. In other words, austerity had the almost exact same impact in the wake of the Great Recession as it did in the Great Depression--a profoundly negative one, in almost the exact same amount. (See Paper at pp. 3-4).

As Peter Martin of the Sydney Morning Herald notes, this error had real consequences:
Rather than suffering far less than the savings they made on their budgets, the economies suffered far more. As mistaken advice it's monstrous - like going to see a doctor who tells you the medicine won't hurt much and finding it lays you low for years.
The fund forecast that if the eurozone took its advice it would grow 1.8 per cent throughout 2011. It grew 0.7 per cent. Italy would climb 1.3 per cent; it slid 0.5 per cent. Spain would surge 1.8 per cent; it grew not at all.
Another lesson learned by Blanchard and Leigh?
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 profits, with both effects leading to larger multipliers.
(Paper at 4.)

[Notably, the Paper cites for that last proposition a 2012 study co-authored by Keynesian Paul Krugman, in what must seem to Krugthulu (as he is known on the blogs), a sweet bit of irony.]

So let's recap: Austerity, tried in the 1930s failed miserably, producing $1.60 in lost growth for every dollar in deficit reduction. Tried again, it failed to almost exactly the same extent. Of course, Blanchard and Leigh still contend that:
Finally, it is worth emphasizing that deciding on the appropriate stance of fiscal policy requires much more than an assessment regarding the size of short-term fiscal multipliers. Thus, our results should not be construed as arguing for any specific fiscal policy stance in any specific country. In particular, the results do not imply that fiscal consolidation is undesirable. Virtually all advanced economies face the challenge of fiscal adjustment in response to elevated government debt levels and future pressures on public finances from demographic change. 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 country.

Austerians, I have only this to say to you:

(H/t: Balloon Juice

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