The launch of the IMF’s autumn 2012 World Economic Outlook (WEO) report stimulated a controversy over economic forecasting during the annual meetings of the IMF by admitting that the Fund’s models, used to dictate the terms of bailouts, were flawed.
The WEO revised down 2013 growth forecasts for emerging and developing economies from 6.1 per cent to 5.8 per cent. For advanced economies, expected growth had been 1.8 per cent, but this too was revised down to 1.5 per cent growth. It identified two principal causes of slowing growth: fiscal consolidation and “weak” financial systems, still vulnerable to crisis. Other causes were specifically ruled out, notably the areas of structural reform normally associated with the Fund’s advice to countries undergoing financial crisis, such as trade and financial sector liberalisation. An IMF study, cited in the report, noted that in emerging markets and developing countries “greater trade openness and trade liberalisation are not significantly associated with the duration of expansions. Nor are the extent of trade among emerging market and developing economies or greater financial integration.”
The senior advisor of the Fund’s research department, Jorg Decressin, said that these figures also relied on “two assumptions: the first is that the euro area crisis gets gradually resolved” and that “the US economy avoids the fiscal cliff and the debt ceiling is raised.” Positive forces supporting growth were attributed principally to accommodative monetary policy, such as the policy of quantitative easing in some advanced economies, plus support to the financial sector. IMF chief economist Olivier Blanchard, speaking at the 9 October WEO launch, advised: “continue with accommodating monetary policy… and continue with fiscal consolidation … [on which] our advice still holds: don’t do it too slow, don’t do it too fast.” The major risk factor for these forecasts was identified as the “state of the euro zone”. Blanchard contended “in the shorter term … more immediate measures are needed.”
Underestimating short-term fiscal multipliers
A controversial text box in the WEO outlined one of the key reasons why the Fund has yet again had to downgrade forecasts for global growth, after already having done so in consecutive prior editions of the WEO. The box, co-authored by Blanchard, has re-fuelled the argument over whether austerity policies, which are supposed to create growth, have been counterproductive in Europe and developing countries.
A statistical cross-country analysis in the box found that “the negative short-term effects of fiscal cutbacks have been larger than expected because fiscal multipliers were underestimated”, and that the impacts were “large, negative and significant.” A fiscal multiplier is an estimate of the knock on impact of growth from changes in government spending or taxation. The study found that “the unexpected loss associated with a 1 per cent of GDP fiscal consolidation are in the range of 0.4 to 1.5 percentage points.” The Fund had been using a multiplier of 0.5 in its previous work, but with top end of 1.7 from the new analysis, which means the negative effects of spending cuts could be more than three times as bad as assumed previously.
The analysis also provided evidence that unemployment was also affected more than anticipated, finding “large and significant” impacts. The underestimation of growth impacts was more pronounced in states that had “more aggressive fiscal consolidation plans, suggesting that fiscal multipliers used in making growth forecasts have been systematically too low.”
There have been voices disputing this conclusion however, including an analysis in the Financial Times that suggested the statistical results were incorrectly or inappropriately calculated, something that the Fund vehemently denied, as the analysis “holds up to a battery of robustness tests” that were conducted as part of the WEO study. Writing in his blog at the New York Times, Nobel-prize winning economist Paul Krugman suggested “kudos to the Fund for having the courage to say this, which means bucking some powerful players as well as admitting that its own analysis was flawed.” The finance minister of Brazil, Guido Montega, provided another perspective on the controversy, saying that “we have been arguing for some time that single-minded and draconian fiscal policies may be counterproductive and have a tendency to backfire.”
Implications for borrowing countries
This analytical discussion transformed into a debate over the validity of current Fund advice, with a Fund seemingly trying to convince its European partners to moderate some of the stricter requirements placed on euro zone states seeking loans. Blanchard indicated that the evidence cited in the study had contributed to the decision to moderate the conditions required of Portugal, allowing it to “readjust the targets [for Portugal’s budget deficit], moving from 3 percent next year to 4.5 percent.” He added, “when the case is there, we have to be ready to readjust the targets given that fiscal multipliers are very large.” Subsequently, IMF managing director Christine Lagarde backed this analysis in the context of Greece, advocating an extension to the time allowed for Greece’s debt repayments. She also stated her support for the European Commission’s recent decision to extend by a year the time allowed for Spain to reduce its budget deficit to 3 per cent of economic output under European fiscal stability rules.
Media reports suggested that this more accommodative stance was not entirely welcome to the IMF’s partners – the European Central Bank (ECB) and European Commission – nor to key European lender states such as Germany. José Viñals, head of the Fund’s monetary and capital markets department indicated that Spain’s creditors, which include Germany, should not “negate” a request by Spain to trigger the new bond-buying assistance program recently announced by the ECB. However, Lagarde and German finance minister, Wolfgang Schäuble sought to downplay the disagreement in a joint event in Tokyo. Schäuble asserted that “we always agree” while Lagarde responded that “we work hand in hand” with the ECB and European Commission. In the final press conference of the IMFC, the Fund’s ministerial oversight committee, Lagarde downplayed suggestions of disputes, suggesting that claimed disagreements regarding the required speed of fiscal adjustment “were more about perception than reality.”
Civil society organisations that have long been arguing against the conditions the IMF puts on its loans felt vindicated by the IMF’s admissions. Jesse Griffiths of European NGO network Eurodad called the report “an extraordinary admission by the IMF” and concluded that it “will add to growing calls for the Fund to radically alter the conditionalities it attaches to its loans, which consistently promote austerity.” Ronald Janssen of the European Trade Union Confederation wrote: “The IMF’s ‘mea culpa’ is certainly admirable and hopefully helpful in introducing a bit more modesty in the attitude and positions of the ‘austerians’ over here in Europe.” Janssen went on to analyse an IMF working paper from the summer (see Update 82) which brought him to the conclusion that what is needed is “Stop frontloading austerity! Stop cutting social benefits and public services! Do not cut spending in the middle of a recession! Shift deficit targets over a longer time horizon! Consolidate by ending tax dumping in Europe! … Anyone listening in Brussels, Frankfurt, Berlin or Paris?”