The IMF’s shift in stance regarding easing Greece’s debt burden (see Update 83) reflects a deepening controversy about whether austerity policies are counter-productive.
The IMF triggered renewed debate over austerity (see Update 82, 80, 78, 76) when its October World Economic Outlook (WEO) revised growth forecasts down significantly for advanced, emerging and developing economies, after already having done so in three consecutive previous WEO editions. The IMF examined the economic impact of austerity policies by re-estimating so-called fiscal multipliers; it concluded that its economic models were incorrect.
The WEO section examining fiscal multipliers, co-authored by IMF chief economist Olivier Blanchard, found that “the negative short-term effects of fiscal cutbacks have been larger than expected because fiscal multipliers were underestimated” by a factor of two to three. The degree of under-estimation was found to be “large, negative and significant.” The analysis suggested that socio-economic factors were also more negatively affected than presumed, including “large and significant” effects on unemployment. Paul Krugman, Nobel prize-winning economist, writing in the New York Times offered “kudos to the Fund for having the courage to say this, which means … admitting its own analysis was flawed.” Criticism of the Fund’s approach has emerged however, including a Financial Times analysis by its economics editor Chris Giles which argued that the Fund’s new methodology was not robust. This was vehemently denied by the Fund, which argued that its analysis “holds up to a battery of robustness tests.” Brazil’s finance minister, Guido Mantega, welcomed the Fund’s position, suggesting that “single-minded and draconian fiscal policies may be counterproductive and have a tendency to backfire.”
The IMF is adamant that this analysis merely confirms the Fund’s advice for fiscal consolidation, articulated by Blanchard as “don’t do it too slow, don’t do it too fast.” The Troika, consisting of the Fund, European Central Bank (ECB) and European Commission, has agreed to extend deficit target deadlines in Greece and Portugal, and the Commission has permitted Spain to do so as well. The IMF’s desire to reduce Greece’s debt and the easing of Portugal’s deficit targets were attributed to the changed analysis. Writing in the Financial Times in October, Lorenzo Bini Smaghi, former board member of the ECB, suggested that the Fund’s analysis does not warrant controversy as it does not imply “which scenario is preferable” between the benefits of sharp fiscal consolidation or taking a more gradual approach to cuts. The conclusion of Bini Smaghi is that the Fund’s study does not prove that austerity is “doomed to fail”, instead it depends on the “patience of voters to endure a prolonged adjustment effort and the patience of financial markets … if markets become impatient, credit risks start to rise, market access is impaired and the overall adjustment costs increase in a dangerous feedback loop.” He argued that the IMF’s “subtle message” is that countries “wishing to spread out fiscal adjustment should probably seek the assistance of the IMF.”
The austerity balancing act
The IMF appears to be striking a balance between softening austerity while cautioning against expansion. In its November briefing note to the G20 it acknowledged the risk of a vicious circle of austerity impacts in Europe: “austerity may become politically and socially untenable in periphery countries, as structural and fiscal reforms will still take years to complete … governments under pressure would be forced to implement even further fiscal adjustment, resulting in larger GDP losses and significant spillovers on other economies.” Bolivian finance minister Luis Arce Catacora argued at the IMF annual meetings in October that the ongoing financial crisis is symptomatic of a “macroeconomic policy crisis, expressed in the lack of adequate policy responses.” His statement added that due to the crisis’ global impact “developing countries will end up paying for what they have not caused.”
The WEO has triggered debate not only over whether austerity is working but also whether financial markets could support an alternative. An editorial by financial news agency Bloomberg argued in mid October that “it’s clear Europe has overdone austerity … euro-area governments should recognise this.” Moreover, the editorial discounted the risks that investors will “punish” states that relax their fiscal reforms timetable, suggesting this is “unlikely, because investors understand that Europe has locked itself into a vicious circle of slow growth and excess austerity”, adding “the link between fiscal pressure and financial panic … must be broken.” Furthermore, research on fiscal multipliers conducted by Özlem Onaran of the University of Greenwich corroborated the WEO findings of an underestimated fiscal multiplier. She concluded that “even financial speculators are worried that austerity measures will deepen the recession, and create a double dip in the global economy, decrease tax revenues, and make it even harder to repay debt. The need is for decisive leadership by governments to signal that the only way out of this crisis is expansionary fiscal policy and higher wages.”
Austerity versus investor confidence?
In the same week as the WEO launch, Blanchard told the German newspaper Frankfurter Allgemeine Zeitung that expansionary measures would be “playing with fire” adding that “now is not the time for fiscal stimulus.” Writing in October, Cornel Ban of Boston University suggested that the Fund’s analysis “has had modest effects on the actual IMF line on austerity” adding “an epiphany it was not.” Ban argued that the limiting factor in the Fund’s softening of its stance remains the idea that a more gradual deficit consolidation, or even expansion, can only be “legit[imate] as long as financial markets deemed it sustainable.”
An analysis by the US think tank Center for European Policy Analysis of whether financial market actors’ views are crucial to limiting the benefits of fiscal expansion examined non-euro area fiscal consolidation programmes in Hungary, Poland, Czech Republic and Slovakia, all of whom underwent recent periods of sharp contraction and austerity. It found that fiscal policy, rather than investor confidence, “offers a more credible explanation of the economic divergences”. Comparing their divergent recovery paths, the study found that “it is evident that temporary fiscal measures aimed at lessening the shock to the domestic population can be helpful in supporting economic growth in times of crisis.”