IMF Economists Raise Alarm Over Austerity Measures

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Austerity measures in the West have had a devastating effect on the Eurozone, according to a new paper published by the chief economist at the International Monetary Fund, with damage more pervasive and widespread than previously imagined.

The paper, co-authored by IMF chief economist Olivier Blanchard and IMF economist Daniel Leigh, titled "Growth Forecast Errors and Fiscal Multipliers," is likely to cause a dramatic shift in macroeconomic policies across Europe, even within influential international bodies such as the IMF, European council and OECD.

Blanchard argues that policymakers in Europe were gravely off in their estimates of the damage sustained by their economies as a result of austerity measures and governmental budget cuts.

Policymakers throughout the Eurozone assumed fiscal multipliers would be 0.5 (meaning that for each one-euro budget cut, GDP would be affected by 0.5 euros), Blanchard writes. But in practice, the real fiscal multiplier was actually close to 1.5 – that is to say, the damage to GDP was three times as much as they thought.

Ergo, the austerity measures in the West hurt economic activity and employment much more than thought.

With the results of the study proving to be solid, economic bodies are already shifting gears in their attitude toward austerity. Long touted as a solution for breaking out of the financial crisis, Europe is now looking to move away from such stringency. In a strong first move, the IMF recently relaxed the deficit targets it requires from the Portuguese government.

A forecast based on hindsight

How can such an egregious error – damage three times the rate than believed – be made in an economic forecast that has such a drastic effect on the citizens of so many countries? It turns out that just like their friends in banking and finance, the economists who calculated the fiscal multipliers were working with outdated data, numbers from a time when European countries enjoyed growth and prosperity.

The proper way to calculate multipliers and make a forecast would have been to take the European financial crisis into full account, accepting that the balmy economic climate of previous years didn't accurately reflect the new, turbulent reality. The economists based their predictions upon a reality where governments can significantly stimulate economies, including via cutting interest rates; and could spur exports and foreign trade by weakening the currency.

It is true that in the past, such actions could put a curb on the economic contractions that comes from governmental budget cuts. But in a post-2008 reality, this sort of thinking no longer holds.

Central banks lowered interest rates to rock bottom as the crisis unfolded, leaving no more room to maneuver. And as the whole world – including the economic blocs that trade with European countries – sank into crisis at the same time, foreign trade simply couldn't bounce back.

If economists had built their models and projections as the situation required them to do, it would have been clear that the fiscal multiplier was much higher than anticipated. In practice, perhaps out of their blind faith in mathematical models, the European leaders dragged their countries into a recession, bringing with them unemployment levels that undermine the social order, all on the basis of a methodological error in an economic model.

Later on, the mistake became clear. A look at the data on Europe's recent financial performance showed that economic activity had nosedived much deeper than anticipated, and that fiscal multipliers were hovering much closer to 1.5 percent than 0.5 percent. Their impact on unemployment rates has been far more severe than anyone guessed.

At the moment, policymakers are hitching their wagons to the hopes that the crisis stabilizing, and partial recovery of some Western countries, will bring the multipliers back to a more normative level. But the damage has already been done.

This is a widespread, mortifying error. In the paper's concluding remarks, which, it must be said, do not officially represent the IMF or its views despite its authors' affiliations, readers are nevertheless asked not to jump to conclusions.

"Our results need to be interpreted with care ... There is no single multiplier for all times and all countries … As economies recover … multipliers are likely to return to their precrisis levels." That plea for prudence given, they add, "Nevertheless, it seems safe for the time being, when thinking about fiscal consolidation, to assume higher multipliers than before the crisis."

To put it into layman's terms: When additional budget cuts are considered in the future, it will be taken into account that the damage to economic activity and employment, and the suffering of citizens, will be much greater than previously expected.

This is no trivial matter. As more and more Europeans get wind of the economists' screw-up, the anger toward the institutions and economic leaders of the continent is growing. In France, for example, the influential and renowned blogger Hubert Huertas wrote: "The error is even more infuriating when you recall the condescending lectures we received from economists and commentators, who preached to us the need for austerity policies."
According to Huertas, "The most amazing thing is something else entirely. Did we really have to discover a mistake in the formula in order to figure out that something isn’t working in real life?"

Huertas estimates that the influence of Blanchard's paper has only begun to be felt, simply because large bodies don’t give up on their ideologies so easily. It's safe to assume that in Israel as well, they will hear about this paper, about the influence it will have on European economic policy, and on the most important question in economics: How to deal with a country that is unhappily caught in a difficult economic crisis.

Steinitz wants to cut 14 billion shekels – will growth be affected?

Finance Minister Yuval Steinitz has said that the 2013 budget must be slashed by NIS 14 billion. When you connect this statement to the revelations of the IMF paper, it's easy to start panicking. Ostensibly, if Europe's fiscal multiplier of 1.5 is valid in Israel as well, such a cut could lead to a sharp drop in business activity and a subsequent spike in unemployment. But that would be mistaken thinking: In this case, Israel probably doesn't bear much resemblance to Europe, and in any case Steinitz's cut isn't a real one. All he's doing is canceling various spending items approved under law that would have kicked in this year.

As in Europe, the economists at the Finance Ministry and the Bank of Israel use fiscal multipliers in their economic projections. They, too, use a fiscal multiplier of 0.5 percent – and probably aren’t free from mistakes. But for the time being, Israel is not in an economic crisis or suffering from liquidity problems. Its interest rates are still far from zero, and there's still room to reduce them, and it can increase its foreign trade, simply because it is a small country that is flexible in global terms and isolated from the major economic blocs. Therefore, at least according to local economists, the destructive effects the budget cuts had in European countries aren't to be expected here.

Moreover, no one knows if Steinitz will really slice NIS 14 billion from the budget. Most of that money never was part of an actual budget spent on the public. They're shadow numbers, mere figments of the national accounts, meaningless integers in the murky depths of the state's books. In Europe, the damage happened because the population, accustomed to a certain standard of living, reduced their consumption when that standard fell. The economy was the first casualty. In Israel, the opposite could happen: Although income hasn't actually fallen, many Israelis are fearful of potential cuts and curbing their consumption accordingly. It's possible that when they see their balances haven't been adversely affected, they'll kick right back to their old levels of spending and stimulate the economy once more.

The truth is that no one knows what will happen with the budget cuts for the coming year. As election day looms, it is possible that politicians will jump on the bandwagon of the new approach that is starting to filter through Europe, using it to base their economic platform to increase the governments ' budget. And maybe, just as the economists in Europe were mistaken when they thought they built models based on the reality of 2006, the idea that today's Israel looks like the Europe of 2009 will also turn out to be incorrect.

A camera store in Europe advertises slashed prices as the region continues to struggled with a battered economy.Credit: Bloomberg

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