By Mark Whitehouse
Sharp spending cuts and tax increases have long played a central role in the International Monetary Fund's prescriptions for governments in financial distress -- most recently for the struggling members of the euro area. Now, officials at the world's primary arbiter of fiscal prudence are recognizing that such austerity can do a lot more damage than previously thought.
The first major indication of the IMF's change of heart came in October. In its World Economic Outlook, the fund published research showing that back in 2010, when Greece and other European countries embarked on severe austerity programs, its forecasters underestimated the negative impact spending cuts and tax increases would have on the broader economy.
In a paper presented today at the annual meeting of the American Economic Association, two IMF officials -- chief economist Olivier Blanchard and economist Daniel Leigh -- elaborated on the findings and their implications. The paper contains the boilerplate statement that it "should not be reported as representing the views of the IMF." Nonetheless, given its authors, it provides a good indication of the zeitgeist at the fund.
The authors focus on a number known as the fiscal multiplier -- the amount a country's economic output changes for each euro of change in government spending or revenue. They estimate that for European austerity measures started in 2010, the multiplier was significantly greater than one, meaning economic output shrank by more than one euro for each euro in deficit reduction. That's much higher than the multiplier of 0.5 that the IMF and other forecasters typically used in 2010 and that had proven more or less accurate in the years before the 2008 financial crisis.
The upshot: Fiscal multipliers can be a lot higher in times of distress than in normal times. The logical conclusion is that Europe's austerity policies were founded on faulty assumptions and should be eased -- something Bloomberg View has advocated. To some extent, that has happened in recent months with the loosening of demands on Greece and with European leaders' tentative discussions of fiscal transfers to stimulate growth in stricken economies.
Blanchard and Leigh are quick to point out that their results don't mean austerity is always a bad idea. Governments can't run large budget deficits and build up debts indefinitely without disastrous consequences. The question is how -- and how fast -- they can get to fiscal prudence without tanking their economies.
(Mark Whitehouse is a member of the Bloomberg View editorial board. Follow him on Twitter.)
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