This Sunday, Deutsche Welle published a short interview with the head of the IMF, Christine Lagarde (link to interview here). The interview did not attract particular attention in other media, but the issue of the underestimated fiscal multiplier came up again, so I found this to be a good opportunity for a comment on the IMF’s recent “sincere admission” of its past mistakes.
I am referring specifically to the IMF’s self-assessment of the Greek bailout program, summarized in a report published last May (link to report here). After the failure to reliably forecast the depth of the Greek recession, the IMF came forth with this lengthy report wherein it admits that the consequences of austerity to the economy of Greece were at the very beginning of the program significantly underestimated. In their own words:
“The program initially assumed a multiplier of only 0.5 despite staff’s recognition that Greece’s relatively closed economy and lack of an exchange rate tool would concentrate the fiscal shock. Recent iterations of the Greek program have assumed a multiplier of twice the size. This reflects research showing that multipliers tend to be higher when households are liquidity constrained and monetary policy cannot provide an offset, influences that appear not to have been fully appreciated when the [Greek] program was designed.”
During the said interview, the reporter brought this issue forth to Christine Lagarde. Of course she sang the same song:
“What we are known for is for acknowledging when we make mistakes […] And I will tell you where we very publicly acknowledged that we had underestimated certain factors, and that’s on the fiscal multiplier effect of combined fiscal consolidation around the euro area and where… you know we had underestimated the fiscal multipliers…”
The “admission” of this mistake has been repeated enough times already by Greek and foreign media and critics of the IMF have been quick to make it part of their criticism. However, the underestimated fiscal multiplier story is but a fairy tale which should have already been publicly exposed as such.
What is clearly missing from the IMF’s report is an analysis of the effects of balance of payments (BoP) deficits on GDP, what could be called the “BoP multiplier”. Of course such a term cannot be found in economics literature, since every economy is assumed to use its own currency and therefore its balance of payments (BoP) is always nil. But in the case of a euro country, where countries may have non-zero balances of payments, there has to be a careful consideration of the impact of a BoP deficit on an economy’s performance and its ability to consolidate public finances.
In a nutshell, what happens in a euro country which faces a BoP deficit, is that its money supply decreases (ceteris paribus), leading to a reduction in aggregate demand (a first order effect on GDP), which in turn causes households and businesses to limit spending, reduce risk exposures, hoard liquidity, deleverage, disinvest etc., effects which altogether have a second order effect on GDP, which in turn feeds on itself and so on and so on. That is the BoP multiplying effect which I have previously described here. Yet, the report does not make any mention of the effects of projected BoP deficits on the program’s estimates. Why?
Simply, because admitting that the reason for the failure of the IMF program can be attributed to an innovative concept of a BoP multiplier would imply that the IMF employed a wrong model in the first place and that their response to the euro crisis was flawed even on a theoretical basis. It is far easier to defend an error in the estimation of a parameter of a model, rather than defending an error in the theoretical foundations of the whole model. The IMF has been eager to admit its mistakes, but not to the extent that would make them seem like complete idiots.
Besides, it has been of utmost importance to the IMF and their companions not to publicly elaborate on the structural deficiencies of the euro, especially at the beginning of the crisis when doubts over the viability of the common currency were stronger. A public admission and demonstration of how balance of payments deficits cause instability in the national economies of the eurozone would call for a shift of policy-making towards internal, structural monetary measures for the entire euro area, which certain countries would not like to consider.
The fiscal multipliers may have been underestimated or not. But there have been stronger economic forces that caused the economic collapse of Europe’s periphery, forces independent of fiscal consolidation measures, forces unique for the euro area. This repetition of the tale of the underestimated fiscal multipliers is frustrating and unfortunately serves to solidify the belief that this has been indeed the (only) error of the IMF with respect to its response to the euro crisis.
It was a nice PR touch from the IMF to try to redeem itself by acknowledging its own errors, but we should not give any merit to these efforts. The IMF can live happily with these tiny “admissions”. Can we?