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On that fiscal multipLIEr

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?


2 thoughts on “On that fiscal multipLIEr

  1. I like what you are arguing. It corresponds with what I have been intuitively arguing over the last 2 years. I say ‘intuitively’ because I haven’t been able to find an economic model which would explain my intuitions. Let me elaborate on my intuitions.

    Much more than the budget deficit, what mattered the most to the Greek economy was the tsunami of cross-border capital flows after the Euro’s introduction. Those capital flows came almost exclusively in the form of foreign debt which increased by 283 BEUR between 2001-10, and they went 50:50 into the public and private sector.

    Even if Greece had had a balanced budget between 2001-10, the situation would still have exploded as long as 283 BEUR flowed into the country (in this scenario, all of it into the private sector). It was not so much the budget deficit which stimulated economic activity. It did so only on a secondary level. On the primary level it was the flow of foreign capital into the country which became the gasoline which drove the Greek economic engine. And like with any engine, when it runs out of gas, the engine stops.

    The Greek economic engine never ran out of gas entirely. In fact, the capital inflows after 2010 continued to be quite substantial (see increase in foreign debt). Except: they were smaller than before and they no longer came voluntarily. Instead, they had to be forced.

    This is a bit like tapering in connection with QE in the US. Whether the Fed buys 85 BUSD or 75 BUSD of securities every month should objectively be immaterial. But once the Fed goes below 85 BUSD, markets will see it as a sign that Armaggeddon is near and they will head for the exit door. Same with Greece.

    By 2008, the Greek economy had become a recycler of foreign capital: it entered as debt and left as current account deficits and deposit flight. Obviously, a lot of ‘recycling jobs’ come into creation when there is a lot of recycling. The high flow of gasoline really made the engine turn and as the engine turned, there were a lot of jobs directly related with the turning of the engine: retailers, bars, restaurants, other services, public sector, etc. (I always referred to that phenomenon as “selling souvlaki to each other and paying for it with money borrowed abroad”). As soon as the flow of gasoline slows down, those jobs go out the window.

    I have never understood why the Troika and everyone else was only concerned with fiscal numbers like budget deficit and sovereign debt when those issues were only the symptoms. The root of the problem was the flow of foreign capital and its misapplication.

    Posted by Klaus Kastner (@kleingut) | October 8, 2013, 10:24
    • You are precisely right. Europe’s call to Greece to reign in its budget deficit was a double whammy for the Greek economy. First, reduced public spending caused a GDP contraction, that is quite clear and we couldn’t disagree with IMF’s assessment on this matter. But secondly, reduced government spending left the current account deficit of the country underfunded at a moment when it was quickly rising year-over-year. My argument, with which as I understand you are in agreement, is that this underfunding played a much bigger role in the eventual collapse of the Greek economy.

      The result of the current account underfunding was much more obvious in the case of Spain. After the real estate bubble burst and the capital account inflows ceased, the spanish economy contracted much faster than for example that of the U.S. or the U.K., which went through the same real estate crisis, but were lucky enough to have their own currencies. Had private capital inflows been weaker in the years prior to the bubble burst, the Spanish government would have found it much more difficult to ran budget surpluses. Most probably it would have been forced by circumstances to follow Greece in increasing its public borrowings from abroad and run a deficit. And it would probably have been engulfed in a Greek-style sovereign debt crisis already by 2009, despite its low levels of public debt.

      I cannot imagine that the IMF is still oblivious to the BoP deficit effects to the eurozone’s periphery, so I can only presume that they intentionally choose to misrepresent their analysis so as to avoid being exposed as responsible for the continuation of this mess. And they are not alone in this effort, the media have also been complicit. For instance, up until the end of 2012 (if not for longer) we kept reading in the news, on and on and on, that the reason for Greece missing its budget goals was the delays in the reform program caused by the back-to-back elections of that year. As if a two-week election drama was the only problem that Greece had to deal with! That too was a convenient story that helped misdirect public opinion away from the issues that really matter, although in this case it was probably steered by sheer ignorance on behalf of the media rather than deceit.

      Posted by 2mtm | October 9, 2013, 09:11

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