Fiscal multipliers, a cause worth fighting for
It was in the IMF’s October 2012 World Economic Outlook (WEO), in Box 1.1 with the title “Are We Understanding Short-Term Fiscal Multipliers” that Olivier Blanchard and Daniel Leigh presented for the first time the findings of their study into the impact of fiscal consolidation on economic activity.
Using data from 28 different economies – G20 and EU member countries – for the years 2010 and 2011, they concluded that there is strong evidence that the fiscal multipliers used since the Great Recession that started in 2008 were systematically miscalculated by a range of 0.4 to 1.2. The implicit 0.5 multiplier used in international organizations’ models to forecast economic growth – which was based on empirical evidence from the three decades prior to 2009 – might be significantly higher, between 0.9 and 1.7, they found. In simple terms, it had previously been thought that cutting a euro from the government deficit would have an impact of 50 cents on economic output but their findings suggest that the damage on the real economy can be more than three times than initially thought, with a euro of deficit reduction coming at a cost of between 90 cents and 1.70 euros on the economy.
The underlying model of the study is too technical for someone without an econometrics background but their findings are straightforward and robust. Even excluding economies that would be considered outliers and are part of IMF programs, the value of the variable that captures the economic activity forecast error indicates a significant miscalculation.
At the time, not many picked up on this major policy-related development and the discussion was primarily limited to think-tanks and economists. It was not before January 3rd, when the full paper was published in the IMF publications section that the issue became an agenda-topping item and one of the main discussion points at the end-of-January press conference during the World Economic Outlook update.
Unsurprisingly, Blanchard’s and Leigh’s research is one of the main topics in the public debate in Greece and the battleground between the coalition government and the opposition parties. Even Finance Minister Yannis Stournaras inquired at the latest Eurogroup if the troika has a consolidated view in light of the newly discovered evidence and its implications for the Greek program.
The issue has triggered a response from Blanchard himself in an article in last Sunday’s Kathimerini newspaper and from Olli Rehn, who responded to Stournaras question via a letter to the Eurogroup president and ministers. As much as the Commission remains, as it has been from the start, sceptical about the validity of the IMF findings – Rehn seems to believe that there is not enough evidence and that the study does not capture the supposed confidence effects from fiscal consolidation – in the case of Greece the two men are aligned. Greece is a special case and it was political instability and poor program implementation that have thrown all projections on economic growth and unemployment out of the window.
What are the real implications of the IMF chief economist’s findings and how strong are the arguments that wrong assumptions on fiscal multipliers had no role to play in the derailment of Greece’s program?
Any debate on the topic must begin with the recognition that the Greek state could not carry on the same fiscal path it was on in 2009. It could not have primary expenses that exceed revenues by 24 billion euros. It could not keep adding 36 billion euros of debt each year – the amount of the 2009 total deficit. Primary expenditure could not remain at 113 billion, an equivalent of 49% of the country’s GDP. It could not continue spending 80 billion euros in salaries and social benefits which corresponds to 71% of total expenses and even more worryingly 90% of the state’s revenues. With the state’s credibility battered by dodgy statistics, no one willing to finance it at reasonable rates and a debt pile close to 130% of GDP, large scale fiscal tightening was the only option.
Under any circumstances, fiscal tightening from the side of the state has major implications on economic activity. Given the magnitude of fiscal correction required for Greece’s state finances, the impact was even more severe. It is explicitly stated in the first memorandum of understanding (MoU) between Greece and the troika that a deficit reduction of 11 percentage points of GDP required measures worth 18% of GDP due to the loop between state finances and economic activity.
As such, the correct projections on economic activity – for which the fiscal multiplier is used for – are not just one variable of many, they are the cornerstone of the program. Miscalculation of economic growth will lead to lower VAT and consumption taxes revenues. Provided that employment and economic activity are tightly linked, missed projections on economic activity lead to higher unemployment, lower income tax revenues, lower social insurance contributions and higher expenses on unemployment benefits which can throw a budget completely off track.
The Greek program has an extensive element of internal devaluation to correct the substantial current account deficit, which in 2007 and 2008 had climbed to 15% of GDP. Aside from the impact of the state pulling out of economic activity, the suppression of incomes was from the start a program objective aimed at reducing imports by suppressed demand and cutting labour costs and lowering prices of domestic goods to improve exports and the trade balance. It was intended that key components of the economic output identity, income, disposable income through taxes, and government spending would take a massive hit.
On the basis of these universally accepted economic principles and given the level of miscalculations and continuous revisions of GDP in Greece’s program, it is at least naive to even politely attempt to deflect the importance of the findings of Blanchard’s and Leigh’s research.
In May 2010, when the first program was agreed, 2011 GDP was projected to contract by 2.6%. In April 2011, it was revised to 3%, in June 2011 to 3.5% and in September to 5%. The recession forecast almost doubled in just six months in 2011 and eventually the year recorded the biggest drop during the program implementation, a 7.1% decline. Equally, 2012 projections started with an expected growth of 1.1% to be revised by September 2011 to a contraction of 2%, three times worse than the initial estimate.
Are these major misses in projections and the repeated revisions just 16 months into the program a product of political instability and poor product implementation as Blanchard and Rehn argue?
As much as it presents a convenient argument, since the program inception the political situation in Greece was not as fragile as some want to present or any different than any democratic country that has a government, an opposition and the natural tensions that a consolidation effort of such magnitude brings. George Papandreou and PASOK had won the October 2009 elections by a landslide and with 160 MPs had a comfortable majority in the 300-seat Parliament. Although New Democracy’s Antonis Samaras back then was wearing his anti-memorandum hat, the first MoU passed from the Greek Parliament in May 2010 with the support of close to 180 MPs.
In October 2010, Greece held municipal elections which traditionally have been highly partisan. Despite the fact that Papandreou also gave the elections a character of being an implicit referendum on his government’s policies, candidates supported by PASOK won the country’s major cities and the district of Attica, where half of Greece’s population lives. In 2011, although the social tensions were rising, Papandreou managed to pass in June the Medium Term Fiscal Strategy.
Up to September 2011, when the troika had a cumulative miss on 2011 and 2012 projections of 5.5 percentage points – from an 1.5% contraction to a revised 7% – there were no signs of political instability in Greece. The size of the forecast error and the numerous revisions of the depth of Greek recession are undisputable evidence that Blanchard’s and Leigh’s findings need to be given serious consideration.
In November 2011, after the referendum idea that led to Papandreou’s eventual political demise, Greece ended up with a coalition government – no different than the one that Italy formed around the same time – led by a technocrat trusted by the troika, supported by close to 250 MPs and who got the backing of the memorandum’s biggest opponent up to that point, Samaras. His party not only voted for Greece’s second program in February 2012 but Samaras committed in writing that he would not deviate from the program.
Even the calling of elections in May 2012, on the insistence of Samaras, was not of particular concern as both Venizelos, the new PASOK leader, and Samaras had committed in writing that they would follow the same policies. It was the surprise second place of the radical left party SYRIZA that had an anti-memorandum and eurosceptic agenda that shook the political establishment. Combined with the inexcusable failure of New Democracy, PASOK and Democratic Left to form the coalition government which they eventually came to after the June elections, this made the political situation in Greece fluid. The instability was fuelled, and confidence was impacted, by the combination of repeated comments from European officials regarding the country’s future into the euro and the decision of Greece’s traditional political establishment to give the repeat elections the character of a euro referendum.
It is important to note, therefore, that the period of political uncertainty was two full years since the first memorandum was signed and most critically outside the 2010 and 2011 period which was used for the study.
Poor program implementation is also cited as one of the reasons why Greece’s program went off track, especially those of growth-enhancing reforms. As much as it is true that primarily on the front of opening closed professions Greek governments showed resistance under the pressure of vested interests, the argument seems to be missing the main point: the issue in Greece over the period was one of demand and not of supply.
With disposable incomes reduced over the period by an average of 30% from a combination of wage reductions and tax hikes, with the country effectively without a banking system and deteriorating credit conditions – as Blanchard states in his Kathimerini post – and a complete collapse in consumer and business sentiment that led to a 20% drop in investments during 2010 and 2011, it is hard to see to what extent the indeed needed reforms would have an immediate short term effect and offset a GDP loss in the volume of 38 billion euros during the troika era when it is widely accepted that structural reforms need time to bear fruit.
Is Greece an outlier in the fiscal multiplier study? Without a doubt it is. For a combination of reasons mostly attributed to the uncertainty of the country’s future in the eurozone that had a ripple effect on various aspects of economic activity and the financial system, Greece is not the typical fiscal consolidation case.
However, dismissing the conclusions of the study by just narrowing it to the case of Greece does not do the research of Blanchard and Leigh justice. Their findings suggest that even excluding potential outliers the forecast errors are significant. Just as Greece is not a conventional case, the period after 2008, especially due to simultaneous fiscal consolidation efforts following the significant stimulus during 2009 to stave off a global depression, is equally unconventional.
In his letter to the Eurogroup, Olli Rehn gave the impression that he wants to close the matter in a hurried manner – presenting a series of weak arguments very concisely debunked by Jonathan Portes and Karl Whelan – considering it an “unhelpful” debate that will scare the confidence fairy away.
For Greece, this is exactly the debate that needs to happen. Over a period of three years, Greeks have managed the phenomenal achievement of turning a primary deficit of over 10% of GDP into small primary surplus and the Commissioner can rest assured that vast majority of the Greek population want to hold on to this achievement and build on the sacrifices made thus far.
It is Olivier Blanchard himself in the WEO update press conference that presented the way forward. Consolidation targets must shift from nominal to structural and countries should allow automatic stabilisers to work, accepting the fact that the fiscal outcome may not be exactly what as was initially planned. Both the IMF and the Commission have accepted that Greece’s fiscal adjustment has outperformed initial estimates and is 5 percentage points bigger than what was initially planned in May 2010.
Greece must not and is not asking to change course. At the same time a fiscal consolidation effort must not lead to the impoverishment of a nation. All the program needs are the necessary adjustments that will ensure its success and not lead once more to missed targets and dramatic reviews.
Some argue that pursuing these necessary adjustments is like fighting for lost causes given that the only available source of financing depends on the willingness of reluctant Europeans. However, with 3.9 million Greeks facing poverty and deteriorating social conditions, this is definitely a cause worth fighting for.