Walker's World: Why the IMF was wrong

By MARTIN WALKER, UPI Editor Emeritus  |  Oct. 15, 2012 at 6:30 AM
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FRANKFURT, Germany, Oct. 15 (UPI) -- In the five years since the financial crisis began, economic analysis has been dominated by the Keynesians who want more government stimulus spending to restart growth and the followers of Hayek and the Austrian school who insist on austerity by cutting public spending and paying down debt.

Now we should start paying attention to the French. For most of the crisis, the International Monetary Fund, the nearest we have to a system of global economic governance, has been in French hands. Its leaders have been two French finance ministers in succession, Dominique Strauss-Kahn (more famous now for extra-curricular activities) and Christine Lagarde, a lawyer by training.

The IMF chief economist since 2008, Olivier Blanchard, is probably more important. On leave from the Massachusetts Institute of Technology where he is a professor of economics (he previously taught at Harvard), he along with Fed Chairman Ben Bernanke and European Central Bank chief Mario Draghi is one of the three most powerful economists alive.

Blanchard has just revolutionized the academic debate about economic policy and the crisis. In the IMF's latest World Economic Outlook Blanchard and his team have come up with new research which convinces them that austerity is the wrong way to go.

Some of us saw this coming. Last December, Blanchard's blog referred to this ongoing research and its affect on the spreads on government bond yields. But he didn't spell out as clearly as he has now done the implications of the research.

To try and make a complex issue more simple, the question Blanchard's team addressed was the affect of cuts in government spending on gross domestic product growth. We know that cuts will reduce output, since there will be less money in the hands of the public to buy products and thus less incentive for manufacturers to make more. But it is hard to calculate how much the knock-on effects of the cuts bite into growth.

This is called the fiscal multiplier. Usually, we try to calculate this another way, by asking how much extra growth will a certain amount of extra government spending produce.

For the past decade and more, the IMF (and almost all government economists around the world) have assumed that the multiplier effect of spending cuts is 0.5; that is to say, cut public spending $100 billion and you cut growth $50 billion.

The new IMF research says this was wrong, and the multiplier effect is much greater -- somewhere between 0.9 and 1.7. That means that cuts of $100 billion means growth reduced $90 billion-$170 billion.

Wow! If that is right, the IMF is saying that the more you cut government spending the more your overall output will shrink -- and you will never get out of the hole. Your economic output just continues to decline, which is precisely what we have seen happening in Greece.

How could the IMF have been so wrong in the past? There are two explanations.

First, the previous calculations about the multiplier effect were made before the crisis when most of the world economy was doing fine. So when one country got into trouble and started to cut public spending, it could export its way out of trouble.

With the whole global economy faltering, that is no longer possible, and eurozone countries are no longer free to devalue their currencies which would make exports cheaper.

The second explanation is that for the past few years central banks have been artificially holding down interest rates to extraordinarily low levels, which distorts everything.

If the IMF is right, then the Keynesian school appears vindicated and the austerity school looks like a bunch of economic sado-masochists who should be locked away in the attic like so many crazy aunts. Government should start to use those low interest rates to borrow (and when governments can borrow for 30 years at 2 percent interest, that is like free money) and invest the money is job-creating infrastructure like repairs and maintenance on roads and bridges.

The best investment of all would probably be retro-fitting all buildings to Swedish standards for insulation, which would cut future energy costs dramatically and permanently.

A huge debate is under way among economists and financial analysts to double-check the IMF's research. At first sight, it is persuasive but there are weaknesses. Much of the analysis is Europe-based and gives a lot of weight to the experiences of Greece and Germany, which may not be typical, and no weight to some Baltic countries which succeeded with debt-reduction (but which were free to devalue).

The IMF is cautious about recommending changes in economic policy, saying only "if growth should fall significantly below current projections, countries with room for maneuver should smooth their planned adjustment over 2013 and beyond."

Translated, that means don't cut for the sake of cutting; remember the need for growth.

What they left out was an apology to the Greeks.

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