October 15, 2012
“When faced with the choice between changing one’s mind and proving that there is no need to do so, almost everyone gets busy on the proof.”
This brilliant quote from economist JK Galbraith just about sums up why individuals and organisations tend to stick to plan A when the evidence suggests that Plan A isn’t working. No one likes to be proved wrong but, ultimately, the worst thing we can do when our world view turns out to be flawed is stick to it. Yet this is precisely what many of us do.
Given this general observation, it was fascinating to see the IMF conclude last week, with its influential world economic outlook, that it might have got its basic economics wrong. If not quite apologising for leading half of Europe up the economic garden path, the IMF has at least admitted that what we have been arguing for years in this column is right. For the first time, the IMF conceded that austerity doesn’t work and, not only does it not work, but it is counter-productive.
The implications of this concession for the continuation of the ‘austerity at all costs’ policy are enormous – and may prove to be the first chinks in the armour of the troika.
Christine Lagarde’s IMF noted in its global outlook that the world economy has slowed down more rapidly than it had expected, and its experts asked themselves why had they got it so wrong yet again. Given that the main pillars of Irish economic forecasting – the Department of Finance, the Central Bank and the government’s own fiscal advisory thingy – all subscribe to the IMF’s original view of how the economy works, this volte face by the IMF is not merely academic.
So the IMF asked itself what was going wrong with its economic models which, yet again, got the projections so wrong. Remember, this is the organisation, along with the ones mentioned above, that didn’t foresee the greatest crash in recent economic history.
The nub of the issue is what economists call the size of the fiscal multiplier. This concept relates to how much a cut in government spending or increase in taxes affects the rest of the economy. If it doesn’t have much impact, this would be a small multiplier and mean that a country could cut government spending and not be affected so much because the private sector would take up the slack.
This is what the IMF believed up to now. But last Wednesday, it admitted that it may have been wrong. It admitted that the private sector, reeling with too much debt and no access to new funding, might not be taking up the slack at all.
It’s worth looking at what the IMF itself had to say about issues in the report because it reveals the evolution of thinking at the institution that, more than most, affects Irish economic policy. Here’s the direct quote:
“With many economies in fiscal consolidation mode, a debate has been raging about the size of fiscal multipliers. The smaller the multipliers, the less costly the fiscal consolidation. At the same time, activity has disappointed in a number of economies undertaking fiscal consolidation. So a natural question is whether the negative short-term effects of fiscal cutbacks have been larger than expected because fiscal multipliers were underestimated.”
After pages of charts and numbers, and probing into what exactly happens in an economy like Ireland’s, when the government slashes spending, the IMF concludes: “These results suggest that actual fiscal multipliers were larger than forecasters assumed. But what did forecasters assume about fiscal multipliers? Answering this question is complicated by the fact that not all forecasters make these assumptions explicit. Nevertheless, a number of policy documents, including IMF staff reports, suggest that fiscal multipliers used in the forecasting process are about 0.5. In line with these assumptions, earlier analysis by the IMF staff suggests that, on average, fiscal multipliers were near 0.5 in advanced economies during the three decades leading up to 2009.
“If the multipliers underlying the growth forecasts were about 0.5, as this informal evidence suggests, our results indicate that multipliers have actually been in the 0.9 to 1.7 range since the Great Recession.”
Wow! Just take this in for a moment.
This means that the IMF now admits that the impact of cutting government expenditure on economic growth, demand and unemployment is twice as much as it had thought – or maybe more.
The reason for this as the column has been arguing all along, that Ireland and Europe are experiencing an old-fashioned liquidity trap made worse by vicious deleveraging, which is destroying asset prices. Imposing more austerity simply doesn’t work.
The main reason for this is what Keynes described as the paradox of thrift. Most of us are employed buying and selling to each other. Therefore, your spending is my income and my spending is your income. My income is also the root of my savings. But if we all save at the same time, who is spending? And if no one replaces our spending, then demand will keep falling.
Retailers react to falling demand by cutting prices to coax us to spend. But the very fall in prices convinces people that prices will fall further, and the bargain will come next month or next year. So the laws of economics are turned on their heads. When prices fall, demand doesn’t go up; it goes down.
Balance sheets are broken because, on one side, we have assets – houses, bonds, land and apartments – which are falling in value but, on the other, we have debts, which are fixed.
At a time when income is falling due to rising unemployment and taxes, this means the debt burden is getting heavier every day relative to income.
As a result, people with savings are saving yet more. Those with debts are trying to pay them down.
People don’t want to borrow because they have too much debt, and banks don’t want to lend because they have too much bad debt. Yet the deleveraging is destroying their capital base, too. Again, the paradox is that deleveraging my balance sheet might make my position better, but when we all deleverage at the same time, we drive down asset prices further, demanding yet more deleveraging. If everyone is saving, who is spending? The rise in government spending is the logical reaction to, not the cause of, the liquidity trap.
As demand falls, real wages don’t fall because those with jobs protect themselves and the adjustment comes via unemployment. Irish unemployment has more than trebled in four years.
So, austerity becomes self-defeating – and can’t work.
The IMF now admits this and, interestingly, the implication of this realisation is that the fiscal compact we enthusiastically signed up to will destroy Europe’s economy.
This change at the IMF is significant. A few weeks ago, this column suggested that the only way out of Europe’s growth mess would be a huge fiscal expansion. The IMF now seems to agree.