IMF: We All Underestimated The Pain of the Cuts
What if the fundamental assumptions upon which we’ve based our economic plans were flawed?
What if Britain’s fiscal plan – the “plan A” we hear so much about – was predicated on an economic model which vastly underestimated the crippling economic impact of austerity?
Those are the questions buried away in the International Monetary Fund’s World Economic Outlook report. For while most of the attention over the WEO has been focused on those horrific downgrades to UK growth – and the even more striking fact that for the first time in the crisis Britain’s deficit is now bigger than Greece’s, the report also raises deeper concerns.
The basic point is pretty simple (though this being the IMF they couch it in economic jargon): the Fund and most other economists have for years been underestimating the knock-on effect of public spending cuts on economic growth. It goes back to something economists call multipliers, which give you a rule of thumb about how much you can expect a change in public spending to affect economic growth.
So, for instance, if you assumed a fiscal multiplier of 1, that would mean that for every pound you cut in public spending, you can expect a pound to come off Britain’s gross domestic product – the broadest measure of economic growth. And vice versa if you increased spending. Of course, in practice it’s slightly more complicated than that, with economists using lots of different multipliers for different elements of government spending and taxation.
The IMF’s point today is that economists, including at the Fund and also, by implication, at Britain’s Office for Budget Responsibility, have been using multipliers that are “systematically too low since the start of the Great Recession, by 0.4 to 1.2, depending on the forecast source and the specifics of the estimation approach.”
Imagine you’re the OBR and you have a fiscal multiplier of 0.5 in place (in actual fact its multipliers range from 0.35 to 1 depending on what kind of spending you’re talking about). Let’s say the Government is due to cut public spending by £100bn: you would predict that this would knock £50bn off GDP. If, on the other hand, you were to use a multiplier of 1.5, the effect of those spending cuts would be three times bigger, knocking £150bn off GDP.
That’s a big difference – and the IMF’s report says that “the multipliers implicitly used to generate these forecasts are about 0.5. So actual multipliers may be higher, in the range of 0.9 to 1.7.”
It would help explain why economic growth has disappointed for so long and so repeatedly, not just for the UK but for other countries around the world as well.
The problem is that predicting the impact of fiscal measures is a very imprecise science – no two countries are alike, and no single spending cut is alike. But then again, the very foundations of the Government’s economic plans are built on multipliers like these.
Which brings us back to Downing Street, and the question of whether the Chancellor will change his fiscal plans in the Autumn Statement next month. He certainly looks likely to miss his “supplementary fiscal target” – that Britain’s national debt should be falling as a percentage of GDP by 2015/16: that becomes all the more difficult when both GDP is falling and the deficit is rising.
And, as Vicky Redwood of Capital Economics points out, “the fact that the fiscal squeeze is now estimated to have a bigger adverse effect on the economy could clearly be taken as support for the argument that the Government should ease off a little.”
But if he doesn’t want to do that, what other options are left to him?
Well, let’s go back to those multipliers. According to the OBR, the biggest impact on growth comes from cutting investment spending (probably the impact is even bigger, based on the IMF’s research). And yet this is precisely where most of the cuts are happening.
It might make sense, then to focus the cuts on areas which have less impact on economic growth. And what are those areas? Well, the smallest impact comes from raising VAT. That’s already been done. The next smallest impact comes from a cut in the personal allowance: but that’s out of the window given that there’s a coalition pledge to raise this towards £10,000.
Then there’s welfare, with a multiplier of 0.6 (at least according to the OBR).
Which might help underline why George Osborne and the Treasury are making so many noises about potentially cutting welfare benefits. Not merely does it play well with the public, it is also comparatively less economically damaging than some of the alternatives.
On another topic, I’ve examined the IMF’s rather peculiar relationship with Britain’s Plan A, which it seems to support even when the economic picture deteriorates, here.