Perspectives On Fiscal Austerity

Businessweek is highlighting the IMF’s nervousness over the impact of fiscal austerity in Europe (excerpt):

More From Olivier Blanchard, the IMF's Dovish Economist

Under Olivier Blanchard, its chief economist, the International Monetary Fund has transformed itself from a strong voice for strict austerity to a strong voice against strict austerity. The latest example is an explanatory box in the IMF’s World Economic Outlook. In it, Blanchard and IMF economist Daniel Leigh present research showing that deficit reduction has harmed growth far more than is commonly understood.

The research (in box 1.1) is technical, but the big idea is that Blanchard and Leigh compared forecasts of nations’ economic growth with what actually happened after countries tightened their belts. They found consistently that growth came in worse than expected, which means that the belt-tightening was more harmful than economists believed it to be—by a lot. Economists have assumed that cutting the government deficit by 1 percentage point cuts about half a percentage point off economic output, but the actual decline is more like 0.9 percentage points to 1.7 percentage points, Blanchard and Leigh write.

“This finding is consistent with research suggesting that in today’s environment of substantial economic slack,” cutting deficits wallops an economy when interest rates can’t be cut any further and many countries are slashing deficits at the same time, they write…

Paul Krugman has seized on the very same IMF report to justify bashing the Republicans (excerpt; via Din Merican’s blog):

Mitt Romney got everything wrong on Economic Policy

...And Republicans are dead wrong.The latest devastating demonstration of that wrongness comes from the International Monetary Fund, which has just released its World Economic Outlook, a report combining short-term prediction with insightful economic analysis. This report is a grim and disturbing document, telling us that the world economy is doing significantly worse than expected, with rising risks of global recession.

But the report isn’t just downbeat; it contains a careful analysis of the reasons things are going so badly. And what this analysis concludes is that a disproportionate share of the bad news is coming from countries pursuing the kind of austerity policies Republicans want to impose on America.

Okay, it doesn’t say that in so many words. What the report actually says is: “Activity over the past few years has disappointed more in economies with more aggressive fiscal consolidation plans.” But that amounts to the same thing…

I’m on record as saying that Malaysia’s deficits and debt levels are not a long term problem. I’ve also no particular objections for the use of fiscal policy as part of a broader tool kit for economic macro-stabilisation.

That’s not the same thing as saying fiscal austerity is always bad, and fiscal pump-priming is always good. I’m not philosophically wedded to the idea that fiscal policy and deficit financing is the sine qua non of economic policy-making. After viewing the above, someone might be tempted to see fiscal austerity as always problematical, but this ignores context. It shouldn’t be an either-or debate.

When demand is deficient (i.e. unemployment is high and capacity utilisation is low), research shows that fiscal multipliers tend to be higher. Technically, that implies that the relationship between changes in fiscal policy and economic growth is thus non-linear. This cuts both ways – higher spending (lower taxation) has a greater impact, but so does cuts in spending (or higher taxes).

But the opposite is also true – when an economy is at full employment, fiscal multipliers tend to fall to zero. Mind you, this also applies both ways: cuts in spending or higher taxation might not reduce real economic growth very much, but neither will tax cuts or higher spending boost it.

What’s often missing from the current discussion and commentary is the complementary impact of monetary policy. The reason why the policy debate in the West is revolving around fiscal policy is because of the perception that monetary policy, leaving aside whether this is true or not, is constrained by the zero-interest rate boundary.

Malaysia’s context is very different. Growth is decent and around the full employment potential. The government’s still running a deficit, but the deficit is below the long run average and the government is also aiming for a slow consolidation towards a lower deficit by 2015. Monetary policy has been on hold, with the OPR at 3.00% for the past year. We’re not facing a zero-interest rate boundary, nor is inflation out of control. That’s a very different set of circumstances than facing the US or Japan or Europe, and we’re not out of options on either the fiscal or monetary fronts.

Just in case I need to spell it out, framing the debate on macro-policy solely around fiscal policy is thus misguided. You have to look at it as a balance between monetary and fiscal policy together, and it’s really about weighing the pros and cons of using each.

On the one hand, monetary policy is likely to be far quicker to implement and far more effective on an overall economy basis. On the other hand, fiscal policy is better suited for addressing structural issues and dealing with micro-economic issues.

Which policy instrument should lead depends on the specific set of economic circumstances facing policy-makers. So the set of solutions will in practice never be composed of a binary choice between fiscal austerity and fiscal profligacy.

(Incidentally, that’s one big reason why balanced budgets make zero economic sense to me).

The true menu of policy choices is in reality far wider. For example, it’s more than possible to achieve a faster consolidation of the budget deficit; all you have to do to neutralise the impact on growth is to talk Governor Zeti into cutting interest rates (and good luck with that). You can even aim for a permanent budget surplus; just be aware that there will be deep ramifications for household and corporate borrowing from the resulting cheaper borrowing costs (for those who are old enough, remember 1993-1997).

On the other hand, it’s more than possible to maintain the current level of deficits for the foreseeable future, but at the price of higher real interest rates. At the structural level, it’s also philosophical choice of how much government involvement is wanted or desirable in an economy – as the choice of fiscal deficit/surplus (and the complementary monetary policy setting) will have an impact on the level of “crowding out” of private sector consumption and investment.

Personally, I don’t have a big problem with either scenario – its always been about aiming for the long run maximum potential, full-employment path to me, which can be achieved either way (I’m a macro-guy, what can I say?). Just remember when reading articles like the ones linked to above, that the economic context matters a great deal. As Keynes once said, “When the facts change, I change my mind.” When the Malaysian context changes, I’ll be changing my mind too.