Same Research, Two Viewpoints

President Harry Truman of the US was once reputed to have said, “Give me a one-handed economist! All my economists say, On the one hand…on the other.”

Here we see a corollary to that truism – for every economics research paper, there’s two (or more) perspectives.

So, on the one hand (excerpt, emphasis added):

IMF's economist: budget cuts may hurt growth less now

WASHINGTON: Belt-tightening in advanced economies may not be as harmful to growth now as it was during the height of the financial crisis, but governments should still be careful about drastic cuts, an International Monetary Fund research paper found on Thursday.

The IMF came under heavy criticism in October when it conceded that austerity programs it recommended during the global economic crisis were more costly than expected, causing economic damage that was as much as triple the amount forecast.

In a follow-up paper by the IMF's chief economist, Olivier Blanchard, and his colleague, Daniel Leigh, stood by their initial conclusions but said the harshest impact of those programs may be fading as economies start to recover…

…The paper found that every dollar of deficit reduction subtracted "substantially" more than a dollar from economic growth, as much at $1.70. Economists had previously estimated that a dollar in government cuts would drain only 50 cents from the economy…

…Blanchard and Leigh said the effect of government spending on the economy could vary depending on the country and the state of the economy. They cautioned that governments should not necessarily delay austerity, but should take into account its negative impact on growth. - Reuters

...and on the other hand (excerpt, emphasis added):

The IMF Admits It Was Wrong About Keynesianism

In an important new study, Olivier Blanchard, the Chief Economist at the International Monetary Fund (IMF), has just admitted that having respected and accepted the advice of conservative economists has turned out to be a blunder.

This has cost the world’s advanced economies dearly, and must be reversed if the world is to avoid an economic tailspin.

The new “IMF Working Paper,” titled “Growth Forecast Errors and Fiscal Multipliers,” prepared by Blanchard and Daniel Leigh of their Research Department, reports that whereas the IMF had been accepting conservative economists’ estimates that the multiplier was “about 0.5” percent growth, the “actual multipliers were substantially above 1 early in the crisis,” which was the period when the IMF was recommending and pursuing “fiscal consolidation,” which is called in the United States “austerity.”

In other words, the policy recommended by the Republican Party’s economists, and which has actually been tried especially in Europe, has failed miserably.

Allow me to present a third hand .

I think both the interpretations above have to be considered biased and coloured by personal viewpoints. My own reading of the paper certainly suggests that Blanchard and Leigh didn’t have either particular interpretation in mind when they wrote the paper.

For instance, nowhere does it explicitly state in the paper that further austerity will “hurt growth less now” as implied by the Reuters report. The actual relevant passages, from the conclusion, are as follows (excerpt, emphasis added):

However, our results need to be interpreted with care. As suggested by both theoretical considerations and the evidence in this and other empirical papers, there is no single multiplier for all times and all countries. Multipliers can be higher or lower across time and across economies. In some cases, confidence effects may partly offset direct effects. As economies recover, and economies exit the liquidity trap, multipliers are likely to return to their precrisis levels. Nevertheless, it seems safe for the time being, when thinking about fiscal consolidation, to assume higher multipliers than before the crisis.

Finally, it is worth emphasizing that deciding on the appropriate stance of fiscal policy requires much more than an assessment regarding the size of short-term fiscal multipliers. Thus, our results should not be construed as arguing for any specific fiscal policy stance in any specific country. In particular, the results do not imply that fiscal consolidation is undesirable. Virtually all advanced economies face the challenge of fiscal adjustment in response to elevated government debt levels and future pressures on public finances from demographic change. The short-term effects of fiscal policy on economic activity are only one of the many factors that need to be considered in determining the appropriate pace of fiscal consolidation for any single country.

You could take this as another case of economic two handedness, but from my viewpoint, this is largely one more piece of evidence that fiscal multipliers are non-linear to potential output (“…there is no single multiplier for all times and all countries…”). You could also chalk this up as one more vote for the Lucas Critique.

The second perspective is also off-base, though more overtly so with its political undertones. If you’ve followed the initial policy debate when the crisis accelerated in late 2008, its clear that the “conservative” economists (read: the New-Classical school or sometimes disparagingly known as the “fresh water economists”), didn’t really believe in fiscal multipliers at all.

I remember reading a couple of papers e.g. from John Taylor of Stanford, which provided the result that additional government spending would only crowd out private spending i.e. fiscal multipliers are necessarily zero. Again, nowhere is there a rejection of the validity of fiscal multipliers in the Blanchard and Leigh paper. Rather, their research relied on their own and others empirical findings that the multiplier was around 0.5.

That this strong historical structural relationship broke down shouldn’t come as too much of a surprise after the lessons of the last fifty years, but you have to base your forecasts on something, unless you want to rely on pure guesswork. Wrong forecasts just come with the territory (and I don’t want to digress into a discussion of the challenges of forecasting).

That the costs of this particular forecast error was so high is really what should be of concern right now.

(H/T Ahmad Nubly Isahak for the second article)

Technical Notes:

Blanchard, Olivier & Daniel Leigh, "Growth Forecast Errors and Fiscal Multipliers", IMF Working Paper No 13/1, January 2013