A history lesson on multipliers

Jonathan Fortes 450 large

Q. The IMF’s recent World Economic Outlook has cast doubt on its own forecasts for the fiscal multipliers.

The report states: “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. This finding is consistent with research suggesting that in today’s environment of substantial economic slack, monetary policy constrained by the zero lower bound, and synchronised fiscal adjustment across numerous economies, multipliers may be well above 1.” What is the significance of the findings?

A. I think it reflects the fact that the IMF have commendably acknowledged that their analysis relied too heavily on the experience of changes in fiscal policy over the past 30 years or so. Actually, it is quite different when interest rates are up against the Zero Lower Bound. We are in the aftermath of a financial crisis and in terms of the things we know now, history has proven not to be a very good guide. They are recognising that the people who were saying that it is different this time and that we should be paying less attention to what happened in the past and more attention to the theoretical models that talk about what might happen in this context were right.

People like Paul Krugman and Simon Wren-Lewis, who argued that from a theoretical perspective multipliers would be significantly higher, have proven more accurate in their predictions than people who based their arguments on historic data, which included NIESR, to be frank.

Q. Chris Giles, economics editor of the Financial Times, has cast doubt over the IMF’s methodology and the Office for Budget Responsibility has claimed that other factors may have played a Iarger part in falling output: “Estimates of multipliers vary widely, so it clearly possible that the fiscal consolidation exerted more of a drag on growth than we assumed. But persistent inflation is likely to have weakened consumption in 2011 and deteriorating export markets are likely to have weakened net trade more recently. And it is difficult to distinguish the impact of the fiscal consolidation in other areas – such as business investment – from the impact of anxiety about the euro area’s future and the ongoing dislocation of the financial system.” Are these aguments credible?

A. It is clearly not the case that the only reason the forecasts were wrong is because the multipliers were wrong.

All these other factors were also going on, so that part [of Giles’ analysis] is clearly true. On the other hand, the Government spending multiplier in the OBR calculations is something like 0.5. So in other words
what they are saying is that a reduction in government spending leads to a less than one-for-one reduction in GDP. This means at least one of these other factors must get better.

So, for the OBR to be right, either household consumption, investment or net trade has to increase. Now which of those would we say has increased as a conseq-uence of a fall in government consumption?

In normal times, a fall in government consumption will lead to a fall in deficits, which would in turn lead to a fall in interest rates.

So it is perfectly possible in normal times that the multiplier is less than 1. If interest rates fall, you would see household consumption rising and also at the same time the exchange rate might depreciate improving net trade. None of those things are happening, however. So why would you think the multiplier is less than 1? What mechanism remains to offset the reduction in government consumption? It is difficult to see what evidence there is to support the assumption of multiples lower than 1.

Q. Glies claims that the growth shortfall “splits almost equally between lower household consumption at the start of this period, weak business investment throughout and, more recently, disappointing exports.” Presumably, a counterargument that could be given is that external factors, such as the eurozone crisis, have weighed on the potential for Government cuts to be offset?

A. My view is that if you believe the multipliers are higher, then that applies in equal measure to what is going on in Europe. Clearly, there are spillover effects.

I absolutely believe that part of the weakness is due to the fact that the Europeans were also doing stupid things. It is not just our multipliers that have restrained growth in the UK, it is the multipliers from the eurozone that feeds through to us in net trade.

It is not as simple as simply saying that the UK’s problems are just a domestic thing but it seems clear that multipliers are higher than the OBR thought they would be.

Q. Would you say that those arguing against a higher multiplier are conflating the difficulty in establishing a definitive figure with an improbability of a higher one?

A. I think that is right. I certainly do not think that you could look at the IMF’s research and say that proves that the multiplier was “x” in the UK. That would be a step too far. The IMF’s report just adds weight to a whole range of evidence, from theory to common sense, that taken together lead you to the conclusion that the multipliers were significantly higher than the IMF and others thought at the time.

That does not give you an exact figure but it does tell you that the error was significant and what the direction of that error was.

Q. Do you think that the IMF’s findings will ultimately be vindicated?

A. It is bad enough to say whether research has established anything after it has been published, let alone before anybody’s done it. So I am not sure that I would go that far.

Q. Does NIESR have its own estimate for the multiplier?

A. We are publishing something this week that will re-examine this issue in the context of current circumstances, explicitly taking into account the spillover effects within Europe.