Monday, January 14, 2013

Britain, Austerity, and the Multiplier: The IMF Says "Oops"

John Lanchester provides an acerbic appraisal of the British government’s last three years of economic "austerity" in an article in the London Review of Books. The title used in the article is Let’s call it failure. A more colorful title, and one more representative of the tone of the article, was used on the magazine cover: The Shit We’re In.

Lanchester begins with this barb:

"As [Chancellor of the Exchequer] George Osborne’s autumn statement made clear, the scale and speed and completeness with which things are going wrong are numbing."

The current government came into power with a very specific plan and goal.

‘We will cut government spending to bring the deficit down and restore stability.’

When the austerity policies were initiated, the government claimed a budget deficit of 4.8% of GDP. After three years of spending cuts and tax increases, Lanchester concludes that the deficit has moved not down but up and resides now at 4.9% of GDP.

He finds the imposed government policies to be bewildering. Severe public spending cuts have been authorized, but the biggest components of public spending—education, healthcare, and pensions—have effectively been excluded, producing draconian cutbacks in other areas.

"We can all agree that there have been savage cuts to public spending. Examples are not far to seek: the police have lost more than 24,000 jobs since the coalition came to power; more than two hundred libraries closed in 2011 alone; local councils are on a four-year track which will see their budgets cut by more than a third."

"Is this achievable? Could any government do that? No government in British history has, which should give us a clue. The cuts to unprotected, unringfenced departments, in real terms (that means adjusted for inflation), would amount to more than 30 per cent. The Institute for Fiscal Studies thinks it is ‘inconceivable’ for the implied levels of cuts to be achieved."

One of the areas required to cut back is the military.

"In....March 2010, when the cuts to unprotected departments were set to be 18 per cent, I quoted an IFS economist as saying that ‘for the Ministry of Defence an 18 per cent cut means something on the scale of no longer employing the army.’ Upgrade the level of cuts to 30 per cent and the cuts are, I suggest, politically and practically unachievable."

The only explanation for this type of planning is that the government hoped to be bailed out by a resurgence of economic growth that would have precluded the need for such drastic measures. Not only has the growth been lacking, but the economy has experienced a double dip recession, and could be headed for a third dip.

"In June 2010, the OBR [Office of Budget Responsibility] predicted that the UK economy would grow by 2.8 per cent in 2012. By this year’s budget in March, it had revised that estimate downwards to 0.8 per cent. By the autumn, the new guesstimate was that the economy would shrink by 0.1 per cent this year. The OBR predicts that the economy will shrink again in the last quarter of the year, before slowly picking up in the first quarter of 2013. If they are right about the first part of that guess but wrong about the second – which looks far from improbable – then we will have entered a historically unprecedented triple-dip recession."

How could government projections be so far off?

Lanchester suggests a misunderstanding of the concept of the "multiplier" is the cause. If the government pays someone a dollar, or a pound, to do something, that dollar has increased economic activity by that amount. If that recipient then goes and purchases something with that money, then another increase in economic activity has occurred. Subsequent transactions could ensue and also contribute to the economy. The value of the initial expenditure has been "multiplied." Note that the concept of a multiplier holds for cuts in spending as well, becoming a negative factor in tallying economic activity. It should also be clear that different types of spending or spending cuts are likely to have different multipliers. It is difficult to predict the effect of government spending changes if one cannot quantify these multipliers.

How could such fundamental economic parameters not be available for accurate budget planning? It seems the concept of a multiplier was first introduced long ago by a student of Keynes. Unfortunately, much of the economic profession has devoted decades to proving that Keynes was wrong.

"About thirty years ago, when Keynes was in the depths of economic unfashionability, going up to a group of macroeconomists and trying to start a conversation about the multiplier would have been roughly like going up to a group of astrophysicists and trying to start a conversation about your star sign. The multiplier was so far off the agenda that it was no longer considered a serious economic principle."

Given the need to prove Keynes wrong, it was necessary to argue that multipliers are small, if not zero. Otherwise, government spending in a recession could be deemed a good thing. Not surprisingly, political and economic conservatism go hand in hand. If an economist wants to believe a multiplier is small he/she can come up with conclusions to support that bias. Keynesians believe multipliers can be large, conservatives believe they are small.

What if the conservatives are wrong?

"What if the effect of public spending cuts is bigger than they thought, bigger than they have allowed for in their models? What if, quite simply, they’re using the wrong multiplier? If that were the case, then austerity policies would be doing more damage than good, and the countries that were pursuing them would be digging themselves further and further into a recessionary hole. The amount they’re saving in spending cuts would be more than accounted for by the extra damage they were doing to themselves."

Lanchester was startled to discover that one of the most influential and conservative of the economic voices has just admitted that the assumptions about the multiplier being small have been wrong.

"In the October edition of its regular World Economic Outlook, the IMF studied the question and announced that governments had been basing their calculations on the effects of austerity using a multiplier of 0.5. So for every £1 billion removed from government spending, GDP would contract by £500 million. The IMF looked at the relevant historical data, and concluded that the real multiplier for austerity-related cuts was higher, in the range of 0.9 to 1.7. So that same package of £1 billion in fact removes as much as £1.7 billion of output. This was a jaw-dropping thing to discover, not just because it was surprising in itself, and because it explained the surprising-to-governments economic damage being done by austerity packages, but also because the people saying so were the IMF. The very same IMF whose off-the-shelf policy recommendations for indebted governments and struggling economies always, but always, involves swingeing packages of spending cuts."

Such an admission of economic incompetence is stunning. Lanchester provides this analogy.

"In terms of the surprise, and its source, the IMF announcing that the multiplier effects of spending cuts had been underestimated was like the BMA [British Medical Association] announcing that they had studied all the relevant evidence and come to the conclusion that exercise is bad for you."

Yes, the British are deep in it—and so is much of Europe.

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