The Myth of Austerity and Growth
Greg Mankiw, a Harvard economist and a respected voice in economic policy-making, recently wrote a New York Times article discussing five possible explanations for slow growth in rich countries. The final possibility he discusses is one that I haven’t seen much in recent years -- the notion that government deficits slow economic growth.
Five years ago, it was common to hear claims that too much government borrowing would hurt growth -- an idea known as expansionary austerity. Much of the research cited by the proponents of this theory was done by scholars at the International Monetary Fund. But during the past few years, there have been quite a few questions about the IMF’s past cheerleading for belt-tightening.
The IMF’s job is to lend to countries in distress. But it also tries to make its loans conditional on countries implementing policy reforms to fix the problems that got the country into a crisis in the first place. For a long time, it viewed government deficits as a major source of trouble. After episodes like the 1997 Asian financial crisis, the IMF would press borrowers to cut government spending.
But the fund came under increasing criticism for this approach. The principles of Keynesian fiscal policy -- which have slowly been coming back into vogue -- say that tightening spending is the worst thing you can do in the middle of a recession. More generally, it isn’t clear just how austerity is supposed to work its positive magic. The main claim seems to be the rather vague idea that lower budget deficits increase business confidence.
Some pieces of research seemed to support austerity policies. Work by economists Carmen Reinhart and Kenneth Rogoff -- the latter of whom served as the IMF’s chief economist from 2001 to 2003 -- purported to show that countries that borrowed more grew more slowly. But in 2013, this research was widely discredited when a number of errors were discovered. Subsequent analysis, including some by my doctoral adviser Miles Kimball, showed that there isn’t any evidence that high debt causes low growth.
Another paper on the austerity side -- and one of the papers Mankiw cites in his Times column -- was a 2002 study by Olivier Blanchard and Roberto Perotti. They found that when government spending goes up, business investment goes down. That pro-austerity result contradicts a lot of other papers -- see here and here, for example -- but it was very influential in part because of the prestige of Blanchard, who is a towering figure in macroeconomics (and was the IMF’s chief economist from 2008 to 2015).
But in recent years, Blanchard has shifted his stance. In a 2013 paper with Daniel Leigh, he showed that the IMF had been consistently wrong in its forecasts of the effects of austerity. The more beneficial the IMF predicted that austerity would be, the more incorrect its predictions were!
Blanchard and Leigh conclude that fiscal multipliers -- the mainstay of Keynesian policy -- are much higher than they had previously thought. In other words, each dollar of stimulus spending produces much more than an additional dollar of economic output. The IMF’s 2012 World Economic Outlook, while it still pays lip service to the value of fiscal consolidation, demonstrates the shift in thinking:
[Economic] activity has disappointed in a number of economies undertaking fiscal consolidation…. So a natural question is whether the negative short-term effects of fiscal cutbacks have been larger than [we] expected because fiscal multipliers were underestimated…[our new] results suggest that actual fiscal multipliers were larger than [our] forecasters assumed.
This paper isn’t a one-shot mea culpa. The IMF’s overall policy position has changed a lot in the past few years. A 2015 paper by Fund economists Abdul Abiad, Davide Furceri and Petia Topalova found that government investment boosts the private sector rather than crowd it out. In 2010, the IMF admitted that its demands exacerbated the pain of South Korea’s financial crisis in the 1990s. And in 2016, the Fund released a report questioning whether its entire economic philosophy had major weaknesses.
As we all know by now, certainty is very hard to come by in macroeconomics. Cross-country comparisons are naturally unreliable creatures, since nations aren’t very similar, and because spillovers from country to country are common. The IMF’s new conclusions about fiscal policy might eventually prove to be as wrong as its old ones -- in fact, people were quick to point out weaknesses as soon as Blanchard and Leigh’s paper came out.
But there are two larger points here. The first is that because the IMF has reversed its pro-austerity stance, people citing the IMF ought to recognize this. Mankiw treats the expansionary austerity argument as though it’s still a popular hypothesis, when some of its biggest proponents have now turned against it. That means no one should be taking the idea as seriously as some took it several years ago. There are still a few pro-austerity papers out there -- Mankiw cites one of them -- but they’re increasingly swimming against the tide of evidence.
There’s also the lingering question of why the IMF got things wrong for so long in the first place. It’s good that the Fund has altered its stance -- recognizing a mistake is very important, and plenty of other organizations wouldn't be so intellectually honest. But if the IMF’s policy advice is always one step behind the pace of global events, it’s worth asking whether it should reduce the amount of advice it gives to borrower nations. If we don’t know which policies are good, the best approach might be to let each country figure things out for itself.
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