Multiplier maths

By C.W. | LONDON

THERE used to be a popular quip that the IMF’s acronym stood for “It’s Mostly Fiscal”, because, whatever the problem, the fund’s economists would advocate tighter fiscal policy. How times change. In recent months, the IMF has been arguing for a more nuanced approach to austerity.

The new thinking has been focused on Europe. Olivier Blanchard (the chief economist at the Fund) and Daniel Leigh* recently looked at the “fiscal multiplier” – the extent to which changes in fiscal policy have knock-on effects on the rest of the economy. They examined several European countries and showed that fiscal multipliers are substantially higher than previously assumed. Previous IMF studies had assumed multipliers of roughly 0.5. In other words, a €1 injection of government money into the economy would only have a net benefit of 50 centimes. By contrast, Messrs Blanchard and Leigh found that the actual multipliers in the early years of the crisis were “substantially above 1”.

Why have the multipliers been revised upwards? The main answer seems to be that economists failed to realise that market turmoil and the nature of the Great Recession would lead to much higher multipliers. Economic weakness meant more spare capacity in the economy, which reduced the risk of “crowding out” effects. Increasing government demands for funding did not have a large upward impact on interest rates—which in normal times would have slowed economic growth.

For a global institution like the Fund, a big question is whether high multiplier effects apply elsewhere—in particular, emerging markets. One of the few big international studies of multipliers suggests they can vary hugely between developed and developing countries.

One study, by Ethan Ilzetzki and colleagues**, looks at multiplier effects in a number of ways. They start by looking at multipliers for government consumption. Government consumption refers to day-to-day government spending—teachers’ salaries, hospital operating costs and so on. In developed countries, they find that the long-run multiplier is 0.66. This means that for every dollar of extra government spending, the net benefit to the economy was only 66 cents. For developing countries, the figure was even worse. A one-dollar injection would result in a decline in GDP by 63 cents. Why? Some economists put it down to the high volatility of government consumption in developing countries. As Mr Ilzetzki notes, developing countries often see one year of government expansion, followed by another of government contraction. And this makes it difficult for a multiplier effect to get going.

However, government investment—things like infrastructure building—results in higher multipliers. Here, the long-run multiplier was 1.5 for developed countries and 1.6 for developing countries. In other words, developing countries really benefit from government investment over government consumption. This may be because government investment is more focused and less wasteful than government consumption spending. Investment can also build the productive capacity of the economy, resulting in beneficial long-term effects.

Carlos Végh, at the University of Maryland, suggests that developing countries may see higher multiplier effects in future years. This is to do with more confident exchange rate policy. In the past, finance ministries in developing countries were worried about the effect of fiscal policy on exchange rates. If government spending were extended, there would be concerns about exchange rate depreciation. Finance ministries therefore had to raise interest rates to preserve the exchange rate. But now, the markets trust the finance ministries more. Look at Brazil. Following their fiscal stimulus in 2012, interest rates did not need to be immediately increased. As a result, the effect of their stimulus was greater. Even though many developing countries are now worrying once again about exchange-rate depreciation, all this suggests that the multiplier effect may have become higher in developing countries.

All told, the latest research shows that fiscal policy might have more of an effect on the economy than previously thought. But this is not an excuse for rampant government spending, in the hope of kick-starting an economy—especially in developing countries. Judicious use of government investment seems to be the way forward. It’s Mostly Fiscal still applies, but perhaps not as surefootedly as it did a few years ago.

*Blanchard, O. J., & Leigh, D. (2013). “Growth forecast errors and fiscal multipliers” IMF Working Paper.

**Ilzetzki, E., Mendoza, E.G. & Végh, C.A. (2013) “How big (small?) are fiscal multipliers?”, Journal of Monetary Economics, Volume 60, Issue 2, Pages 239-254.