Olli's Follies: Is Debate About Fiscal Multipliers Unhelpful?

Olli Rehn is the European Commissioner for economics.  Olli has spent much of his time in recent years telling everyone that Europe’s austerity policies were working and the Eurozone economy was just about to turn the corner.  In reality, the Eurozone has been in recession since the third quarter of 2011 and the recession appears to be deepening: Eurostat this week reported a decline of 0.6 percent in real GDP in the final quarter of 2012.

International Monetary Fund Managing Director Christine Lagarde (L) speaks to EU Commissioner for Economic and Monetary Affairs Olli Rehn (R). (Image credit: AFP/Getty Images via @daylife)

This week, Olli sent a letter to the EU’s finance ministers and other luminaries including IMF managing director Christine Lagarde.  So what was on Olli’s mind? Concern about the ongoing slump? Worries about record high unemployment?  No. It turns out Olli is worried that IMF economists are doing research on fiscal multipliers.

Last year, IMF Chief economist Olivier Blanchard released apaper co-authored with Daniel Leigh examining the impact of fiscal austerity (Full disclosure: Blanchard was my PhD supervisor).  They compared the IMF’s forecast errors for GDP growth in recent years with plans for fiscal consolidation.

The paper found a negative relationship between fiscal consolidation and growth forecast errors and concluded that fiscal multipliers during the crisis must have been larger than had been assumed. In other words, austerity has had more negative effects than the IMF had previously assumed.

Olli isn’t happy that this research has been released.  His letter says that this debate

has not been helpful and has risked to erode the confidence that we have painstakingly built up over the past years in numerous late-night meetings.

Even leaving aside the medieval prince aspects of these comments (“Galileo needs to stop undermining confidence in the Ptolemaic system”) can Olli really believe that Europe’s finance ministers have been building up confidence while the economy languishes in recession?

Olli’s letter then launches into an amateur referee report on the Blanchard-Leigh paper.  His first critique of their result is that the actual amount of fiscal consolidation was larger than planned, so the IMF paper is over-estimating fiscal multipliers. However, pages 13 and 14 of the paper contains a detailed discussion of this issue and concludes “on average, actual consolidation was neither smaller nor larger than expected.”  So, as far as I can tell, this issue was dealt with in the original analysis.

Olli’s second critique stems from the fact that the largest growth shortfalls occurred in 2010 when many countries were still implementing  temporary fiscal stimulus.  He asserts (without providing any evidence) that permanent consolidation is associated with lower fiscal multipliers, suggesting that the kind of fiscal consolidation that occurred in Europe in 2011 and 2012 will not have contributed to unexpectedly low growth.  But Figure 2 of the Blanchard-Leigh paper also shows strong negative relationships between fiscal consolidation and growth forecast errors for 2011 and 2012 so this point does not appear correct.

In terms of who to believe here, you can choose to trust Olli the Confidence Man who believes debate about fiscal policy is unhelpful or the IMF’s chief economist who also happens to be the world’s tenth best economics researcher. I know who my money is on.

more at http://www.forbes.com/sites/karlwhelan/2013/02/17/ollis-follies-is-debate-about-fiscal-multipliers-unhelpful/