Have the Eurozone’s fiscal policies failed? Have they been fooled by models that were out of date? The recent note by CPB researchers Möhlmann and Suyker is only two and a half page long. Still, it got a lot of attention in the Dutch newspapers. Why?
IMF considers EU fiscal policies too austere!
Let us go back to 2013. The economic crisis in Europe has entered its second phase or, as argued by Richard Baldwin and others, has become a Eurozone crisis. Output growth in the Eurozone has been weak since the outbreak of the financial crisis in 2008 and many countries suffer from high unemployment. Meanwhile, public finances are deteriorating. In particular, a number of countries have difficulties meeting the 3 percent criterion on the public deficit ratio. Then, we come to know that IMF economists Blanchard and Leigh (B&L) have done empirical research on the fiscal multiplier, i.e. the output loss that will occur in reaction to an exogenous cut in public spending. And that they conclude that in the crisis years 2009-2011 the fiscal multiplier has been much larger than previously expected. That is news! It means that policy reforms that countries are undertaking in order to meet the deficit criterion are accompanied with bigger output losses than previously thought. And although the two researchers warn against the idea that they are criticizing EU fiscal policies, the message immediately starts to spread across the world: IMF considers EU fiscal policies too austere!
The CPB note repeats the IMF research, but with more recent data. The conclusion of the researchers is twofold. For the period 2009-2011, they confirm B&L’s earlier results. By the way, this is what you would expect if the same data are being used (guess what would have happened if the CPB researchers had not been able to reproduce the earlier results). But for the years 2011-2015 the researchers calculate that the fiscal multiplier has a normal value. The Dutch press immediately concludes that the CPB research overthrows the earlier IMF research. However, one can argue that that is unfair to the IMF. In their report, B&L state, I quote “(..) we look at the results for other time intervals since the start of the crisis, as well as the results for “normal times” (1997-2008). (..) Interestingly, and again perhaps not surprisingly, we find no evidence of systematic forecast errors related to planned changes in fiscal policy during the pre-crisis decade (1997-2008).” If one counts the 2011-2015 period fully as crisis years, the two institutes indeed disagree. But if one reasons the peak of the worldwide financial crisis was in the years 2009-2011, the CPB research merely confirms the IMF research.
they cannot reject the hypothesis that the multiplier has the same value during an economic crisis than before or after a crisis
Meanwhile, a debate has started on the interpretation of the CPB results. The small forecast errors found for the years 2011-2015 indicate a normal value for the fiscal multiplier only if the expectations on the fiscal multiplier have not changed. Jacobs contacted the IMF researchers and was told that indeed adjustments have been made. We do not know what these adjustments imply precisely, but they could partly invalidate the results of the CPB research.
It thus seems that the confusion is complete. But things are even worse. Recently a very good read on fiscal multipliers appeared, authored by Alesina and Giavazzi, two Italian economists who have been doing research for quite some years on the topic of fiscal multipliers (it is multipliers, as they distinguish between the multiplier that relates to spending cuts and the multiplier that relates to tax hikes. They find the latter multiplier to be (much) higher than the former multiplier). In one of their analyses, they look at the question whether fiscal multipliers are larger during an economic crisis than before or after a crisis. Contrary to B&L, they cannot reject the hypothesis that the multiplier has the same value during an economic crisis than before or after a crisis.
What is painful is the increase in unemployment
Thus, not only are we unable to answer the question whether the value of the fiscal multiplier has returned to normal, but also are we unable to tell whether the fiscal multiplier has increased in value when the crisis unfolded in the first place. The conclusion is obvious then: (much) more research needs to be done before we can tell whether fiscal policies were too austere. However, before closing, let me add one more thing: research should better not only focus on the value of the fiscal multiplier. Why? Let me give you three reasons. First, what makes an economic crisis painful is not so much the loss in output. People can get over that. What is painful is the increase in unemployment which deprives people from much more than the consumption to which they have got used. Second, deficit reduction is not only costly, it is beneficial at the same time. For it reduces the public debt and thereby the vulnerability of a country to future economic crises. Thirdly, there are externalities. If a country like the Netherlands with a strong reputation in financial markets judges its public debt situation not so bad to warrant fiscal austerity policies, this could spill over to other countries. These other countries, with less sustainable public finances, could be tempted to follow the Netherlands. To be sure, I am not saying the Netherlands is so powerful that this would happen; but spill-overs are a possibility that one should keep in mind.
I conclude that the picture of the effects of fiscal policies during an economic crisis is far from clear-cut. This does not disqualify economics. That would be the case if economists would leave the issue for what it is. But I do not expect this to happen. I expect bright young students will take up the questions that we now have been confronted with. Even if that does not yield a Nobel prize, it might give you worldwide fame! (that is, in the Netherlands)