Antonio Fatas and Ilian Mihov:
Underestimating Fiscal Policy Multipliers: The October [2012] edition of the IMF World Economic Outlook is out with very strong warnings about risks to growth… a nice analysis about whether in our most recent growth forecasts we have recently underestimated fiscal policy multipliers….
With many economies in fiscal consolidation mode, a debate has been raging about the size of fiscal multipliers. The smaller the multipliers, the less costly the fiscal consolidation. At the same time, 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 expected because fiscal multipliers were underestimated.
And the answer is yes….
[H]ere is my reading of what has happened: About eleven years ago there was a series of academic papers that estimated fiscal policy multipliers… in the range 1-1.5…. [But]papers that used events such as wars tended to find smaller multipliers…. As soon as the 2008 crisis started the debate went from a simple academic discussion to an urgent policy issue. What will be the impact of fiscal stimulus? The Obama administration produced a report (co-authored by Christina Romer) that suggested multipliers around 1.5….
Since then the debate has become much more ideological than academic. We have had a series of additional academic papers that, if any, suggest that multipliers are even larger than the initial estimates because of the special circumstances we are in (monetary policy stuck at the zero-lower bound and a deep recession caused by develeraging forces that reduce private demand).
But… the ideological debate… somehow led to the conclusion that those policies did not work and that what we now needed was more austerity. And when over the last two years we forecasted GDP growth rates in the face of coordinated austerity by many governments we somehow forgot to consider that multipliers can be large.
This is what the IMF suggests now in their analysis, which… is… self critical…. [T]heir model was implicitly using fiscal policy multipliers around 0.5…. The analysis in the current World Economic Outlook suggests that multipliers might be within the range 0.9 to 1.7, a range which happens to be very almost identical to the one produced by the early papers and confirmed by the most recent academic literature.
