Financial Times
October 17, 2012
The World Economic Outlook published by the International Monetary Fund last week has created new excitement around the debate on the effectiveness of fiscal retrenchment. The evidence that governments have consistently been underestimating the size of the fiscal multiplier – which measures the impact of deficit reduction measures on economic growth – has been used to suggest that austerity policies are doomed to fail.
That is the wrong conclusion to draw from the IMF study.
The fiscal multiplier quantifies the impact of a given change in taxes or public expenditures on gross domestic product (GDP). Those who interpreted the IMF study as evidence that austerity is self-defeating mistakenly believe the multiplier measures the impact of a change in the budget deficit on the long-term rate of growth of the economy. In fact the multiplier measures the one-off impact of budget changes on output when the adjustment is made.
Let us consider a simple example of a country with a budget deficit of 1 per cent of GDP, a debt to GDP ratio of 100 per cent and a trend growth rate of 1 per cent per year. A multiplier lower than one implies that when the deficit is reduced from 1 per cent to zero, GDP continues to rise – although temporarily at a lower rate than the trend – and the debt falls as a percentage of GDP.
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