Several factors suggest that the fiscal multiplier is particularly high in the current
economic environment. As a result, fiscal austerity may hurt growth more than initially
anticipated.
What’s Inside?
The author analyzes the effects of fiscal consolidation on growth. New research on the fiscal multiplier, which provides the link between the two variables, suggests that it is likely to be particularly high under current economic conditions. Consequently, the recent wave of budget consolidation will have a disproportionately large adverse effect on output.
How Is This Article Useful to Practitioners?
As the International Monetary Fund (IMF) points out in its most recent "World Economic Outlook," fiscal multipliers since the last recession have been between 0.9 and 1.7. In previous work, the IMF had assumed a value of only 0.5. Thus, the adverse effect of fiscal consolidation on economic growth was severely underestimated in earlier forecasts.
There are several theoretical reasons to suggest that fiscal multipliers are above average in the current environment. First, with simultaneous spending cuts in virtually all major economies, the impact of austerity on growth could not be passed on to other countries. Second, given high uncertainty and a desire to save, private sector spending did not pick up. Third, borrowing costs were already at very low levels in major economies (such as the United States and the United Kingdom), so the improved budgetary outlook did not lead to further declines in refinancing rates. And fourth, record-low central bank rates did not leave any room for additional monetary easing.
Recent empirical work supports the idea of time-varying multipliers. When interest rates are very low, multipliers can rise to more than 3 and thus deviate significantly from their normal value of 1. During recessions, fiscal multipliers can be as high as 2.5, whereas they can turn negative during booms.
Abstractor’s Viewpoint
Accurate estimates of the fiscal multiplier are very important for economic modeling and forecasting, especially in times when fiscal tightening is a dominant theme. Modeling the fiscal multiplier as a time-varying variable that depends on the state of the business cycle and related economic variables is a promising approach.