The IMF’s about-turn on the merits of fiscal policy as a tool for promoting growth may prove game-changing in the long run
Ever since Milton Friedman’s ideological assault on Keynesianism in the 1970s, a standard answer to the question posed here has been: ‘nothing’ or ‘not much’. But recently this view has been challenged from an unexpected quarter – the International Monetary Fund (IMF).
Whilst reiterating how economic policy needed to prioritise the real economy and growth, IMF Managing Director Christine Lagarde recently noted how the Fund is always open to rethinking its underlying economic ideas. She said: ‘The pride of this institution is to constantly question, challenge, revisit, reexamine, and test its findings and assumptions, in order to be as up to date as possible’.
Her remarks arose from discussion of IMF ‘fiscal multipliers’. These are the assumptions conventionally plugged into economic models about how much effect on economic activity increasing (or reducing) government spending has. This apparently arcane, technical topic is actually crucial to consideration of which economic policy levers governments can pull, and to what effect, when faced with a prolonged downturn.
Since the crisis, governments trying to bolster their borrowing credentials have liked to evoke the authoritative views of the IMF about economic policy. This is vital to the construction of economic credibility, given that the IMF is such an important conduit of influence for economic ideas to spread to the wider world economy.
In this light, the Fund’s somewhat Keynesian rethinking of fiscal policy effectiveness (and how to target spending at lower earners to boost confidence and demand) has the potential to change macroeconomic policy responses to the crisis.
The standard view about fiscal policy, shaped by Friedman’s neoliberal Chicago School, has long been that ‘fiscal multipliers’ are low. In short, public spending does not tend to create additional economic activity or employment, but rather ‘crowds out’ private spending (deemed more efficient). The Fund has begun to subject such assumptions to extensive interrogation. This is the culmination of a process of reflection about the appropriate underpinnings of post-crisis economic policy begun by IMF Chief Economist, Olivier Blanchard and others in late 2008.
Since then a string of Fund research papers has revisited assumptions about how effective fiscal policy has been at stimulating economic activity. They noted that, if fiscal policy had more effect than they had given it credit for previously, this might explain why economic growth had undershot their forecasts during recent ‘fiscal consolidations’ (the reduction of government spending to restore public finances).
Other papers noted good reasons to expect fiscal policy, targeted towards lower earners, to be more effective in a downturn. This is because recessions mean more unused capacity in the economy, and more ‘liquidity-constrained’ (or cash-strapped) households. Fiscal policy effectiveness was thought to be particularly likely following a financial crisis, especially when monetary policy was doing all it could with interest rates at or around zero (the so-called ‘zero lower bound’). Other eminent public intellectuals, notably Nobel laureate Paul Krugman, have of course been making similar cases for the merits of activist fiscal policy.
This new wave of Fund research resulted in a sharp upwards re-evaluation of ‘fiscal multipliers’ in the IMF’s October 2012 World Economic Outlook, causing shockwaves amongst the small group of commentators and economists who take an interest in such esoteric issues. The Financial Times challenged the Fund’s methodology and findings, and quickly this apparently technical debate about fiscal policy became ideologically charged.
Why? Because so attuned have the ears of many economic policy commentators become to the standard tropes of the neoliberal case against activist fiscal policy that they feel a visceral aversion to the notion that it can have a beneficial effect.
Blanchard has now revisited and re-evaluated the research underpinning the Fund’s new fiscal policy ideas. He co-authored a research paper in January 2013 which rebutted critiques and confidently re-asserted the Fund’s new understandings about fiscal policy and its efficacy, especially in a post-crisis scenario.
It is important, though, to interpret accurately the Fund’s shift in thinking about fiscal policy. The argument is not that a more activist fiscal policy would make the economic slowdown disappear. The IMF is not saying that fiscal policy is the answer to all ills, or that countries can forego restoring their public finances. Nor does it neglect concerns about the difficulties of pursuing activist fiscal policy to boost demand in an open economy (given time lags, leakages, the sucking-in of imports and so on).
Nevertheless, it is saying that there exists an important role for fiscal policy in supporting demand, economic activity and growth – certainly more of a role than economic policy commentators, including within the Fund, have been in the habit of assuming since the 1980s.
In today’s specific post-crisis conditions, and in the light of its updated thinking on this important matter, the Fund is urging those countries with sufficient ‘fiscal space’ to slow down the pace of their government spending cuts.
All of this has relevance for the UK growth debate and the UK Government’s economic policy. The new fiscal multiplier assessments will likely further depress growth forecasts in countries like Britain that are still pursuing austerity measures. This will be grist to the mill of those arguing that fiscal consolidation can be self-defeating in regard to growth.
The impact of this potentially important shift in economic policy thinking will, however, not be felt overnight.
Treasuries and Finance Ministries will have to unlearn decades of economic policy orthodoxy first. Some governments (such as the new regime in Japan) seem more open to a rethink than others. For all that, tales of the death of Keynesianism may have been exaggerated. The potential for an eventual recalibration of post-crisis economic policy following dissemination of the Fund’s surprising and important research findings is substantial.
Ben Clift gratefully acknowledged the support of the Leverhulme Trust for the research fellowship funding which enabled the research for this post to be undertaken.