fiscal multiplier

This week the International Monetary Fund argued that Keynesian short-term multipliers used in economic forecasts had been “systematically too low since the start of the Great Recession”.

The multiplier describes the relationship between changes in taxation or public spending and output. For a multiplier of 1, a $1 increase in taxation will reduce GDP by $1. For a multiplier of 0.5, a $1 reduction in spending will reduce GDP by $0.50. The higher the multiplier, the more painful deficit reduction.

The IMF justified its concern over multipliers by evaluating its April 2010 forecasts for growth. It found that in countries that planned significant fiscal consolidation, its growth forecasts were systematically too optimistic and they were too pessimistic for countries planning to let spending rise quickly or cut taxes. Read more

Robin Harding

Although it seems like a world away, the main economic policy argument in the early summer of 2010 was about the effectiveness of fiscal stimulus, in the wake of the Obama administration’s $787bn American Recovery and Reinvestment Act.

Now that the administration is asking for a new $447bn stimulus that question should be back at the top of the agenda – and thanks to two excellent new NBER papers it is going to be a lot harder for people to distort the economic argument.

Most of the new evidence suggests that in today’s specific circumstances – where the zero lower limit means that monetary policy is not as loose as the Fed would like – then fiscal stimulus could be very effective indeed. Read more

Since Monday’s announcement of the Office for Budget Responsibility, it has become apparent that the new fiscal watchdog will enter an academic and policy-making viper’s nest when it produces its first forecasts. On top of some of the OBR’s obvious flaws, George Osborne has given Sir Alan Budd the hospital pass of making an explicit assumption of the fiscal multiplier, something policymakers like to fudge (see below).

Why so? The OBR will produce its first growth and borrowing forecasts a few days before the 22 June Budget. The Treasury’s unit handling the OBR says these forecasts will be on the basis of no policy change from the 29 March Budget.

The forecasts will therefore be the Budget forecasts, adjusted for any fiddling of the figures under Labour, updating for almost three months extra data and, perhaps, including the £6bn spending cuts for 2010-11 to be announced on Monday. I say “perhaps” because these spending cuts are for one year only and will be offset thereafter by tax reductions, so it would be seriously misleading to include them in a forecast alone (improving the outlook for borrowing) without the subsequent and known tax reductions.

Then, the chancellor will make the substantive spending cuts and tax increases he promised in his FT interview. And then the OBR will have to produce a second set of growth and and borrowing forecasts, taking into account the additional fiscal tightening planned by the new Con-Lib coalition government.

Here the OBR will have to make an explicit assumption of the fiscal multiplier – the ultimate effect on the economy of changes to tax or public spending. Its assumption will be easy to derive from the way it changes its growth and borrowing forecast. This will be an extremely political act for the OBR and it had better be ready to put its reputation on the line. It can also be an iterative process – if cutting public spending reduces growth, which in turn cuts tax revenues, borrowing still falls short of the chancellor’s fiscal goals and this requires further cuts in public spending etc.

When you talk to OBR people in the Treasury, they say: “Ah… the second round effects …hmm, we’ll get back to you”. And they don’t. Let’s think through what the outcomes could look like.

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