You don't have to be Paul Krugman to see that fiscal austerity has deepened and prolonged Europe's economic downturn. Just ask the millions of Spaniards, Britons, and Greeks suffering from government cutbacks and higher taxes. But for years, there has been little willingness among policymakers to recognize that austerity was not the magic bullet they had hoped.
For that reason, the latest edition of the International Monetary Fund's World Economic Outlook is an important step in the right direction. In a highly self-critical report, the IMF admits it systematically underestimated the consequences of contractionary policy:
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.
The IMF goes on to say that for decades they had been using an implicit fiscal multiplier near 0.5 for advanced economies. That means that when they made forecasts about how government cutbacks would affect economic growth, their model assumed that for every dollar lost in government spending, economic output would fall by 50 cents.
But after reviewing the evidence, the IMF now believes the correct multiplier is in the 0.9 to 1.7 range—similar to the estimate of 1.57 made by Christina Romer and Jared Bernstein when the Obama administration made the case for economic stimulus in 2009. Using the higher multiplier, the IMF acknowledges that austerity programs are far more contractionary during economic downturns than they had previously thought.
The IMF graph below illustrates this point nicely. With few exceptions, countries that have pursued expansionary monetary and fiscal policy are growing, while those with austerity programs are below trend or contracting. Europe, the poster child for fiscal consolidation, is almost entirely in the red.
These revised estimates have critical implications for U.S. fiscal policy. At the present moment, Congress is at loggerheads over the approaching “fiscal cliff,” when several major budget items—including the Bush tax cuts, the payroll tax cut, and other emergency stimulus benefits—are scheduled to expire. Without any further change to current policy, taxes will rise by over $500 billion, affecting households at every level of the income distribution. At the same time, the government will automatically cut $1.2 trillion from the budget over the next nine years, split evenly between defense and discretionary domestic spending, as part of last year's Budget Control Act.
Unless elements of these policies are revised or repealed, the IMF warns the fiscal cliff will decrease GDP by more than 4 percent in 2013:
If this risk materializes and the sharp fiscal contraction is sustained, the U.S. economy could fall into a full-fledged recession. The global spillovers would be amplified through negative confidence effects, including, for example, a global drop in stock prices.
Given the recent experience of Europe, where the recessionary effects of austerity far exceeded what IMF and other analysts had forecast, the United States has no reason to attempt fiscal consolidation of this magnitude.