Deficit Cuts: Bad Policy based on Bad Research

The Economist reports that the International Monetary Fund (hardly a bastion of Keynesian types) is taking a dim view of recent calls for increased fiscal austerity.  On top of this, the IMF argues that the trend toward austerity is based upon flawed research by two Harvard economists:

In particular the fund criticises the way Mr Alesina and Ms Ardagna identified periods of deficit-cutting. The Harvard economists defined major fiscal adjustments as episodes during which the cyclically adjusted primary fiscal balance (CAPB) improved by at least 1.5% of GDP. The IMF argues that movements in the CAPB can give a misleading impression about changes in a country’s fiscal stance. For instance, Ireland implemented sharp spending cuts and tax hikes amounting to 4.5% of GDP in 2009. But a collapse in house prices meant that its primary deficit actually worsened. The method used in the Harvard study would not count this as a case of fiscal tightening. By the same token, in Japan in 1998 the government made a one-time capital transfer amounting to 4.8% of GDP to the railways, worsening its budget balance for that year alone. The CAPB improved sharply in 1999 without the government needing to implement any austerity measures, yet the Harvard study would count this as a fiscal adjustment. The fund argues that omitting cases like the Irish one (which was associated with a decline in growth) and mistakenly counting instances like Japan’s in 1999 (when growth did not decline) reduces the Harvard study’s ability to pick up the growth-retarding effects of actual fiscal contractions.

To take it further, the IMF paper argues that, at a time when banks have lowered their interest rates to virtually zero percent, fiscal austerity will be even more contractionary than usual.  The full story is here.

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