Missing the point at the IMF

The IMF have just published a working paper entitled: ‘Assessing the Impact and Phasing of Multi-year

Fiscal Adjustment: A General Framework’. Or to put it more simply: should austerity be front loaded or delayed? A really important topic and one where the views of the IMF are of some importance.

I guess if you call anything a ‘General Framework’ you are taking a risk. But honestly, if you also write this

“our framework does not explicitly model the monetary policy response, which could have an important impact on output”

then you have no business using the word ‘Framework’, let alone ‘General’. [1]

We need to go through the logic one more time. When monetary policy is not constrained (we are not at the Zero Lower Bound), monetary policy can (and to a first approximation should) completely offset the impact of any fiscal consolidation. The multiplier in that case will be approximately zero. [2] However if we are at the ZLB, then within the current monetary policy framework (essentially inflation targeting), and unless you are really optimistic about unconventional policy, the ability of monetary policy to stimulate aggregate demand is severely compromised. As a result, any fiscal multiplier will be substantially greater than zero.

Now consider two periods. In the first, we are at the ZLB. In the following period, we are not. Consider two fiscal consolidation programmes. In the first, everything is front loaded into the first period. In the second, nothing happens in the first period, and all fiscal consolidation takes place in the second. Design the two programmes so that we end up with the same debt to GDP ratio by the end of the second period, so they are neutral in this respect.

What is the overall impact on output of the two programmes? Frontloading hits output in the ZLB period, with possible hysteresis effects in the second. Delaying consolidation until the second period has no impact on output whatsoever, because any impact on output is offset by monetary policy. Simple. So the choice is a no-brainer - you delay fiscal adjustment until the ZLB period has ended.

You would think that with these very dramatic implications for the optimal path for fiscal consolidation, allowing for monetary policy would have to be part of any ‘general framework’. Not the whole of any such framework, of course. You would want to consider the particular situation of countries without their own monetary policy. You would also want to consider countries where credibility was so low that delay would raise interest rates on debt (which the paper does do). And of course many countries are not at the ZLB. However some rather large ones are (like the US or the Eurozone as a whole), so ignoring monetary policy in any ‘general framework’ is just crazy.

What the paper does do is allow the size of the multiplier to vary with the output gap. Now you might think that this does something similar to allowing for a monetary policy response and the ZLB. However the way the paper sets things up it does not, because it fails to allow for the fact that outside the ZLB, monetary policy can offset the impact of fiscal policy. In their simulations the gradual (not front loaded) consolidation paths still involve large output losses, because they assume that without fiscal adjustment the output gap would be zero, so delaying fiscal adjustment creates a large negative output gap, which leads to a large multiplier. So this completely misses the idea that monetary policy could and should offset the impact of fiscal consolidation once we are well clear of the ZLB.

This is by now such an obvious and basic point I can only wonder why it is not incorporated into the analysis. By ignoring this point, what has been done is just inapplicable to some major economies. I do not like being so critical and blunt, but this is no academic debating point. And I would hate to think that this reasoning has been ignored precisely because its implications about the timing of fiscal consolidation are so clear.

[1] The paper says, immediately after the quote I give in the main text: "This is reflected implicitly in the fiscal multiplier assumptions in our framework (which can be allowed to vary with the output gap), but future work would be needed to explicitly integrate the monetary policy response into the picture." I discuss below why the 'reflected implicitly' is misleading, and also how the impact of monetary policy could have been captured quite simply.

[2] Approximately, because policy may be targeting inflation instead of or as well as output, and the inflation/output implications of monetary and fiscal policy may differ. It would be wrong in this case to say that multipliers would still be positive because monetary policy is not perfect (and to use something like a Taylor rule to reflect that). Here we are looking at planned fiscal consolidations, which the monetary authorities will know about well in advance. Of course uncertainty means that monetary policy makers will not exactly offset the impact of expected shocks, but they may over compensate (negative multiplier) as well as under compensate (positive multiplier). 

Tweet

Jangan sampai ketinggalan postingan-postingan terbaik dari OBAT KUAT ALAMI | 51B333E5. Berlangganan melalui email sekarang juga:

Atau sobat juga bisa follow OBAT KUAT ALAMI | 51B333E5 dengan mengklik tombol di bawah ini:

Artikel keren lainnya:

Ditulis oleh AndreSurbakti pada tanggal Sabtu, 24 Agustus 2013