Fiscal Closing Time?

Economists may not be able to pinpoint the precise economic impact of fiscal retrenchment. But, by improving their methods and collecting new data, they can tell us with much greater accuracy than ever before when and how consolidation should be carried out.

BRUSSELS – Is it time for fiscal consolidation or stimulus? Should governments cut or increase spending? Once again the issue is a matter of dispute among policymakers and economists. Citizens, having been told in 2008-2009 that the imperative was to stimulate the economy, and in 2010-2011 that the time had come for retrenchment, are understandably confused. Should priorities once again be reversed?

At the International Monetary Fund’s annual meeting in October, the Fund’s chief economist, Olivier Blanchard fueled the controversy by pointing out that in recent times governments have tended to underestimate the adverse growth consequences of fiscal consolidation. They have typically assumed that to cut public spending by a dollar would reduce GDP by 50 cents in the short term; according to Blanchard, the true outcome in current conditions is a decline by between $0.90-1.70. That is a big gap, but also a perplexing finding: how can there be so much uncertainty?

Contrary to what such forecasting disparities may suggest, economists actually know a lot about the consequences of fiscal policy, at least much more than they used to know. Until the 1980’s, it was routinely assumed that the so-called “multiplier” – the ratio of change in GDP to the change in government spending – was stable and larger than one. A one-dollar spending cut was believed to reduce GDP by more than one dollar, so that fiscal retrenchment was economically costly (while, conversely, stimulus was effective).

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