Home > General Politics > The IMF: The Intentional Macro-economic Fallacy

The IMF: The Intentional Macro-economic Fallacy

In circles where this kind of thing matters, there’s been a lot of attention paid to the most recent World Economic Outlook report from the IMF, and more particularly the findings in Chapter 3.   I’ll let David Osler take up the story, as he puts it succinctly:

IMF analysts looked at all known instances of fiscal adjustment in OECD countries.They found only two episodes in which economies expanded as deficits were cut: Denmark in 1983 and Ireland in 1987.

‘All known instances’ isn’t entirely accurate; in fact one of the purposes of the study is methodological – to show that you get different results depending on whether you study swings in the ‘standard’  ‘Cyclically Adjusted Primary Budget Balances’ or whether, as the authors do in this study, they study ‘action-based’ fiscal adjustments. 

It’s technical stuff, worthy of the appendices afforded it, but it’s important stuff, in that it really challenges the dominant view, on its own grounds, that cutting spending in the way the Tories, and other European countries (under differing levels of duress) can stimulate the economy through, for example, improvements in household and business confidence.

Nevertheless, the point is well made by Dave (and Martin Wolf does it in more detail in the FT): when you get down to it there really isn’t much evidence at all that what the Tories are now selling as their ‘no alternative’, ‘common sense’ measures.

This dominance of the ‘common sense’ idea is the type so loved by the largely economics-free zone that is the BBC, who recently devoted a whole week of prime-time radio programming to touring the country, hawking around the key idea that cutting £x in spending would lead to exactly the same level of reduction in the deficit.

Simply to equate spending cuts with deficit cuts is, we now know even more surely from this IMF paper, a total fallacy, but a sadly widespread fallacy, courtesy of  a largely compliant media and government more intent on serving its own narrow class interests than on the actual economic health of the country.

Now, we might be tempted to excuse the BBC for this apparently rank stupidity, seeing it more as an act of survival – toadying up to the government to save itself from being killed of completely.  

What’s more interesting, though, and perhaps more worrying, is that the IMF won’t even take any notice of their own findings.  As this paper from the US-based Centre for Economic and Policy Research, analyzing the same World Economic Outlook report, says:

[T]he Fund has so far not given any consideration to central bank financing of additional stimulus, in spite of the WEO’s assessment of the fragility of the current recovery in the high-income economies. Instead, it has emphasized the need for fiscal consolidation in the high income countries– if not immediately as in the pro-cyclical policies described above, then beginning very soon: “fiscal adjustment needs to start in earnest in 2011. Specific plans to cut future budget deficits are urgently needed now to create new room for fiscal policy maneuver.”

Even so, if it was only the fact that the top policy guys at the IMF hadn’t read the papers by their researchers, then we might still be hopeful that soon, when they’ve had time to digest the important new research, they’ll adjust their views and start to talk enthusiastically to governments about them, and how budget cuts of the scale they’d been promoting might not actually be such a good idea after all.

But it’s worse than that.

The authors themselves of this important chapter decide that what they’ve found is not actually in keeping with what they are ‘supposed’ to find, and take steps to avoid the conclusions that come from it.

Because having gone to all the trouble of finding that ‘action-based’ fiscal contraction leads to lowered outputs and increased unemployment in 168 of the 170 cases studied, they then go on to say:

The discussion so far has focused on short-term effects. We now turn to the long term. Does fiscal consolidation generate long-term gains? And if so, how soon do the long-term gains arrive? This question is one that cannot be adequately addressed using the empirical framework used in the previous section, and so we again use model simulations…….

The simulations suggest that, over the long term, a reduction in the debt-to-GDP ratio is likely to raise output both in the G3 economies and in the rest of the world.

The problem is not that simulations are used for this part of the study, rather than the empirical data used for the study of shorter term effects of fiscal consolidation.  Fair enough, if there’s no data, there’s no data.

The problem is much more basic than that.

The problem is that they’ve  just proved, beyond what they themselves consider is reasonable doubt, that action-based fiscal contract does not in fact increase output or decrease unemployment, but then immediately go on to assume that it does, and that this then decreases ‘the debt-to-GDP ratio’, in order then to model how that reduced ratio leads to greater output.

In so doing, they make absolutely the same error as the simpletons at the BBC, and as the class-interested thugs in 10 and 11 Downing Street are happy to see peddled.

Fair enough, the data they analyse in the first half of the study, shows that on average a country’s output as a % of GDP is reduced at a slower rate than the rate of the fiscal ‘consolidation’ (0.5% compared with 1%), so in ‘average’ circumstances it might be argued that it is worth cutting, because you DO get a bit of a reduction in debt-to-GDP ratio, meaning that the second half of the study may have validity.

But these are not ‘average’ times, as the study also make abundantly clear.  Nominal interest rates are already near zero, so the traditional rate cutting exercise can’t help.  More importantly, the studies recognsises that at the moment, many countries are looking to consolidate at the same time:

Overall, these results illustrate that changes in both the interest rate and the exchange rate are important to the adjustment process. When countries cannot rely on the exchange rate channel to stimulate net exports, as in the case of the global consolidation, and cannot ease monetary policy to stimulate domestic demand, due to the zero interest rate floor, the output costs of fiscal consolidation are much larger. Thus, in the presence of the zero interest rate floor, there could be large output costs associated with front-loaded fiscal retrenchment implemented across all the large economies at the same time (my emphasis). (See also my earlier post on the way in which stimulus is more effective when it’s global?  Does the reverse happen with global consolidation?)

So what’s going on?  Why is this research, which could be so influential for the common good – and I hope parts of which may still be – being corrupted by its own authors, with conclusions and recommendations about fiscal consolidation that are out of keeping with their really very innovative findings? 

I think the simple answer may be that these IMG guys, brilliant though they may be, are just like most of us. They want to do what looks right to their bosses, rather than do the right thing. 

Hah-Jooh Chang, from the inside, is less charitable about his  colleagues in the profession:

Economists are not some innocent technicians who did a decent job in within the confines of their expertise until they were collectively wrong-footed by a once-in-a-century disaster that no one could have predicted…..[Economics has been worse than irrelevant. Economics, as it has been practised in the last three decades, has been positively harmful for most people (23 Things They Don’t Tell You About Capitalism, pp.247-8, also featured in Duncan’s Weldon’s ‘Alan Johnson’s essential reading list‘).

‘Three decades’, and counting.

Categories: General Politics
  1. Adam White (@theday2day)
    October 22, 2010 at 9:58 pm

    Great post Paul, but the latter half is pretty difficult to read due to the different font..

    • paulinlancs
      October 22, 2010 at 10:01 pm

      Yes, wordpress appears to be playing silly buggers tonight. It’s all properly formatted and fonted when I put it in…not technically astute enough to work it out though i’ve tried.

  2. Adam White (@theday2day)
    October 22, 2010 at 10:01 pm

    OK, it seems to have gone to the normal font now, very odd.

  3. Adam White (@theday2day)
    October 22, 2010 at 11:37 pm

    It beggars belief that something so self contradicting could be used to support the claims its data disproves.

    The world has officially gone mad!

  4. October 23, 2010 at 9:08 am

    Forgive me the analogy, but I read something on worms from the University of Utah a couple of years ago, you may remember the story; a scientist was able to modify the sexual orientation of worms in his study. The conclusion was that sexual orientation was hard-wired genetically in the brains of worms. All good, that was the data. However the scientist then made an opinionated assessment seemingly out of kilter with the conclusion his study had been witness to; he said that humans, unlike worms, have free will and therefore sexuality is not genetically linked.

    I think this perfectly illustrates economists too – particularly how they’re portrayed in this post. They have a set of data that has been created through objective study, but they add their own assessments to it – perhaps to please their employer, perhaps for some other reason.

    As Paul says of the IMG guys, they’re just like us, which is to say given a set of supposedly objective data, they’re free to make whatever crazy judgement they can. Like “scientist”, “economist” is one of those fetishised words that is erroneously viewed by some as infallible with data.

  5. October 29, 2010 at 10:30 pm

    A vey brief post (from Berlin). Excellent piece. Can I suggets for wider readership you send to Hednning Meyer at Social Europe . Best/George

  6. Barney Stannard
    October 31, 2010 at 4:28 pm

    I think I should preface this by saying that I am coming around to the view that the Coalition has cut too fast, and that, so far as I understand it, I’m a relative believer in what one might call Keynesian economics, certainly at least as long as we are in ZIRP-land.

    I hope that stops people jumping on me as some kind of crazed 1920s classicist.

    I have to admit I don’t fully understand your reconstruction of the IMF argument. As far as I do understand it I think you are saying that the IMF do the following:

    1) Show that deficit cutting leads to short run contraction in GDP and employment;
    2) Assume that deficit cutting causes short run expansion in GDP and employment.
    3) Use this assumption to show that deficit cutting can have long term gains.

    This would obviously be an absurd line of argument.

    But you then say that the IMF show that debt is generally reduced by more than GDP. So the IMF argument would be reconstructed as follows:

    1) Show that deficit cutting leads to short run contraction in GDP and employment;
    2) Show that, generally, the decrease in deficit is greater than the decrease in GDP;
    3) Show that decreases in the Debt:GDP ratio cause long run benefits.

    Which obviously isn’t inconsistent. So I am not entirely clear as to why you say that:

    “The problem is that they’ve just proved, beyond what they themselves consider is reasonable doubt, that action-based fiscal contract does not in fact increase output or decrease unemployment, but then immediately go on to assume that it does, and that this then decreases ‘the debt-to-GDP ratio’, in order then to model how that reduced ratio leads to greater output.”

    Because they clearly don’t say that, and in your next but paragraph you say that they don’t say that.

    We then come to the point that the IMF report then examines: that the generalities probably don’t hold true right now because a) we are near the zero-bound; b) lots of countries are attempting to fiscally consolidate. Their model projects that for Canada where i) interest rates are zero for two years and ii) the rest of the world conducts fiscal consolidation at the same time; then iii) a 1%pt cut in the Deficit:GDP ratio causes a 2% fall in GDP.

    Now this doesn’t necessarily mean that the deficit would increase as percentage of GDP (see below). Moreover, the assumption that we will be at the zero-bound for the next two years may not hold true. The result is, as ever in economics, that the policy prescriptions are up for debate.

    Or of course, they could be trying to please their boss, though given that the premise of their chapter is an attack on his methodology I’m not sure that is foremost in their minds.

    Calcs: assuming a starting GDP of 100, a deficit of 10%, and a loss of 2% GDP for every %pt cut of the deficit (I know it is too simplistic given losses in tax revenue etc, but the point still stands – so long as I haven’t made some gross conceptual error…).

    %pt cut// New Debt to GDP Ratio//New Deficit as %GDP
    1 9/98 9.18
    5 5/90 5.55
    9 1/82 0.12

  7. November 2, 2010 at 6:23 pm


    Missed this one two. V interesting response and I’ll coem back to aspects of it when I get time, but I think the thing that stands out is that in your calcs you end up with the deficit as % of GDP as the key outcome from contraction. Surely this misses the point; even if cutting does end up reducing the ratio as you project (and I take your ponit re: tax revenues), that doesn’t mean output (and therefore employment etc) increases. Does it?

  8. Lethe
    November 2, 2010 at 7:41 pm

    I look forward to your longer response but in quick answer to your question, my point was that even if the GDP cost of cutting the deficit is greater than 2:1 then one can still see a falling deficit: GDP ratio which is identified by the IMF as a driver of long term growth.

    The argument one could make is e.g. that although cutting the deficit is sub-optimal (in terms of GDP) for the next three years, it is optimal for GDP over, say, eight years.

  1. October 25, 2010 at 11:17 am
  2. November 13, 2010 at 11:01 am
  3. November 29, 2010 at 12:28 pm
  4. April 8, 2011 at 4:24 pm

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