International Monetary Fund Admits It Severely Underestimated Cost Of Austerity

The International Monetary Fund (IMF) released research today suggesting that it had significantly underestimated the damage European austerity would do to EU growth rates. The paper, by top researcher Olivier Blanchard and staff economist Daniel Leigh, surveyed IMF forecasts released in 2010, when many European nations implemented significant austerity measures.

Most estimates assumed, roughly, that every 1 percent of GDP in spending cuts or tax hikes would lower a country’s GDP growth rate by .5 percent. But it turns out that the costs were closer to 1.5 percent — three times the IMF prediction:

Our forecast data come from the spring 2010 IMF World Economic Outlook (IMF, 2010c), which includes forecasts of growth and fiscal consolidation—measured by the change in the structural fiscal balance—for 26 European economies. We find that a 1 percentage point of GDP rise in the fiscal consolidation forecast for 2010-11 was associated with a real GDP loss during 2010-11 of about 1 percent, relative to forecast. Figure 1 illustrates this result using a scatter plot. A natural interpretation of this finding is that multipliers implicit in the forecasts were, on average, too low by about 1.

As the Wall Street Journal noted, the IMF wasn’t alone in this estimate: “The European Commission, the Organization for Economic Cooperation and Development and the Economist Intelligence Unit also appear to have made roughly the same blunder.” This comports with the Blanchard and Leigh’s finding that the cost really was closer to .5 percent in the past, with the exception of the 1930s, when it was roughly 1.6. Economists, as the Journal suggests, may simply have failed to differentiate between data from financial crises and other data.

This isn’t the first time high-level IMF officials have raised red flags about the effect of austerity on growth. Fund director Christine Lagarde has, in response to the eminent failure of European austerity as compared to American stimulus, suggested that European countries need to deprioritize debt reduction in favor of measures that actually boost economic growth.

The United States is poised to enact a significant austerity package in 2013, even by European standards, due to an increase in the payroll tax and the still-looming spending cuts that were part of the “fiscal cliff.”