IMF: Cuts hurt growth more than expected

The IMF thinks cuts have damaged growth more than previously thought, reports Will Straw.

 

Headlines have today focused on the IMF’s downgrading of the UK economy. But a more significant development is buried in the small print and shows the IMF thinks cuts have damaged growth more than previously thought.

Box 1.1 of the IMF’s World Economic Outlook (pdf) says:

The multipliers used in generating growth forecasts have been systematically too low since the start of the Great Recession, by 0.4 to 1.2, depending on the forecast source and the specifics of the estimation approach. Informal evidence suggests that the multipliers implicitly used to generate these forecasts are about 0.5. So actual multipliers may be higher, in the range of 0.9 to 1.7.

In other words, a cut to government spending or tax increase affects growth by two to three times more than expected. Significantly, the accompanying graph (see right) shows the UK sits squarely on the downward sloping line. This means Britain’s performance is entirely consistent with the IMF’s model showing an error in estimates of multipliers.

The Office of Budget Responsibility published their own estimates of fiscal multipliers in June 2010 (pdf). As shown below, they suggest multipliers were in the range 0.35 for tax cuts to 1.0 for capital expenditure. The IMF’s revelations suggest these were underestimates.

Estimates-of-fiscal-multipliers
The reason for the UK’s dismal growth performance in recent years can be explained by the decisions around spending cuts. The government’s 2010 spending review (pdf) showed capital expenditure would be cut by 29 per cent over four years compared to an 8.3 per cent cut in current spending (Tables 1 and 2).

The former, which was also planned by the Labour government, can now be seen as a catastrophic mistake which has done more to dampen growth than any other measure.

The FT reports (£) the IMF has told George Osborne to prepare for Plan B:

“If growth should fall significantly below current projections, countries with room for manoeuvre should smooth their planned adjustment over 2013 and beyond,” the fund said, adding that they included the UK.

Using the government’s balance sheet to ramp up investment, including by immediately capitalising the Green Investment Bank, should be top of the chancellor’s list.

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