Understanding Austerity

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

One key feature of good risk management is the ability to adapt to a rapidly changing environment.  It is also important to understand the process driving change – is a structural shift in the parameters or just a temporary outlier in the state of the economy.

This issue recently came to the forefront when the IMF raised a new estimate size of the fiscal policy multiplier – and thus the impact of austerity on GDP.  This has been a contentious issue since the crisis started.  The IMF suggests that the multiplier is much higher than previously thought in the current policy environment.

A recent VOXEU communique by Barry Eichengreen and Kevin H O’Rourke called Gauging the multiplier: Lessons from history suggest the economy is undergoing a change that is not fully understood.  The authors confirm the IMF’s estimate of a higher multiplier.  The Fund’s new estimates, which range from 0.9 to 1.7, suggest that Europe’s policies of austerity are in fact directly responsible for the fact that the continent’s recessions have been even deeper than initially forecast.

This is of course just what standard theory would suggest: that the fiscal multiplier will be unusually large when interest rates are at the zero lower bound.  What matters for the multiplier are economy-wide measures like interest rate cuts and quantitative easing?  To date, the latter has been non-existent, while the former underwhelming.  The problem is that standard theory doesn’t tell us much about the precise magnitude of the multiplier under such conditions.

The authors use better statistical estimates for the fiscal multiplier and compare it to data estimates from the 1930s.  These estimates based on 1930s data are at the higher end of the literature, but consistent with the idea that the multiplier will be greater when interest rates are at the lower bound. The 1930s experience suggests that the IMF’s new estimates are, if anything, on the conservative side.

In the classic movie Casablanca, Captain Renault expressed shock when publicly describing an uncomfortable fact of which he was privately aware.  European officials, while also expressing shock and outrage over the IMF’s uncomfortable finding, were similarly aware of what was going on 'in here' well before the Fund brought it to the world’s attention.  The question now is whether, having been forced to go public, they are finally prepared to translate that awareness into action.

Can we apply this lesson to risk management?

www.voxeu.org/article/gauging-multiplier-lessons-history