Sovereign debt bubble thread

[Iormlund]

Interesting paragraph from the lastest IMF WEO report:

In line with these assumptions, earlier analysis by the IMF staff suggests that, on average, fiscal multipliers were near 0.5 in advanced economies during the three decades leading up to 2009. If the multipliers underlying the growth forecasts were about 0.5, as this informal evidence suggests, our results indicate that multipliers have actually been in the 0.9 to 1.7 range since the Great Recession. This finding is consistent with research suggesting that in today's environment of substantial economic slack, monetary policy constrained by the zero lower bound, and synchronized fiscal adjustment across numerous economies, multipliers may be well above 1.

Predictions were made using a 0.5 multiplier (for every € cut in spending the GDP would be reduced by half an €). As it turns out, the multiplier during the crisis has proven to be much larger, from 0.9 to 1.7.

[MadImmortalMan]

Not really news to anyone but the IMF.


Of course, if they are using some kind of multiplier in their calculations at all they should realize the thing is flawed from the start.

[MadImmortalMan]

...And Spain gets downgraded again by S&P. Outlook: Negative

[Admiral Yi]

That 0.5 multiplier is kind of strange.  That seems to indicate that for every dollar of public spending, 50 cents just disappears.

[DGuller]

That 0.5 multiplier is kind of strange.  That seems to indicate that for every dollar of public spending, 50 cents just disappears.

That's a fitting model for Russia. 

[Legbiter]

Spain has it tough. Back here we devalued, spent 2 years eating shit but things are back on the upswing and if the eurozone blows up like a toilet I'll have to play psychotic squirrel again. 

[Sheilbh]

Incidentally the rating agencies also think the German, Finnish and Dutch statement was a change of policy, from their S&P's downgrade of Spain:

A severe and deepening economic recession that could lead to increasing social discontent and rising tensions between Spain's central and regional governments;

A policy setting framework among the eurozone governments that in our opinion still lacks predictability. Our understanding from recent statements is that the Eurogroup's commitment to break the vicious circle between banks and sovereigns – as announced at a summit on June 29 – does not extend to enabling the European Stability Mechanism to recapitalise large ongoing European banks. Our previous assumption was that official loans to distressed Spanish financial institutions would eventually be mutualised.

The French Finance Minister said this 'I participated in a number of decisions that were without ambiguity. Change (by Germany) is possible. But not a misunderstanding.'  Barroso was also asked about it and said the Commission is acting on the agreement reached on June 29th and he's very clear what it means, 'I remember.  I was there when we agreed it.'

Looks like Greece is going to get more time:

Lagarde urges 2 years for Greece. What will it cost?
October 11, 2012 12:47 pm by Peter Spiegel

IMF chief Christine Lagarde's declaration this morning that Greece should be given two more years to hit tough budget targets embedded in its €174bn bailout programme – coming fast on the heels of German chancellor Angela Merkel's highly symbolic trip to Athens – are the clearest public signs yet of what EU officials have been acknowledging privately for weeks: Greece is going to get the extra time it wants.

But what is equally clear after this week's pre-Tokyo meeting of EU finance ministers in Luxembourg is there is no agreement on how to pay for those two additional years, and eurozone leaders are beginning to worry that the politics of the Greek bailout are once again about to get very ugly.

The mantra from eurozone ministers has been that Greece will get more time but not more money. Privately, officials acknowledge this is impossible. Extending the bailout programme two years, when added to the policy stasis in Athens during two rounds of elections and a stomach-churning drop in economic growth, means eurozone lenders are going to have to find more money for Athens from somewhere.

The starkness of the task ahead of them was made clear in the IMF's just-released World Economic Outlook. Buried in the 250-page report is a table that shows the Fund has radically downgraded its outlook for Greece's economy. The IMF now believes Greece's will shrink by 6 per cent this year and 4 per cent next year.

That's a stunning downgrade, particularly considering just in March, when the IMF signed onto a second Greek bailout, the Fund had estimated Greece would only shrink by 4.8 per cent this year and return to flat growth in 2013. It is perhaps no surprise the IMF made such a drastic change in the same report in which it concluded it has been underestimating the impact of austerity measures for years.

Such a dramatic cut in growth will mean an equally dramatic drop in tax revenues, which likely means billions of estimated euros will go uncollected. Add to that a privatisation programme that has gone nowhere because private investors remain spooked that their euro-denominated purchases could be turned into drachma-denominated assets – complete with the full-scale devaluation such a currency change would come with – and the funding gap grows even bigger.

According to one senior eurozone official, the amount of additional financing Greece will need through a two-year extension is about €30bn. There are really only four ways to find that money, each with its unique problem.

The most direct way would be to simply increase the size of Greece's bailout to €204bn. But because eurozone finance minsters have said they won't provide any more money, that's basically been ruled out.

Greece could instead be forced to make additional budget cuts. But by extending the programme two years, IMF and EU lenders are already acknowledging the austerity medicine delivered in March is too much for Greece to handle. So piling more austerity on top does not seem to be a palatable solution.

Athens could try to raise the money itself. Almost unnoticed during the ongoing wrangling over the Greek budget – and Athens' repeated warnings that it is about to run out of money – the government has remained able to raise short-term funding in the private debt markets. The borrowing costs are exorbitant –Greece's 1-year t-bill is currently trading at about 12 per cent, for example – but there's apparently private money out there willing to take the risk. But it's not a long-term solution. Heavy reliance on short-term borrowing only exacerbates the problem, since it adds to Greece's debt burden.

That leaves the most fraught choice for eurozone members: taking losses on their own bailout loans to Greece. According to a recent Commerzbank analysis, about €126bn in Greece's outstanding €326bn in sovereign debt is now in bailout loans.

And it is the only big piece left that can be restructured, since both the IMF and the ECB – both of which are large Greek creditors – have rules against write-downs. Private bondholders – who hold most of the rest of the debt – have already been through a painful restructuring earlier this year.

Eurozone ministers made clear their opposition to any restructuring of their own loans during the Luxembourg meetings, but the IMF is insisting that any realistic re-evaluation of Greece's programme – particularly if it is extended for two years – must include some kind of official "haircut". Otherwise, they argue, the numbers just aren't credible.

The most likely fudge, officials say, is extending the repayment schedule for the bailout loans and cutting the interest rates on those loans, something that has already been done twice. But any further cuts in interest rates will likely mean eurozone governments will actually be losing money on those loans, since in many cases they're already lending below cost.

In other words, an extension of maturities and lowering of interest rates will be a "haircut". But it will probably be a more politically palatable haircut than a full-scale debt restructuring.

Can eurozone countries really find €30bn by just tweaking the bailout loans? According to bailout reports from the IMF, Greece will have to make €48bn in interest payments form 2013 through 2016. They do not detail who that money is owed to, but since nearly 40 per cent of all outstanding Greek debt is made up of bailout loans, it's possible that nearly €20bn is owed to eurozone lenders during the next four years. So a "tweak" of those loans could save some serious money.

But make no mistake. It will still be a loss for eurozone lenders. It's not something they'll want to brag about.

http://blogs.ft.com/brusselsblog/2012/10/lagarde-urges-2-years-for-greece-what-will-it-cost/?#axzz292UhA06H

I thought Lord Turner (head of the Financial Services Authority and probably leading candidate for next BofE Governor) said something interesting about the Eurozone today, he said there was 'enormous national self interest in the eurozone either taking the steps required to succeed or if that is politically unattainable, dissolving in a controlled rather than a chaotic fashion'.  It's considered to be sort of breaking the taboo in commenting on the Eurozone but I think the fact that a man in his position is saying it shows just how much this is now the city consensus.

[The Minsky Moment]

That 0.5 multiplier is kind of strange.  That seems to indicate that for every dollar of public spending, 50 cents just disappears.

IMF is talking here about reverse multipliers - i.e. the effect on overall output from cuts in spending.  A 0.5 multiplier would mean that a $1 cut in government spending reduces output by 50 cents, not by a full dollar or more.  That could make sense if for example, there were crowding out effects from public spending, such that reducing government spending resulted in redployment of capital to the private sector.  What the IMF is saying is that their data suggests that such effects are not happening now, and instead the more traditional Keynesian negative multiplicative fiscal effect of public spending cuts seems to be in operation.

[Sheilbh]

Interesting counter-briefings from the European Council meeting.  The French line, after Hollande's rather public statements this morning:

• FRENCH GOVT SOURCE: DEAL REACHED AT EU SUMMIT ON
HAVING LEGAL FRAMEWORK FOR BANKING UNION BY END 2012, COMPLETION BY EARLY 2014

• FRENCH GOVT SOURCE: GERMANY HAS AGREED
FOR 6,000 BANKS TO BE UNDER UNIQUE SUPERVISION OF ECB, DAY-TO-DAY SUPERVISION COULD BE DELEGATED TO NATIONAL SUPERVISORS

•FRENCH GOVT SOURCE: ECB TO START SUPERVISING BANKS UNDER STATE AID FIRST

• FRENCH GOVT SOURCE: DIRECT RECAPITALISATION OF BANKS TO BE A REALITY IN 2013, LIKELY IN FIRST QUARTER FOR SOME BANKS

• FRENCH GOVT SOURCE: ISSUES OF LEGACY ASSETS FOR BANKS ALREADY UNDER STATE AID TO BE DISCUSSED BY DECEMBER, GERMANY NOT OPPOSED IN PRINCIPLE

• FRENCH GOVT SOURCE: ONE POSSIBILITY WOULD BE TO SHARE BANKS' LEGACY ASSETS BETWEEN STATES AND EURO ZONE RESCUE FUNDS

Reportedly the German position is no direct recapitalisation or banking supervision before Germany elections - which is being interpreted as a victory for Merkel over Hollande.

The press interpretation, via the Guardian is this:

Specifically, from "with the aim of completing banking union legislation" by the end of this year, to "with the aim of agreeing banking union legislation".

It looked like this was going to be a record European Council meeting and finish around two, an hour ago they were finishing the last paragraph.  But according to the Reuters correspondent they're now having a 'little pause' to consider Greece - so this could go on to the traditional 4am finish. 

Apparently there's also a rather unseemly fight over who gets to pick up the Nobel prize.  First it was Van Rompuy and Barosso, then the President of the Parliament (Schultz) said he should go as the representative of the European people (Van Rompuy of governments and Barosso of the Commission).  But then the Cypriots (who hold the rotating Presidency) said that they'd quite like to go too.  So Van Rompuy's suggestion (seconded by Merkel) is that everyone (all heads of state/government and all four Presidents) should go.  Some leaders (like Cameron) are less keen on the idea.  Everyone's unhappy with Schultz's suggestion that the national leaders should go not to collect the award, but to applaud the four President's collecting

The Norwegians have said they'll accept at most three representatives to collect the prize.

Incidentally Yi, on Merkel's leadership I entirely agree with Steinbrueck's comments below:

Steinbrück challenges Merkel in parliament

Germany has witnessed the first rejoinder in parliament from the opposition Social Democrats' new top nominee for next year's election. Peer Steinbrück accused Chancellor Angela Merkel of mismanaging the eurozone crisis.

In the Bundestag, Steinbrück used the full half-hour of the Social Democrats' right-of-reply to a speech just delivered by Merkel before she departed Berlin for a further EU summit in Brussels on Europe's economic woes.

The former SPD finance minister accused Merkel of failing to deter members of her own center-right coalition government from "bullying" European partners when several months ago they openly called for a Greek exit from the eurozone.

Failed to intervene

"You didn't intervene," Steinbrück told Merkel across the chamber. "You didn't speak out for Europe and you vacillated," said Steinbrück who was named by the SPD's executive late last month to lead its campaign for the elections due in September 2013.

Referring to a former conservative pro-Europe chancellor, Steinbrück said, "Neither Helmut Kohl nor any of your predecessors would have allowed a European neighbor to be abused for domestic political purposes like that."

"Rarely has Germany been as isolated as today," Steinbrück added.

Steinbrück asked why Merkel had not declared her commitment to Greece back in 2010 and why she was reluctant to tell voters that Germany and its EU partners would still have to contribute more bailout funding.

Greece to cost more

"Looking at Greece, Germany will have to take on more obligations together with European countries - say it, finally," Steinbrück said.

He also accused Merkel of failing to sell the benefits of eurozone membership to German voters and of placing too much emphasis on a "one-sided therapy of save, save, save."

Instead, said Steinbrück, Europe needs a "true" growth and jobs creation pact and "effective" banking and finance sector regulation.

The current problem is more than just a currency crisis, Steinbrück said, adding that a "socially just Europe" would offer opportunities for all and answers for global challenges such as climate change and migratory pressures.

Avoid bottomless pit

Replying to Steinbrück, Rainer Brüderle, the parliamentary group leader of the liberal Free Democrats, Merkel's junior coalition partners, said Greece must not become a "bottomless pit" without reciprocal obligations to perform.

Merkel, in her speech earlier, told parliament that the EU's economic affairs commissioner should have the authority to intervene when a member state's budget was declared "invalid."

The euro is "much more than a currency," she added and pointed to last Friday's award of the Nobel Peace Prize to the EU in the midst of the crisis.

In June, EU leaders responded to the crisis's impact on Spain by agreeing to move toward tighter coordination of economic policy to safeguard the euro.

In surveys, the SPD as main opposition party lags well behind Merkel's conservative Christian Democrats (CDU), but has declared its hope to gather enough votes next year to rule in coalition with the smaller Green Party.
ipj/pfd (dpa, AFP, Reuters)

[Sheilbh]

Cameron suggested the EU should send a kid from each member state to symbolise European peace into the future - a very Cameronian suggestion.  Needless to say it was not popular

Edit:  And the Council's informed the press it'll be another hour while they have a further readthrough.

Edit:  Council finished.  As Sony Kapoor put it Grexit may still happen, Spain's unresolved and the banking timetable's still uncertain.  The ECB intervenes, the markets calm and Europe's political leaders respond with complacency.  I'm starting to think Merkel's right about Europe needing market pressures to do anything, but I don't think it's a uniquely peripheral problem.

[Neil]

Instead, said Steinbrück, Europe needs a "true" growth and jobs creation pact and "effective" banking and finance sector regulation.

Isn't this sort of a paradox though?  For an area determined not to strip all natural resources, how are they supposed to continue to drive more illusory growth without wild, irresponsible financialization?

[Sheilbh]

Charlemagne's review:

EU Summit
The kiss of life, or of death?
Oct 19th 2012, 15:57 by Charlemagne | BRUSSELS

SOME in the Irish opposition are already calling it the "Judas Kiss". Angela Merkel, the German chancellor, greeted the Irish prime minister, Enda Kenny, with a kiss at the start of the European summit that ended today. But then she betrayed his hope that the euro zone would lift at least some of the burden of saving Ireland's banks from the shoulders of the Irish sovereign.

At the end of the summit, the French and European officials had claimed a points victory over the Germans by getting them to agree more firmly to a target date of January 1st next year to entrust the European Central Bank (ECB) with the ultimate authority to supervise the euro zone's 6,000-odd banks.

The importance of this "Single Supervisory Mechanism" (SSM) is that, once up and running, and deemed "effective" in the course of 2013, the euro zone's rescue funds could start directly recapitalising troubled banks. When the deal was first agreed in June, Spain hoped this would save it from taking on more debt to salvage its banks, and Ireland had been led to believe it could benefit retroactively.

The Taoiseach, or prime minister, Enda Kenny, left Brussels in upbeat mood, insisting that EU leaders had given a clear reaffirmation of the June promise. And the Spanish prime minister, Mariano Rajoy, declared himself to be "very satisfied".

But down the corridor, Mrs Merkel was quickly disabusing them. "There will not be any retroactive direct recapitalisation," she said, "If recapitalisation is possible, it will only be possible for the future." In the case of Spain, she said, the timetable is such that "when the banking supervisor is in place we won't have any more problems with the Spanish banks, at least I hope not." The problem of Spain's banks would be dealt with by euro-zone loans already approved earlier this year. By implication, Ireland would also have to lump it.

Her comments inverted the familiar cycle of European summits: leaders arrive in a climate of crisis, and leave after having decided action that, they hope, will control the fire. This time they gathered in Brussels with markets relative calm, but left in disarray.

One senior eurozone source claimed, improbably, that the issue of recapitalising Spanish and Irish banks had, in fact, not been discussed directly. Instead the leaders debated the preliminary steps needed to get to the stage of direct recapitalisation. Many issues remain open and were left for finance ministers to settle in the coming months, not least how to deal with "legacy assets". But the source added: "Mrs Merkel's declaration is a surprise for me. She is prejudging decisions that ministers of finance will take."

Germany often worries that easing market pressure on troubled countries will dent their zeal for budgetary and economic reforms. But this week the feeling is that the reduction in bond yields in recent weeks had blunted Mrs Merkel's readiness to fix the flaws of the euro zone – not least because she is entering her campaign for re-election in autumn next year.

Some diplomatic sources think Germany's stance is a negotiating position, and that direct recapitalisation of Spanish and Irish banks will eventually take place – though perhaps not before the German election. If such measures did not apply to Spain and Ireland, say Eurocrats, to whom are leaders referring in their communiqué restating that "it is imperative to break the vicious circle between banks and sovereigns"?

The Spanish prime minister at least had the foresight to sense the obstacle: he said that having to take on another €40 billion worth of bank recapitalisation on to its books, or about 4% of GDP, was "not the biggest worry". Instead he welcomed the evidence that the euro zone was moving towards banking union.

A more immediate question is whether Mr Rajoy will formally seek a wider bailout from the rescue fund, the European Stability Mechanism. This would come with strings attached (how onerous remains unclear) but would activate the commitment by the ECB to intervene in bond markets to bring down Spain's borrowing costs. Mr Rajoy must calculate whether the relief is worth the political humiliation and, more importantly, be sure that it would not be blocked by sceptical German leaders. Both sides may be still hoping that the gradual but steady narrowing of bond spreads in recent weeks (see the charts in my earlier post here) will obviate the need to ask the restive Bundestag for more money.

Though ostensibly "independent", the ECB president, Mario Draghi, participates in European summits and proved instrumental on setting out a clearer timetable. "He is the only expert in the room," says one source.

Another thorny problem is how to reconcile the ECB-linked supervisor with the interests of the ten EU members who do not use the euro.

Most want to take part in the system, but fear they will be left without a voice as the treaties give decision-making power to the ECB's governing board, from which they are legally excluded. The strategy will be to create a supervisory arm where euro-outs will enjoy "equitable treatment and representation", as the conclusions put it.

But Britain is principally concerned with not being over-ruled by a giant euro-zone supervisor, carrying the weight of 17-plus EU members, in the European Banking Authority, which co-ordinates supervisors' work and sets rules.

Part of the summit was taken up in a row about the impact of a proposed new budget for the eurozone on current negotiations for the EU's regular seven-year budget.It had been sparked off by comments in recent days by the British prime minister, David Cameron, who appeared to argue that the proposed "fiscal capacity" for the euro zone reduced the need for an  increase in the EU's budget, to be fought over at a special summit next month (Mr Cameron said he was ready to veto a budget deal he did not like). The communiqué insisted any "fiscal capacity" for the euro zone would be "unrelated" to the EU budget.

The "fiscal capacity" will be part of a final report to be submitted by Herman Van Rompuy, who presided over the summit, setting out a "specific and time-bound roadmap" to fix the euro zone's flaws. But nobody expects it to be the final report on reforming the euro zone, and there is a growing belief that the EU will have to start renegotiate its treaties some time in 2014.

David Cameron, the British prime minister, seized on these momentous changes to argue that Britain's relationship with the EU would also change, though he insisted that membership of the EU was in Britain's national interest:

Am I happy with the status quo in Europe? No I am not, I think there are changes that we need. There are opportunities opening for what I have said should be a new settlement between Britain and Europe and there will be opportunities to seek that new settlement.

It is a state of mind that is worrying liberal-minded allies of Britain. Finland's Europe minister, Alexander Stubb*, told Reuters:

I think Britain is right now, voluntarily, by its own will, putting itself in the margins. We see it in foreign policy, we see it in economic policy, we see it linked to the single currency. And I, as someone who advocates the single market and free trade, find that very unfortunate, very unfortunate.

* In an earlier version of this post I had mistakenly spelled Alexander Stubb's name as Studd. Sorry

Since then I believe the Germans and Irish have issued a joint statement after talking about the specific circumstances of the Irish bailout and financial crash.

[Sheilbh]

IMF is talking here about reverse multipliers - i.e. the effect on overall output from cuts in spending.  A 0.5 multiplier would mean that a $1 cut in government spending reduces output by 50 cents, not by a full dollar or more.  That could make sense if for example, there were crowding out effects from public spending, such that reducing government spending resulted in redployment of capital to the private sector.  What the IMF is saying is that their data suggests that such effects are not happening now, and instead the more traditional Keynesian negative multiplicative fiscal effect of public spending cuts seems to be in operation.

I thought this was interesting on the subject:

High fiscal multipliers undermine austerity programmes
October 21, 2012 3:25 pm by Gavyn Davies

Nothing in economics is more potent than a simple idea whose time has come. Illustrating this maxim, a 3-page article in the IMF's latest World Economic Outlook promises to have a greater effect on global economic policy than all of the interminable meetings held at the Annual Meetings of the IMF and the World Bank in Tokyo a week ago.

That article, written by IMF Chief Economist Olivier Blanchard and Daniel Leigh, presented evidence that the fiscal multiplier [1] in the advanced economies is considerably larger than had been assumed when fiscal austerity plans were set in train in most economies in 2010. The implication, if they are right, is that austerity is much more damging to output in the near term than was anticipated. As a result, the planned fiscal retrenchment could be hard to sustain in the next few years, not only in the eurozone but in the US and UK as well. In fact, we are already seeing signs of this in peripheral Europe and the UK.

It is no wonder that many Keynesians (see for example this blog by Paul Krugman) have welcomed the IMF article as a vindication of their earlier warnings about the dangers of austerity. The Blanchard/Leigh paper shows that there is a cross-country relationship between GDP performance in 2010/11 and the relative size of the fiscal tightening which was announced in 2010: those countries with the largest tightening tended to have the worst outcome for GDP growth, relative to 2010 expectations.

The authors believe that this is because the fiscal multipliers have turned out to be higher than was assumed when the austerity programmes were designed. In fact, they suggest that the multiplier under current circumstances might be as large as 0.9-1.7, compared to the initial assumption of 0.5.

If true, the implication of this would be critical. If the multiplier is 0.5, then an initial public expenditure reduction of 1 per cent of GDP reduces real output by 0.5 per cent. Using normal rules of thumb, this drop in output would in turn reduce taxation or increase public transfers by about 0.2 per cent of GDP, leaving the budget deficit improving by 0.8 per cent of GDP. This ratio of budget improvement to reduced growth might be just about acceptable to democratic governments.

If, however, the multiplier is 1.7, then the same initial public spending cut of 1 per cent of GDP would reduce real output by 1.7 per cent. The second round effects of this reduction in output would reduce tax or raise transfers by 0.68 per cent. The net overall improvement in the budget deficit would therefore be only 0.32 per cent. The economy would be in recession, and the budget deficit would hardly improve at all. Even if this were acceptable to governments, it would not be acceptable for very long to their electorates.

This pessimistic arithmetic is not that far away from describing what has actually happened in some countries, like the UK, in the past two years. Furthermore, if we take this arithmetic as a given, there is more bad news to come. The major four advanced economies are now all planning to tighten fiscal policy in the years ahead by an average of 1 per cent of GDP per annum. The following graph shows the latest IMF estimates for planned fiscal tightening:


With a fiscal multiplier anywhere near the upper end of the Blanchard/Leigh suggested range, the effects of these policy changes would eliminate any chance of a rebound to normal growth rates in the advanced economies for some time to come. Interestingly, the planned fiscal tightening in the troubled economies of the eurozone is no longer any greater than it is for the major economies, because of the recent relaxation of some budget targets. Even so, it is hard to see how these plans could be sustained if the fiscal multiplier is at the upper end of the possible range.


Much therefore hinges on whether Blanchard and Leigh are right. Their methodology is certainly not watertight. Cross-sectional country studies are notoriously unreliable. As demonstrated by Chris Giles in the FT, if we exclude Greece and Germany from the 28 countries in their study, then their result largely melts away. It is also sensitive to the time period chosen, and does not appear to work for other similar periods. It is surely asking a lot to change the entire course of global economic policy on the basis of a result as flimsy as that.

Having said that about this particular study, there are other, stronger, reasons for believing that fiscal multipliers are higher than many governments have been assuming. In the 1950s and 1960s, when Keynesianism was at its height, the multiplier was generally assumed to be around 2. Then in the 1990s and 2000s, these estimates gradually dropped, leaving the consensus range around 0.5-0.7 by 2009.

The decline occurred mainly because economists became much more aware of the need to make assumptions about monetary policy when making the estimates. If the central bank is assumed to hold monetary growth or inflation at a given target rate when fiscal policy is tightened, then interest rates will decline and this will offset some of the negative effects of the fiscal change on output. The multiplier will be lower.

The opposite is also true. Now that interest rates are stuck at the zero lower bound, central banks cannot reduce policy rates when fiscal policy is tightened, and the multiplier is correspondingly increased.

Kudos to the Keynesians for predicting this in advance, but in many ways this is a fairly standard result from dozens of econometric simulations and it should not really have come as a total surprise to policy makers.

So how high should we assume the multiplier is today? [2] That will always be subject to great uncertainy. A very important paper earlier this year by Summers and DeLong, analysed in this earlier blog, argued that the multiplier should be assumed to be a minimum of 1.0 under present circumstances. It explains very clearly why the multiplier should be much higher than normal when the economy is stuck in a recession with interest rates at the zero lower bound. [3] Another noteworthy empirical paper, by Auerbach and Gorodnichenko, says that the multiplier during recessions might be around 1.5-2, while in expansions it drops to zero.

No-one really knows for sure. However, what does not seem plausible is that the multiplier, in the current recession, is as low as governments assumed when they embarked on their austerity programmes in 2010. And that will make austerity much harder to sustain.

———————————————————————————-
Notes:
[1] The fiscal multiplier is usually defined as the change in real GDP which is produced by a shift in the fiscal stance equivalent to 1 per cent of GDP. The maintream approach to the multiplier used by most policy-makers is well summarised in this IMF work published in 2009 .

[2] It should be added that classical economists believe that the fiscal multiplier is around zero, either because the economy rapidly approaches equilibrium output after a fiscal shock (because prices are flexible), or because the private sector anticipates that future taxes will need to be increased when fiscal expansions are announced. These approaches are not, however, usually adopted by current policy-makers, though they are often influenced by them.

[3] Interestingly DeLong and Summers argue that in normal times the multiplier should be assumed to be zero.

http://blogs.ft.com/gavyndavies/2012/10/21/high-fiscal-multipliers-undermine-austerity-programmes/?#axzz29z25rTyo
Worth having a look at his links.

[MadImmortalMan]

This is just like everyone saying invest in real estate in 2007.

[Count]

jumping into this thread about 147 pages late- but any interest in Modern Monetary Theory? My friend has been pushing it on me for about half a year. Long story short, MMT argues that in countries that control their own currency (notably NOT countries in the EU) deficits only matter to the extent they cause inflation, and in fact government deficits create private wealth. I'm not sure if I totally buy it, but it frames the European crisis in a different way.

http://en.wikipedia.org/wiki/Modern_Monetary_Theory