Recently, the Portuguese fiscal multiplier size got the attention of the country’s media. The origin was the release of a statement by Olivier Blanchard – IMF chief-economist – stating that the multiplier had been “underestimated” following the disclosure of the World Economic Outlook (WEO) for October 2012. But what does this mean? What impact has it for Portuguese people and policy makers?
First the interpretation of the multiplier: it tells by how much is real GDP affected when overall budget deficit varies. The staple idea about the size of the multiplier was the value 0.5, i.e. a 1 percentage point of fiscal consolidation (budget-deficit-to-GDP-ratio), thus of austerity, was statistically associated with a decrease of real GDP of about 0.5 percentage points. What Blanchard says is that value was not accurate for advanced economies in the beginning of the 2010’s. In truth he estimates that it was between 0.9 and 1.7 since the 2008 crisis.
The new estimation of the fiscal multiplier is about 2 to 3 times higher than what initially expected. In the study conducted by Blanchard and Leigh for the WEO they controlled for many factors, from the fact that simultaneous fiscal consolidations across Europe to financial systems stressed could be driving the previous result of higher than expected fiscal multiplier. They weren’t.
In my opinion the revised higher figure for that multiplier comes from the fact that the 2008 crisis and subsequent sovereign debt crisis in Europe affected severely the Portuguese financial system ability to allow agents to get access to credit necessary to smooth consumption and finance investment projects. And if today’s financing is shut down then agents are much more dependent of their available income. In turn, their available income being depressed by fiscal consolidation measures will result in a drastic contraction of consumption and investment. Lastly, increasing negative expectations enter in stage as agents see the depressed economic mood around them, thus cutting back even more consumption (to prevent lower available income in the future) and investment (less expected customers in the future). All in all it is no surprise that the final short-term impact of fiscal consolidation in the context of a stressed financial system is higher than 0.5.
Finally, the implications of a higher multiplier are twofold: on one hand, it means that Portuguese people will suffer more with the necessary fiscal consolidation to control the public debt-to-GDP ratio dynamic because this path will not be changed by the current authorities, so, for any level of necessary austerity, the negative impact on real GDP will be sharper, which is to say less available income and less consumption; on the other hand the very strategy of fiscal consolidation is now much more riskier. It is so because fiscal consolidation measures may act reversely: instead of decreasing the public deficit they may increase it: in face of a higher multiplier the more depressed the economy gets the much less revenues the Government raise and the much more expenditures with unemployment benefits and such it has to cope.
It is narrow the Portuguese future fiscal policy horizon.