Multipliers in Europe and Africa

IMF Chief Economist Olivier Blanchard created quite a stir at the recent American Economics Association Meetings when he presented his joint paper with Daniel Leigh that showed that, for 26 European countries, the fiscal multipliers—the amount by which output expands with an increase in the fiscal deficit—were considerably higher than previously thought.  Whereas these multipliers were previously thought to be around 0.5, they find them to be above 1.0.  Applying these figures to a reduction in the fiscal deficit (sometimes called “fiscal consolidation”), Olivier and Daniel suggest that people may have underestimated the extent to which European economies would contract in the wake of their fiscal consolidation.

Several people have been asking whether the same reasoning applies to African countries, whether expanding the fiscal deficit will lead to a more-than-one-for-one increase in GDP. Or, conversely, whether contracting the deficit by, say, one percent of GDP will lead to a fall in GDP of more than one percent. The short answer is no.  A recent paper by my colleague Aart Kraay estimates multipliers for a sample of 29 low-income, aid-dependent countries (all but four of which are in Africa).  Using a clever econometric technique (that exploits data from World Bank projects), he finds multipliers that are not statistically significantly different from zero.  In other words, increases in the deficit appear not to have an effect on GDP in the short run.

On reflection, this result is not too surprising. An increase in the fiscal deficit (by, for example, an increase in government spending) will stimulate output if that additional spending increases employment of idle resources.  For example, if the government spends on building a road, it will hire workers and purchase construction materials.  If those workers were previously not working, and the construction materials could be produced using existing machinery, then the spending will contribute to an increase in GDP.  However, if those workers were already working elsewhere (perhaps in the informal sector), and the machines are producing at full capacity, then the stimulative effect will be minimal. 

Furthermore, in many countries, a decision by the government to spend on a road does not always lead to a road being built that year—or ever, sometimes.  This is what many observers, including some African policymakers, call “the execution deficit.”  It may also explain why, in the wake of the global economic crisis of 2008-9, many African countries, even though they had fiscal space, ran fairly modest fiscal deficits to cushion their economies from the global recession. 

When I suggested that he might want to increase the fiscal deficit because the global economy was contracting, one finance minister said to me, “Shanta, if I could stimulate the economy by running a higher fiscal deficit, I would have done it last year.”