The hopeful message for the global economy from monetary and leading indicator data – see yesterday’s post – contrasts with consensus gloom, epitomised by the IMF’s latest World Economic Outlook (WEO), containing downgrades to the organisation’s global GDP growth projections for 2012 and 2013. The IMF claims that fiscal consolidation is exerting a much larger drag on economic expansion than previously assumed by itself and other forecasting bodies. Analysis by its chief economist, reported in Box 1.1 on page 41 of the WEO, suggests that the “fiscal multiplier” – the percentage impact on GDP of a change in the “structural” budget balance of 1% of GDP – averaged as much as 1.7 across a group of 28 economies in 2010-11, compared with an expectation among forecasters of about 0.5.

Fiscal tightening is scheduled to continue in 2013, with the IMF projecting a 1.0%-of-GDP fall in the structural deficit of advanced economies. If the fiscal multiplier were really 1.7, this would imply “fiscal drag” of 1.7% of GDP – probably sufficient to neutralise or outweigh stimulus from faster real money expansion. On closer inspection, however, the analysis generating the 1.7 estimate turns out to be suspect, relying heavily on results for two small countries. A defensible reworking of the numbers suggests that the prior hypothesis of a multiplier of “only” 0.5 cannot be rejected by standard statistical tests.

The 1.7 estimate is based on a comparison of deviations of GDP growth from forecasts over 2010-11 with projected changes in structural budget balances. Using the IMF’s own numbers, the best-fit line drawn through the associated scatter chart has a slope of -1.2, implying that fiscal tightening of 1% of GDP was reflected in a growth undershoot of 1.2% relative to forecast, on average. This 1.2 estimate must be added to the sensitivity of about 0.5 incorporated in the growth projections, implying a “true” multiplier of 1.7.

One oddity of the IMF’s analysis is that, while claiming to investigate the impact of fiscal consolidation, it includes eight countries whose structural budget balances actually worsened in 2010-11. Restricting the sample to only those countries that tightened fiscal policy, in fact, has no impact on the estimated “true” multiplier; the slope of the relationship is unchanged at -1.2 – see the red line in the chart below.

The chart, however, makes clear the dependence of this result on two “extreme” observations towards the bottom, for Romania (middle) and Greece (right). When these two countries are omitted, the estimated slope falls to -0.3 and is not statistically significant – green line. The claim, in other words, that the true multiplier is greater than 0.5 rests entirely on developments in Greece and Romania in 2010-11.

Significant fiscal tightening has clearly contributed to a deep Greek recession but it is impossible to disentangle this from the impact of a slump in the money supply caused by capital flight and lack of monetary policy autonomy – Greek narrow and broad money fell by 22% and 24% respectively in the two-years to end-2011. There has been no such money supply contraction in Romania but nor has the economy been notably weak – GDP expanded by 0.2% in 2010-11 combined. The undershoot relative to forecasts may simply reflect unwarranted IMF growth optimism in 2010.

Summing up, the IMF’s bold claim about the fiscal multiplier has provided a publicity coup for Keynesians but rests on flimsy statistical foundations. Fiscal tightening will exert a modest drag on global GDP growth in 2013 but real money supply developments should continue to drive the economic cycle, with recent trends warranting optimism.