Don’t click away! Really: this is interesting, and simple, and important. I promise you! Just give me one paragraph to explain.
Let’s suppose that the government decides to spend $100 million on starting a new program. This money will be paid out in salaries (it doesn’t matter and this makes it simpler). Let’s assume that 80% of this money earned is spent. Thus, just at this second level, $100 million spent results in $180 million dollars in economic activity. Of course, this continues on for an endless number of levels because that $80 million will be earned by others who will spend it and so on. This is the economic multiplier effect.
There are two aspects of underestimating the economic multiplier. First, it means that the positive effects of government spending are underestimated. Second, it means that the negative effects of government cuts are also underestimated.
So by noting that they’ve been underestimating the economic multiplier, the IMF is doing a Rick Perry, “Oops!” Traditionally the IMF has pushed countries to take on governmental austerity. This is what Paul Krugman refers to as belief in the Confidence Fairy. But over the last decade, the IMF has started to push the idea that maybe the Confidence Fairy doesn’t exist and that austerity is not the panacea that had been claimed.
This is an important reason why all of the austerity in Europe has been such a bust and why the United States (with much less austerity) is doing better. Unfortunately, the European Central Bank (and the whole of the Republican Party and much of the Democratic Party as well) hang on to the idea that it is only through austerity that we will flourish. This is the idea that is behind Romney’s statements that governments don’t create jobs and Ryan’s assertion that the stimulus is just a temporary “sugar high.”
It is good that the IMF is now on the right side of the facts and pushing for more expensive fiscal and monetary policy. Of course, it won’t really help. If facts mattered to the austerians, they would not—after 4 years of failed policy—continue to be austerians.