In a rare volte-face, the International Monetary Fund this week admitted that it grossly underestimated the impact of the austerity regime it advised Europeans to adopt.

A paper authored by IMF chief economist Olivier Blanchard found that every dollar that governments cut from their budgets actually reduced economic output by $1.50.

The IMF forecast originally that economic activity would be reduced by only $0.50 for every $1.00 fiscal spending cut. Now this is not the IMF’s official position, mind you. But Blanchard, as chief economist, makes the IMF look shame-faced. Indirectly, at least.

Predictably, this has given considerable ammunition to critics of the bitter austerity prescription that has characterised European governments’ fiscal policies.

Economics is known as the dismal science. But for the IMF’s critics, this egregious forecasting error — upon which so much policy advice was built — is more than a crime. It’s a mistake.

The fact is that economics is much more of an art than a science. Econometricians can factor in x amount of data into a model to show outcome y. Like actors, who are only as good as their scripts, economists are only as good as the data they input.

Go forth and multiply

How did the IMF get it so wrong? Multipliers. Specifically, the wrong ones.

Although the 18th-century physiocrat, Quesnay, formulated the basis of multipliers in economics, John Maynard Keynes is generally credited with the conceptual modernisation and application of the “multiplier effect”. Briefly, every dollar that’s spent increases aggregate demand, as that same dollar is spent again and again and again. It’s this fiscal multiplier that the IMF employed to measure the likely effect of budgetary spending cuts.

Fawlty forecasting

To understand multipliers, here’s a brain teaser for you. Imagine we’re in the 19th-century equivalent of Fawlty Towers.

His Lordship arrives at a hotel and requests a room.

“Certainly, m’lord,” replies the manager.

But the man wants to see the room first. He puts his coat in the cloakroom and goes upstairs to take a shufty. While he’s gone, the manager steals £5 from his wallet. He then runs down the street and pays off the, er, lady of the night, to whom he owes five quid.

Said lady then hoofs off to the butcher’s to pay off her £5 worth of sausages. The butcher, in turn, heads over to the baker, where his account is in arrears to the tune of a fiver. The baker pays his £5 to the milkman. And the milkman heads to the hotel to pay the manager the £5 he owes on the room he rented there the last time he met up with the shady lady.

Then the manager replaces the £5 he stole from the toff’s wallet. His Lordship decides the room is not at all like Hampton Court Palace and leaves.

So, goods were produced. Services were rendered. Debts were paid. There were economic outputs. GDP — in theory — increased. And all due to one lousy £5 note. That’s a multiplier for you.

One more thing: in all instances, credit was extended. You could consider the aristocrat the government. Or a bank. Except, unlike governments, banks don’t give away money; they rent it out.

Meanwhile, back at the IMF…

Blanchard calculated that the IMF utilised a multiplier of 0.5. In reality, it should have been 1.5. In the IMF’s defence, Blanchard argues that the Fund underestimated the extraordinary financial circumstances of the European economies. In other words, the IMF was too optimistic about the impact of austerity measures upon GDP, and did not expect the effect upon unemployment would be so severe.

In a sharp response to critics, Blanchard’s report also notes that: “Some commentators interpreted our earlier [findings] as implying that fiscal consolidation should be avoided altogether. This does not follow from our analysis. The short-term effects of fiscal policy on economic activity are only one of the many factors that need to be considered in determining the appropriate pace of fiscal consolidation for any single economy.”

In other words, Blanchard doesn’t find that fiscal consolidation is the incorrect prescription, but that individual economies need to find the correct policy mix to ameliorate the worst effects of fiscal discipline.

Casino capitalism

Blanchard’s paper shows that the OECD, the EU and the Economist Intelligence Unit all got their forecasts wrong. The IMF was just – well – even less accurate.

But that merely reinforces the point that economics is an art. But a black art, rather than a bad art. Consider the Reserve Bank’s last three interest rate cuts: did you pick them? How about the Australian dollar exchange rate over the last quarter? Or Apple’s share price?

If so, what are you doing here? Why aren’t you playing the global casino? You should have five Bloomberg screens in your living room, a pile of cash a kangaroo couldn’t jump over, and a super-yacht in Antibes.

The difference between private firms and international organisations such as the IMF is that the Fund is not attempting to profit from its forecasts. More accurately, it makes policy prescriptions and offers technical advice. In this instance, it recommended fiscal consolidation.

Now, I fully expect the harbingers of austerity doom (Krugman et al ) to come out of the woodwork any minute now, although they have not been returning phone calls since the Eurozone failed to implode, as predicted. And, despite serious, long-term problems, Greece has not departed the Eurozone either. This prediction by Citigroup in 2012 should leave you rolling in the aisles:

“Greece WILL leave the eurozone on January 1, 2013.”

About as accurate as a Mayan calendar.

More seriously, the anti-austerity advocates appear to have no real concern for the longer-term consequences of indebtedness. At a certain point, fiscal deficits and sovereign debt become structural (the deficits and debts cannot be eliminated without profound alterations to the structure of public spending, borrowing, the balance of payments and the taxation base).

Which means governments can choose:

(1) Austerity via fiscal spending cuts;

(2) Tax hikes for you, the over-burdened citizen; or

(3) Both.

Whichever way you cut it, your children, your grandchildren – in fact everybody, except Gérard Depardieu, obviously – will be paying more tax and receiving less publicly-funded welfare as governments pursue aggressive debt-reduction strategies.

A return to first principles

A cornerstone of good governance should be a commitment to sound fiscal outcomes. But something happened on the road to sound credit and responsible fiscal policy. Does anyone seriously argue that increasing fiscal deficits and ballooning sovereign debt is not the road to serfdom? By maxing out your credit cards, you are merely postponing the inevitable day of reckoning (yes, I know Washington does nothing but debt, but the US is in a unique position).

True, there is clearly a role for governments to intervene to boost demand via deficit spending during periods of recession. That’s long been the Keynesian prescription.

But most governments ignore the other half of Keynes’ sage advice: namely, saving fiscal surpluses during periods of prosperity to ensure fiscal stability during recession, even as the public sector borrowing requirement increases. And not squandering precious surpluses on pink batt programs (Australia), moat-cleaning (Britain), Facebook-addicted civil servants (“Facebook: it’s French for Work”), and middle-class welfare, corporate welfare, farm welfare and subsidised property bubbles (everyone).

The problem is not liquidity

Austerity be damned. We are still absolutely awash with liquidity. There is more than adequate liquidity in the global financial system at present. The US Fed’s QE3 program will add another $US1 trillion to the debt coffers.

But there’s liquidity – and there’s credit. It’s just that financial institutions aren’t investing in anything other than blue chips and A-rated bonds. Global venture capital plunged 33% in 2012, a disastrous result on the back of a weak 2011. By contrast, global M&A was up in 2012.

So businesses aren’t raising seed capital; IPOs don’t happen; innovations go underfunded; R&D dries up; prospective products remain vapourware; and workers don’t get hired. There’s your lack of a multiplier effect writ large.

Forget IMF forecasts. The crux of the problem remains the vulnerability of the global financial system and its reluctance to lend freely, exacerbated by the fact that global interest rates, for the most part, remain too low to warrant risky lending.

And there’s bad news and worse news. It came out of Basel early this year, courtesy of the Bank for International Settlements (BIS). The much-trumpeted Basel III accord, which sought to place banks’ underlying cash and short-term asset base on a much firmer footing, has been watered down and delayed. Instead of blue-chip assets, financial institutions will be able to maintain or increase their leverage and fractional reserve lending using much lower-quality assets – like those dreaded mortgage-backed securities — that got us all here in the first place.

Someone at the IMF should write a paper about it.