The Curse of Fiscal Procyclicality

Rossa White is today’s contributor to the Irish Times series: “The Time to Take Hard Decisions on Public Pay is Now“.

He concludes by advocating a new system that will avoid fiscal procyclicality in the future, through a ‘golden rule’ policy, plus the establishment of a rainy-day fund.

Institutional reform along these lines is highly important. Indeed, I post a link below to a 1998 article  I presented at Kenmare and published in the now-defunct Irish Banking Review, in which I advocate a similar approach.  However, I wonder about the political incentives to establish such institutional restraints on the conduct of fiscal policy. Again, the current crisis may provide the right environment for undertaking such reforms.

Philip R. Lane, “Irish Fiscal Policy under EMU,”  Irish Banking Review,  1998.

11 replies on “The Curse of Fiscal Procyclicality”

Rossa’s piece contains interesting suggestions for the creation of an asset management company (AMC) — what has been called a “bad bank” — which would pluck €40 billion of the worst of the banks’ loans from their balance sheet and have them managed separately. Creation of such an entity certainly one of the four main candidates for dealing with the banks’ current difficulties. However, there are a couple of features of Rossa’s specific suggestion which I would revisit.

First. he proposes to capitalize the AMC with €15 billion of liquid assets provided by the Government. But I cannot see what need the AMC will have of any substantial block of liquid assets. Besides, if the AMC is to be owend by Government, why does it need capital. Perhaps Rossa has in mind that the AMC could be sold to a private equity firm, in which case it would need to have a positive net worth, but even that could be achieved without cash. (The UBS rescue provides a useful template for that kind of transaction).

Second, the proposal is to replace the €40 billion with a government bullet bond. For reasons given in a 2004 paper, I believe that normally such recaps should not be done with special bullet bonds or otherwise restricted instruments.

Rossa says the government might demand a “modest” discount on the value of the loans, and insist on a warrant for 25-40 per cent of the transferring banks’ shares. The exact numbers matter here, though, and it may be impossible to square the circle of leaving the existing shareholders with a significant share of the banks without imposing a politically unacceptable loss on the taxpayers. The deal risks looking too generous to the shareholders. We can only know for sure when the realizable value of the assets is much clearer than it is now. I have suggested elsewhere that setting an exercise price for the warrants that is inversely related to eventual recoveries on the AMC’s assets could give a better balance to such a deal.

I’ve said it before – even squirrels have the common sense to put aside a few nuts for winter. Why can’t our government outwit a common animal and have money set aside from the surplus years for a time like this?

the public sector believe in benchmarking i do too as long as it works in both directions, they wanted increases in the good days, now – without debate- they should accept decreases as everybody else loses out, it is the very spirit of the argument, that of a degree of equality.

Naturally, there should be a premium on other benefits like defined benefit packages and security of tenure, one reason the private sector should not be matched is that significant savings are required to tide people in it through the times when jobs are scarce, it gets back to the security of tenure issue. Alternatively de-unionise and de-benefit the public sector, the mentality of ‘it has to stay that way’ only exists because we, as a nation, all allow it to.

Why is our Taoiseach paid more than the president of the USA? We need leadership on the state of the public funds, and that has to come from the top, the issues facing the rationalisation of the public sector are systemic and the downside is that the people on the lowest rates of pay may lose jobs while those at the higher end (and more expensive to support) remain largely un-touched.

Is €500,000 p.a. for running a state department good use of available funds? People at that level are not competing for pay alone so why have such a huge level of compensation? Would a council of 5 people paid €50,000 each do a better job? If so that saves €250,000 instantly and you don’t need to extrapolate this to see that the inherent benefit. It would also mean greater accountability due to decisions being made by groups rather than individuals and the work of 5 people for less than the price of one

It is not acceptable to say that one person could out perform 5 – and in that 5 they could each specialise and split labour etc. it would have some benefit because you can keep several jobs alive, save money and phase numbers down over a period of time while the market has time to recover.
This is NOT a solution in the wider sense, just what common sense would dictate in a small area, but as they say in tesco ‘every little helps’.

I don’t believe in zombie institutions, and certainly not a state sponsored one but otherwise I think Rossa White has raised some excellent points and ideas. good work.

The Lex column in today’s FT has the following advice for the US authorities:
“Backing for an aggregator bank to mop up bad assets is growing. Here the Treasury is right to bend the troubled asset relief programme back towards its original objective. The problem, as ever, will lie in the detail and implementation. Toughness and clear rules are needed: banks must write down bad assets in return for taxpayer funds, for example, and recapitalise themselves by a fixed deadline or face nationalisation. The coming days will be critical. But policymakers should act with speed not haste.”

There is a piece in the WSJ on the Irish crash: – Opinion: The Sickly Tiger

Sorry for the off topic post. I’m posting here because I know you are grown-ups and I am hoping someone will take pity on a novice. Please tell me why I’m wrong.

Experts agree that the problem is a collapse in global demand causing an oversupply of labor and unemployment. I think this sounds great because people work too much and buy too much rubbish they don’t need. I also think that the tragedy of unemployment is not a necessary result. Instead of cutting 25% of your work force, you could cut everyone’s hours 25%. The pay cut would hurt but they’d have more leisure time and they wouldn’t starve (or claim the dole). Instead of desperately trying to restore rampant consumerism, you could move to low price, low labor, low demand economy that doesn’t pillage the earth or turn spouses into strangers. Demand becomes less volatile because people are buying things they can’t do without. Right now, we all need Americans to need things they don’t need. That’s not a strong foundation. Demand plummets at the first hint of fear because most of it is frivolous and Americans aren’t as dumb as people think.

Reading the banking review paper makes me wonder why that journal has not persisted. As someone said to me the other day, a regular forum for economists to critically analyse the banking system and related areas of the economy would have been no harm at all in the 2002-2008 period.

Also as a novice I think you are broadly right seeing as what you are talking about is a drop in the standard of living to restore competitiveness but I think your example is a closed world and too simplified to capture the complexity of human nature and interaction. I dont think dropping hours would help as that would run down production.

Buying too much rubbish they dont need is certainly true.

I guess where novices like you and certainly me add some value to a site like this is by representing people who are investing time in furthering our understanding of economics and maybe helping the spirit of this site which is, I think, to make economics accessible to the ordinary person.

I think your post poses the hardest question of economics – namely to what end?

Liam, I think you are right. Irish Banking Review had quite a nice format. Promptly produced–and I think was read by bankers! Let’s hope the new policy section of the ESR gets the same attention. (And this blog of course).

Rossa’s proposal to sell the troubled loans to the AMC at a modest discount has many of the appearances of a back door recapitalisation, notwithstanding the warrants. Presumably good for current shareholders, but bad for taxpayers.

I am puzzled by the treatment of government spending and taxation, in terms of the effects on aggregate demand. The argument seems to be that taxes cannot be increased because that would depress AD, so spending must be cut to narrow the budget deficit. But the logic of the old balanced-budget multiplier would suggest that cuts in spending would depress AD more than increases in taxes. Of course, there are other considerations when deciding on taxes/spending, but the argument that taxes cannot be raised because “it would worsen the recession” appears to be incomplete.

Rossa’s suggestion about rainy-day funds has a lot going for it. We discussed such funds as a way of rewarding countercyclical in EMU in the Coming of Age report below (see page 46):

Apologies to talk off the purpose of the post but I am very glad to hear that ESR is adding a policy section. An advantage of Banking Review was that it had a wide audience. The ESR might be perceived as being only for pointy heads and not make it to the inbox of policy makers and private sector folks. Dare I suggest “Irish Economy Journal” – a fully online addition to this blog featuring reviewed longer articles that perhaps even graduate from the blog posts.

Alan: I agree entirely with you about the way in which some people discuss taxes versus expenditure cuts. They are plain wrong. The US debate on this issue has broken down on very ideological grounds as we know, and I guess something similar is at work here.

John: below is a column by someone who agrees with you:

New York Daily News
Opinions ? Guest Contributor
Pass the stimulus – then help shorten the work week

By Dean Baker

Wednesday, January 28th 2009

As job losses hemorrhage, the American economy is in desperate need of a stimulus. It is becoming increasingly clear that Congress must work rapidly to approve some version of President Obama’s plan.

Then, Obama and the Congress should very quickly turn to taking a second, temporary step to create more jobs: creating incentives for companies to reduce the workweek and work year for many Americans.

The idea is not as radical as it sounds – and could prove very productive indeed for the American worker.

Recent Labor Department data make the scope of the problem clear: The economy lost more than 500,000 jobs a month in the last quarter of 2008. This adds insult to injury as state and local governments are already facing serious budget strains that will lead to massive service cutbacks and public sector layoffs.

President Obama’s $825 billion plan is a very good first step to contain the damage. Much of the package would go directly toward maintaining state and local services. The package also would help those hardest hit by the downturn with increased funding for unemployment benefits. For the first
time, the feds also would cover most of the cost of health care insurance for unemployed workers. Finally, infrastructure and energy spending would inject money into the economy over the next two years and offer long-term benefits.

But, big as the plan is, we’re fooling ourselves if we believe that our work is done when some version of this stimulus gets passed. As President Obama’s own analysis showed, the package would still leave us with 7% unemployment two years from now – roughly the current rate – even if things go well. This is intolerable.

And of course, things could get worse. A further collapse of the banking system due to a tidal wave of bad debt or a run on the dollar are both plausible scenarios that could seriously worsen the situation.

In short, we must right now start brainstorming creative and temporary plans to boost the economy further. One innovative policy that would provide a quick boost to the economy and jobs – and lasting gains in reduced unemployment – is a tax incentive for shorter workweeks or work years.

No doubt, such a suggestion will make conservatives howl about liberals attempting to turn the United States into France, where in 2000 the government mandated a 35-hour workweek.

But I’m not suggesting the government force a shorter workweek; I’m suggesting it create incentives for businesses to make the choice themselves.

And in any event, there are worse examples to follow than France’s on this score. The reduction in the workweek there created new jobs and improved productivity.

Incentivizing a shorter workweek in the U.S. could take different forms. To qualify, an employer who currently provides no paid vacation might offer all workers three weeks a year of paid vacation, approximately a 6% reduction in work time. Alternatively, employers could cut the standard workweek, say from 40 hours to 36 hours, a 10% reduction in work hours. Or they could offer paid sick leave or paid parental leave.

How would this help the economy? The tax break would allow the employer to compensate workers for fewer hours up to some limit, say a maximum of $2,500 per worker. That would cut work hours but maintain staffing levels.

As a result, workers would be getting just as much money as before the reduction in hours – but putting in 10% fewer hours. If workers have the same amount of money, then demand in the economy will be the same. At the same time, firms would then need to hire more workers to meet this demand,
since they would be getting 10% fewer hours from each worker.

Such a tax break would stay in effect for just two years. However, if workers and employers liked the new work schedules, there would be a lasting benefit from this job creation measure.

Dean Baker [] is the co-director of the Center for Economic and Policy Research (CEPR) []. He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy.[]. He also has a blog on the American Prospect, “Beat the Press,” [] where he discusses the media’s coverage of economic issues. You can find it at the American
Prospect’s web site.

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