A sane fiscal adjustment

Under the  Addendum to the Irish Stability Programme Update (January 2009), the deficit target for 2009 is 9.5 percent of GDP.    As a result of the February exchequer returns, it looks as if the actual deficit will be about 2.5 percent of GDP higher.   The government must now decide how to respond.

One approach would be to adjust taxes and spending to hit the original 2009 target.   As Jim O’Leary has pointed out, achieving a 2.5 percent reduction for 2009 based on changes that will be in effect for only a portion of the year would require an adjustment closer to 3.5 percent of GDP if in place over a full year (see here).   Since making permanent changes to taxes and spending part way through a year to hit a single year deficit target would be nothing short of ludicrous, I take it that the gap in question is indeed the 2.5 percent of a full year’s GDP.

In a comment on a previous post of mine, Patrick Honohan made the sensible suggestion that the government should target the structural (or cyclically adjusted) deficit.    It worthwhile to return to the Addendum and consider what level of adjustment would be consistent with the framework being applied in that document.  

Table 8 of the Addendum contains projections for the deficit, the cyclically adjusted deficit, real GDP growth, and the output gap (i.e. the gap between actual output and potential output as a percentage of potential output).    Assuming that the actual deficit as a percentage of GDP (Def) can be written as:  Def = Cyclically Adjusted Def + k(Output Gap), we can back out the value of k – -0.4 – being used in the projections.  The original deficit target for 2009 comprised of a cyclically adjusted deficit of 6.7 percent of GDP and a cyclical component equal to 2.8 percent of GDP (-0.4 times a negative potential output gap of 7.1 percent of potential GDP).  

A key issue is the appropriate adjustment for the recent cyclical deterioration of the economy.   In the Addendum, the projected growth rate for 2009 is -4.0 percent.    Recent official projections for the contraction of the economy this year have ranged from 6.0 to 6.5 percent.   Taking the lower bound, this requires an additional cyclical adjustment to the deficit target of 0.8 percent of GDP (approximately -0.4 times -2 percent of GDP).    (I assume here that the potential growth rate of the economy is unchanged and that the deterioration in the cyclically adjusted deficit is due to a larger than anticipated response of taxes to the bursting of the property bubble.)  This would lead to a modified target of 10.3 percent of GDP and require a full-year  adjustment of 1.7 percent of GDP (i.e.  2.5 – 0.8).   

While still very large (I’m inclined to think too large given the fragile state of demand), this is roughly half of the 3.5 percent of GDP adjustment apparently being contemplated. 

8 thoughts on “A sane fiscal adjustment”

  1. Thanks John This is a very well-reasoned analysis. Still, let me put what I see as the potential counter-argument. The Irish government is already struggling to convince international investors that it can keep the public finances on a stable path. The Addendum Plan is what they have come up with to convince investors that stability can be restored. I think the relevant question here is whether ditching the 9.5% committment at the first hurdle will send such a bad signal to bond investors that it will prove counter-productive, i.e. the extra 1% of GDP of pain that we’d save ourselves just wouldn’t be worth it.

    My instinct would be to stick with the 9.5% target. Even if this means that making a 3.5% adjustment turns out to be the equivalent of a 5% adjustment on a full-year basis, this still leaves a huge amount of adjustment to be done in the December budget when you factor in that the Addendum reckons worsening conditions will mean an automatic 2% worsening of the deficit in 2010 without further action (and the worsening of conditions is probably even more extreme now than envisaged in January). In addition, making an effective 5% adjustment means that we will get some of the “front-loading” of the program (absent in the January plan) that may be necessary to convince the bond market that we serious.

    As for fragile demand, of course you’re right that this will hurt the economy, but we’re still an small open economy and fiscal mulitipliers are small. In any case, I certainly see the point you’re making and it would be nice if we could come up with a new plan that ignores the 9.5%. I’m just not sure we should.

  2. Ultimately, the goal is to restore our public finances to balance i.e. meet the SGP reference figure of 3% Deficit/GDP ratio. The “Addendum” document offers a plan to achieve this by 2013 with the first step being much the smallest (i.e. 2Bn. in 2009).

    It is now clear that the Government projections in January were hopelessly optimistic (let’s draw a veil over the October 2008 budget, probably the greatest single misstep apart from the bank guarantee).

    Any effort to reduce the adjustment this year that is necessary to meet the goal of 9.5% Deficit/GDP will only postpone the pain to later years were massive adjustments were already planned. Cyclical factors could help in later years but who expects an early upturn in the Irish economy that will help us return to 3% Deficit/GDP by 2013?

  3. I’m amazed you still feel that this is a cyclical adjustment and should be treated as such John.
    The scale and breath of the current Irish depression is much more severe than you suggest, and to me indicates that a complete rebalancing of the states revenue and expenditure is needed.

    A fall in national income in excess of 10%, which Ireland will have from peak to trough, requires wholesale and rapid adjustments to survive.
    How many other countries right now or even historically have experienced a recession this severe? Or what other small counties have successfully run deficits in excess of 10%? The answer is very few.
    The theory is all well and good but in practice we have to act quickly or we lose the ability to act independently.

    When you look at the entirety of the Irish situation I really think whether we have a 1.7% or a 3.5% adjustment this year is missing the wood from the trees.

  4. I was thinking about Patrick’s article yesterday and it seems that his basic point — we should target the structural deficit, rather than the total — is in principle absolutely right. But then the question is, how do you identify the structural deficit, which is why posts like this one are so useful.

    Like Karl, I am worried about the markets. Would they believe any Department of Finance (or, more generally, Irish) computations of what the structural deficit and the consequent required adjustment are? I am not so sure.

    It thus seems to me that it would be really helpful if some outside agency, in Brussels or elsewhere, with real credibility in the market place, could come up with an authoritative independent statement of what the structural hole in the public finances is which needs to be filled.

  5. We may have some hint of market perceptions this week when the NTMA issues some paper. If they cant get it away (10y money at 4.5% coupon in an environment where YTM is 280bp over that) without significant pricing under par I would be amazed. Unless there is some sort of immediate pass through to the ECB or elsewhere that seems unlikely. But hey, lets see.
    Note : underpricing is usually seen as below par : but it can be not getting the entire amount placed away.

  6. Thanks for the thoughtful comments. You might be surprised that I agree with the thrust of most of them.

    @Karl, Kevin, and Brian
    I share your concern about the market response. The Taoiseach’s initial determination to do everything needed to hit the 9.5% target was understandable. If feasible, I agree it would be a great way to establish credibility. But given the scale of the adjustment — and the state of the economy — I can’t but worry about the downside risk of extracting that much spending.

    My hope is that credibility could also be built around a revised and more robust Stability Programme. As I see it, this should have three main elements: (1) A target path for the structural deficit. This would be robust against a demand-driven slowdown of the economy. (2) An emphasis on Type 1 adjustment (wage bill and transfers over taxes and investment). Although as always it would be good to have more evidence, the international (and to some extent our own) experience shows Type 1 adjustments are typically better sustained and less contractionary. It is important to note that the relative benefits of this type of adjustment are probably at least as much on the supply side as they are on the demand side (wage competitiveness, infrastructure, incentives, replacement rates, etc.). And (3) A clear plan to put in place a sustainable tax and spending structure along the lines laid out by Patrick yesterday (though there’s lots to argue about on the details).

    @Lefournier
    You are an admirably consistent voice of conscience for meeting our obligations to our European partners. I certainly do not disregard these obligations and take the Stability Programme process seriously. But I don’t see how it is our partners’ interest for us to risk deepening the recession. I doubt if any other country would make such a sacrifice in similar circumstances. What is most important is to put the programme on a feasible and robust footing.

    @James
    You raise a very important point. Given the extent of the rupture to economic activitiy it is hard to say what is cyclical and what is structural. For the purposes of the exercise in the post I largely go with the assumptions in the Addendum. The only assumption I make is that the very recent deterioration in projected growth from -4% to -6% is the result of cyclical deterioration. (I also allow that two thirds of the increase in the projected deficit is due to a structural fall in the tax take for any given level of GDP.)

    Whether the recession is the result of a loss in potential output or a more benign output gap is probably the most significant question we face. While there is no doubt the property bubble massively misallocated resources, and a substantial and inherently costly reallocation of resources is inevitable, I am reasonable optimistic the economy can get back to an impressive potential growth path. This is why it is critical to focus on the supply side in the adjustment. But I’m starting to repeat myself . . .

  7. To quote Lawrence Peter (aka Yogi) Bera, some of the points being made here are déjà vu again for those of us who participated in the Irish policy debate in the 1980s!
    There is a risk of confusing “small” multipliers with zero multipliers. Even if the relevant multiplier under Irish condiitons is only 1.3 or thereabouts, a fiscal adjustment of 3.5 per cent of GDP will result in a significantly larger fall in GDP than is already being projected. The only deus ex machina would be that the fiscal contraction proves expansionary through various supply side mechanisms of varying degrees of plausbility.

  8. The EU leadership are out of touch. They refer to agreements and say waht they say. There may be new agreements! And there will be as it bites ever deeper!

    The prime need is for the team to be introduced to reality. This is even more than structural. Look at Iceland and use it as the worst case. Unity has to be based on truth and equity.

    Those who have most can afford to give most. Increase the passport charge to 1000 euros. Revoke all existing passports. Delay resolution of the legal cases in the courts for a few years, look up deaf army blokes on the www!. Revoke most tax concessions. Increase housing charges as this will help support the inflated values of existing stock. Investigate one or two national politicians and convict for corruption. No more than one or two, the rest can clean a shotgun with their toes. No fancy powerless tribunals please, my pal Fachtna Murphy should do his job. Abolish the creche system by removing state subsidy. In a deflated economy, the spouse will find it difficult to get a job. Dismantle the laws protecting the medical system. They make it too expensive. Allow people to buy their medical assistance but retain trauma services. They can afford to recover in an hotel, cheaper than a hospital. I pity the bureaucrats sacked thereby but there are fields to be tilled, insulation and solar panels to install! Oh and sack all economists in the public service who did not warn of the bubble in writing…….

    We are sinking, please consider breaking out the life rafts as well as the boats. That will really impress the EU and the international creditors. Travel abroad is not a free trade issue. It is one of many loopholes open to us. That is what we are good at,being a small country.

    Of course, I should admit a conflict of interest here: I now reside in Australia. Yes, I do. I did not listen to economists. I thought for myself.

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