Month: March 2009

Krugman on Europe

Paul Krugman’s article in today’s NYT  describes his perspective on the European situation.  His main focus is on thedifficulty in European-level policy coordination, in view of the current institutional configuration. However, he also flags the adjustment difficulties facing Spain (largely similar to those facing Ireland):

“In the past, Spain would have sought improved competitiveness by devaluing its currency. But now it’s on the euro — and the only way forward seems to be a grinding process of wage cuts. This process would have been difficult in the best of times; it will be almost inconceivably painful if, as seems all too likely, the European economy as a whole is depressed and tending toward deflation for years to come.”

It is interesting to note that Krugman accepts the thesis that wage cuts are required as part of regional adjustment within the euro area (indeed, he has signalled this on his blog in the past).  For Ireland, the level of pain may be lower than in Spain,  in view of the relative flexibility in the labour market and the potential for the social partners to contribute a pain-reducing level of coordination to the wage adjustment process as part of an overall reform package. However, a slow rate of adjustment will lead to a prolonged period of high unemployment.  In addition, the slower the rate of economic recovery, the worse will be the fiscal situation.

Budget VAT Change Did Not Cost €700 million

The lead story in today’s Sunday Independent carries the headline “Lenihan admits VAT error cost us €700m”. It states that the Minister “has admitted that his decision to increase the VAT rate in last October’s budget was a “serious mistake” which has cost the state over €700m in lost trade to the North.” Without doubt, this story will further fuel the media’s intense (but misplaced) focus on cross-border shopping as a major source of our fiscal problems. Unfortunately, however, the story is highly misleading and clearly relies on a misinterpretation of the Minister’s comments.

Continue reading “Budget VAT Change Did Not Cost €700 million”

A Grand Bargain?

If media reports are to be believed, the government looks intent on pursuing a large, tax-led fiscal adjustment on April 7.  While determination to take resolute action in the face of the recent exchequer returns is understandable, I am concerned that both the size and composition of the proposed adjustment will deepen the risks facing the economy. 

(1) Size.   My first concern is that the planned adjustment is too large.   As pointed out by Jim O’Leary in Friday’s Irish Times, the adjustment is equal to a massive 3.5 percent of GDP in an already reeling economy. 

The government faces an unenviable risk-management tradeoff.   On one side, it must reduce the risk of unstable public finances.  An out-of-control deficit – with the contingent liability of the bank guarantee looming in the background – increases the risks of higher interest rates, a sudden funding stop, or an even more dramatic forced adjustment later on.   On the other side, a fiscal adjustment of this size runs the risk of intensifying the vicious cycle of contracting economic activity and falling willingness/ability to spend. 

If we assume the 9.5 percent deficit target was appropriate before the news of weaker than anticipated exchequer returns, then continuing to aim at this target means the risk-balancing response is focused only on the public-finances element.

This strikes me as extreme.  The rationale appears to be that the government has tied its credibility to keeping the deficit in single digits.   I think this stance would be correct if there were solid signs that domestic demand is stabilising.  As it is, a too-firm commitment means the government is locked into a potentially increasingly contractionary fiscal stance as the economy spirals downwards. 

(2)  Composition.  Again based on media reports, it appears that tax increases and capital investment cancellations/deferrals will bear the brunt of the adjustment.  Alesina and Perotti (1997)* refer to this as a Type-2 adjustment.   In contrast, a Type-1 adjustment focuses on cuts to the government wage bill and transfer payments.  Although credibly establishing causality with available data is challenging, the international literature has quite strongly concluded that Type-2 adjustments are both less likely to be sustained and more likely to be contractionary. 

The evidence points to both demand-side and supply-side explanations for the relative superiority of Type-1 adjustments.  On the demand side, Type-1 adjustments have a more positive effect on expected future incomes and on interest rates.  On the supply side, these adjustments tend to be more effective in reducing unit labour costs and thus in improving competitiveness.  Added to these effects, I believe there is reason to worry that a shift towards higher marginal tax rates will undermine future growth potential and lead to large deadweight losses.  (Even the relatively innocuous-sounding removal of the employee PRSI income cap will raise the marginal tax rate of those earning more than 52,000 euro by four percentage points.)  And, assuming tax rate increases reach deep down into the income distribution, there is a danger of higher equilibrium unemployment as a result of rising income replacement rates.

Is there a better way?  With a large tax-led adjustment as the default, is it possible for a union-supported “grand bargain” that is better grounded in what we know about successful fiscal adjustments?  

I believe this would be a more modest Type-1 adjustment combined with a well-specified medium-term fiscal consolidation plan.   Interestingly, this is likely to have a good deal in common with Ireland’s successful 1987-89 adjustment. 

I have no illusions about how politically difficult this would be in the poisoned aftermath of the pension levy.   However, the impressive NESC report gives some reason for hope, especially its emphasis on the power of shared understanding:

“[W]hile a fair sharing of burdens is critical to overall success, the politics that can ensure a sense of fairness (such as taxation and holding financiers to account) will not, in general, be very effective in addressing the economic crisis of firm closures and unemployment.  In this sense, the paper seeks to draw on the Council’s particular contribution to Irish policy – the willingness and ability of diverse actors to engage in honest, joint deliberation and analysis of evidence and explanations . . . It is the shared analysis that warrants an integrated response, not the joint engagement that warrants an agreed response.” (p. 5)

I urge the key actors to examine the literature on successful fiscal consolidations in forming this shared understanding.  I believe it would considerably lessen support for a Type-2 adjustment. 

Possible elements of a Type-1 adjustment adapted to Irish circumstances:

  • A 10 percent nominal wage cut and (at least) a freeze in transfer payments in real terms
  • Cancellation of capital expenditure projects where they fail a cost-benefit analysis on current information.   Deferral of projects only when there is substantial doubt about net benefits given the uncertainty about Ireland’s future trend rate of growth.   Projects with a high certainty of positive long-run net benefits should be funded now.
  • The announcement (with as much detail as possible) of phased plans to broaden the tax base (including a residential property tax and a carbon tax)
  • Announcement of plans to raise income tax revenues while limiting increases in marginal tax rates to the greatest extent possible (e.g., phasing out tax credits and child benefit payments at higher incomes)
  • Removal of tax shelters of unproven effectiveness that contribute to a sense of unfairness
  • If necessary, introduction of a Obama-style higher third rate of income tax that raises marginal tax rates only in the thin part of the income distribution
  • Announcement of plans for comprehensive pension reform to deal with what is now a major source of social insecurity

*Alesina, Alberto, and Roberto Perotti (1997), “Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects,” IMF Staff Papers, Vol 44, No. 2 (June), pp. 210-248. 

Economic Adviser to Minister for Finance Appointed

Congratulations to Alan Ahearne on his new role (see also here).

More G-20 bickering

The BBC and several other media report continuing Franco-German opposition to the calls by the US administration, the president of the World Bank, and many others, for the coordinated global fiscal expansion that would seem to be essential at this time. Irish auditors will however be interested in the following from Larry Summers:

“There are some for whom it would be imprudent,” he said, noting that the crisis-hit countries in eastern Europe – which have large foreign currency debts – could not increase spending. “But for a very large majority of the world economy, [a fiscal expansion] is appropriate.”

The BBC further reports:

But European governments have indicated they are unlikely to strain their finances by agreeing to much more spending until they have seen some results from the first round of stimulus programmes already launched, says our correspondent.

Now, if accurate, this report raises some fascinating questions. Given the lags involved with macroeconomic policy, how long a wait would this imply, even if the fiscal stimuli worked according to a Keynesian textbook plan? And what would such a wait then imply for the health of the economy? And, given that the stimuli are small, and that the contraction in the economy is enormous, what sort of ‘results’ is it realistic to expect? I would have thought that the results will be purely counterfactual — the economy will shrink less than would otherwise be the case. In that case the ‘results’ would have to be guaged with reference to the predictions of some model of the economy. Is that what is meant here? Or, are the governments concerned hoping that the stimuli will lead to an actual increase in GDP? And if so, are they implicitly ruling out further fiscal stimuli unless the economy stops shrinking?

Now, that would be an interesting policy stance.

Oh, and a happy St Patrick’s Day weekend to everyone.