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. 

Austrian Economics on Morning Ireland

I’m pretty sure many of our readers who missed it will get some entertainment from the archived version of Jill Kirby’s interview on Morning Ireland. For those who don’t know, Jill is the resident Austrian macroeconomic theorist at the Irish edition of the Sunday Times (double jobs as their personal finance expert, apparently.)  Late in the clip, a highly puzzled Tim Harford of Undercover Economist fame struggles to cope with the full breadth of Jill’s Austrian vision.

Two Scenarios for the Banks

On last night’s Prime Time, Brendan Keenan argued that it didn’t matter much how the government dealt with the problem of bad loans at the Irish banks, as long as they got on with doing it, though he noted he would be very reluctant to nationalise.  Similarly, David McWilliams said that the key thing was to do something to deal with the bad assets and that it doesn’t matter whether we nationalise or not, i.e. that we needed to produce cleaned-up banks and it didn’t matter who owned them.

Let me explain why I think it does matter how we go about this and who owns the cleaned banks.  Continue reading “Two Scenarios for the Banks”

One Step Closer to a Bad Bank Plan

Today’s Irish Independent reports that Peter Bacon has delivered his report on bad bank and risk insurance proposals to the Minister for Finance:

The Government has been advised to set up a ‘toxic debt’ company to take over billions of euro worth of bad property loans from the banks.

I’ve written quite a few times about the bad bank proposal and don’t want to repeat myself.    Still, it’s worth clarifying a couple of the nuances in the article because it likely illustrates the spin that the government would use to justify such a plan should it be adopted. Continue reading “One Step Closer to a Bad Bank Plan”

“High fliers”

No doubt we all noticed this article in today’s Irish Independent. Aside from the issue of whether great universities require great academics or great beurocrats (and the intriguing question of how come, in this trawl for world class talent, the people chosen are so often Irish), one needs to ask what price Irish universities need to pay to get great academics, assuming that they want them.

Presumably that price is falling rapidly, for several reasons. First, a little bit of googling suffices to make it clear that the academic job market is collapsing in the United States. The contributors to this blog will all be familiar with this AEA site listing cancelled or suspended job searches, and there are many more indicators available out there. Second, the high Irish property prices which were used as an excuse for high salaries are also collapsing.

And then there is the bigger picture. The state just can’t afford to pay enormous salaries any more. Moreover, there are obvious political considerations that can’t be ignored. Given that people at the bottom are going to see their net income fall, the case for a cap on all wages paid for in whole or in part by the taxpayer is becoming increasingly compelling. Many posts ago, I suggested a cap of 200K, but that now seems much too generous. 150K should be enough for anyone, and if people want to chance their luck on the national or international market places, good luck to them.

On German Concerns About US Monetary Policy

Kevin has raised the issue of differing attitudes in Europe and the US about the need for expansionary fiscal policy, with the Germans being particularly reluctant to adopt expansionary policies. This piece in today’s FT shows that some of the difference in attitudes reflects German concerns about US monetary policy.

The piece cites Christoph Schmidt, an adviser to Angela Merkel, as saying:

I see an inflationary risk in the US in the medium term because of the development of money supply there.

It also cites Klaus Zimmermann, president of DIW:

The central banks in the US and the UK are now literally printing money. This creates an inflationary potential that is difficult to stop.

In other words, rather than recommending that Europe follow the US in providing more fiscal stimulus, these influential German economists prefer to argue that US policy has already become dangerously expansionary and provides a bad example.

In my opinion, these statements illustrate three popular misconceptions. Continue reading “On German Concerns About US Monetary Policy”

International Trade in Non-Executive Directors

The FT has an editorial today that recommends that Irish firms look overseas in order to obtain a more diverse pool of non-executive directors.  My impression is that the practice so far has been to primarily recruit non-execs from the US and the UK.  A broader geographical range might contribute more to diversity, rather than focusing on countries with very similar approaches to corporate governance.

European Fiscal Assistance: Only with Conditions

Axel Weber made an interesting speech last night. He recognises that European fiscal assistance to a member state may be possible, but only under extreme conditions. Moreover, in order to comply with the ‘no bailout’ clause, any loan would have to be conditional (he does not specify the list of conditions).

Key part of the speech:

“It should be emphasised that the “no-bail-out” rule, as stipulated in the EC Treaty, is an indispensable instrument for preventing moral hazard behaviour by the member states. With that in mind, issuing blank cheques would definitely be the wrong course of action.

Yet, EMU is our common destiny. If any kind of help for a member state were necessary in the improbable case of an extreme emergency, the clear conditionality of such support would be essential in order to comply with the Treaty.”

Explaining the Lisbon Referendum Vote

Last week saw the release of a major study (by a group of political scientists and economists, including this blog’s Kevin O’Rourke) of the factors that explain voting decisions in the Lisbon Treaty Referendum: you can read it here.  No doubt these factors will be closely studied in deciding strategies for the upcoming 2009 vote on the ‘modified’ Lisbon referendum.

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. 

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.

The Johan Cruijff principle

Besides being one of the best soccer players of all times, Johan Cruijff is also a sage who spouts wise platitudes in a heavy Amsterdam accent. One of them is that every downside has an upside.

The economy is contracting rapidly. This is bad. However, greenhouse gas emissions are also contracting rapidly. This is good.

The EPA will today announce that we will be much closer to our Kyoto targets than previously thought. See Harry McGee’s piece in the Irish Times. This means that we will not have to spend all of the 270 million euro that is reserved for importing emission permits. Every little bit helps.

The details in today’s announcement are of historical interest. The latest EPA emissions projection is based on an ESRI economic projection of mid January.* How times flies. Back then, we thought that cumulative contraction would be 7% between 2008 and 2010. If only.

Should anyone want to update the emission projections, the output elasticity of CO2 is about 0.7 while the output elasticity of all greenhouse gas is about 0.5.

*We also projected emissions at the same time. See another piece by McGee.

NESC report advocates integrated national response to the crisis

The NESC has just produced a paper Ireland’s Five-Part Crisis: An Integrated National Response which sets out to assist government in developing an integrated response to the current crisis. The paper stresses the urgency of a holistic and joined-up plan within which we can see how the individual measures required to get us out of the problems we are in relate together. It is hard to argue with this proposition, even if we are a long way from seeing a recognisable plan from the authorities at this point in time.

The paper deliberately eschews making specific policy recommendations (p. 9), though some are discussed in an appendix to the paper. Its argument is that the more important task at this stage is to gain agreement around an overall analysis of the problem and a vision of the way forward. However, while the paper contains many useful insights and observations, my overall impression is that it remains too rhetorical and would have benefited from a harder edge, perhaps in the form of some specific targets to address some of the key imbalances which it identifies.

The paper has a short but useful overview of the position in which Ireland now finds itself and how we got here. It goes on to argue that there are five dimensions to Ireland’s current crisis:

  • A banking crisis
  • A fiscal crisis
  • An economic crisis
  • A social crisis
  • A reputational crisis

The core argument of the paper is that partial, piecemeal and sequential responses to these individual crises will not be sufficient or effective. This is only partly because of the inter-relationships between these individual dimensions of the crisis, but largely because citizens need to be able to see how any sacrifices they are asked to bear fit into the overall response to the crisis.

A key feature of a recovery plan is some statement of how the government intends to allocate the inevitable costs of adjustment across groups in the population, and the mechanisms for achieving this. Beyond some well-meaning statements on the need for social solidarity, the paper is silent on this issue.

The paper’s own list of desirable elements in a recovery plan (p. 40) are very high-level and fail largely to address the distributional issues which will be key to its public acceptability. It is also disappointing that the paper does not address more directly some of the operational issues on which economic and political opinion remains divided, e.g. the optimal balance and speed between addressing the yawning fiscal deficit and maintaining domestic demand, or how to bring about the required adjustments in nominal wages and prices to restore competitiveness.

To be fair, the paper states that it did not set out to get into  this level of detail, and it is more of an essay than a plan. But a plan is needed, and it is to be hoped that the government can produce it in the context of its budget measures on April 7th next.

Deflation Once Again

The CPI has fallen 1.0% sa in February and 3.9% in the four months since the turn in October (versus 4.4% unadjusted). HICP is down 1.1% sa in the three months since its later turn in November. The HICP fall of 0.6% sa in February is its largest to date. The difference between the two is mainly mortgage interest – owner-occupied housing costs are excluded from the HICP.

Year-on-year carryover in the CPI (what the year’s avg for 09 would be versus 08 if there is no further change from Feb) is now -2.7%. At Budget time in October, the expectation was for about +2.5%, so a prospective gap has already opened up of over 5% against Budget-time expectations, even if there are no further CPI falls. The recent ECB cut would have been too late for the March CPI (taken on second Tuesday) but will impact April, as will electricity and gas price reductions. If there are excise duty increases on April 7th., they would be just in time to impact April figs also. It is difficult to know if the currency appreciation against sterling has passed through yet, and there could be some increased outlet substitution bias problems for the CSO to grapple with. Overall there could be some further monthly falls, but the 1%-per-month drop in the CPI can hardly continue for long.

For 5 marks: What would the Budget in October have contained had the Minister known what was going to happen to CPI inflation?

Deutsche Bank on the Irish Economy

Deutsche Bank have an online summary analysis of the problems facing the Irish economy (hat tip Turbulence Ahead).  Overall, it provides a reasonable account of the current situation.   However, it does perpetuate the misleading impression that the the scale of the Irish banking system is extraordinarily large relative to its GDP.  As has been noted repeatedly on this blog and elsewhere in the domestic media,  the aggregate statistics are dominated by the ‘pure offshore’ activities of international banks at the IFSC, with the ‘domestic’ component of the banking system large but not to this ‘off the charts’ extent.

Quote for the day

“We have reached our limits,” said Axel Weber, president of Germany’s Bundesbank, in Frankfurt on Tuesday. “The expectation that we could neutralise this ­synchronised recession through short-term fiscal policy measures is false. We should not even try. There will be costs.”

From this. Apparently they think that the SGP is the key to preserving monetary union, rather than, say, preventing mass unemployment.

For those of us in secure employment, this is shaping up to becoming a fascinating natural experiment in applied political economy.

Update: Christina Romer has a very nice introduction to the lessons of the Great Depression for today’s policy makers here.

Taxes and the Price Level

It looks like the CPI will fall by a substantial amount during 2009 due to the economic slowdown, the weakness of Sterling and the cut in mortgage interest rates, amongst other factors.

This provides an opportunity to raise VAT and excise taxes, in view of the fiscal situation (less painful to raise indirect taxes when the CPI is in decline than when the CPI is increasing). The is the mirror image of the situation several years ago, when Ireland’s relatively high inflation rate led to widespread calls for cuts in indirect taxation in order to combat inflation.  While there would be undoubtedly some leakage across the border,  an increase in indirect taxes should be a significant source of revenue.

In a way, an increase in indirect taxes can be interpreted as a mechanism by which the government can reap some of the gains from the terms of trade improvement that is embedded in the appreciation of the euro against Sterling: this provides a real income gain for Ireland vis-a-vis other euro area countries, since Ireland imports much more from the UK than is the case for other euro area countries.

The regressive nature of indirect taxes can be taken into account in terms of the overall package of tax and welfare policies.

Tax Treatment of Debt

Various commentators and parties have recommended that landlords should not be able to deduct interest payments on debt in calculating taxable income.  More generally, ending the favourable tax treatment of debt is one of the central recommendations from the IMF, in its recent analysis of how macroeconomic policies should change in the wake of the global financial crisis (paper is here).  By favouring debt over other funding options, the tax deductability of interest charges encouraged excessive leverage and thereby contributed to risk in the financial system.

Accordingly, tax reform in this area has the potential to improve allocative efficiency while also raising revenue.  No doubt the shift to a new system must involve a transition phase, such that the initial improvement in revenue may be limited.

Incentive Effects of Taxing High Earners

In a recent post, Patrick Honohan raised the issue of what a sustainable tax system would look like, and in a follow up to that post, discussed whether a goal of keeping low income workers out of the tax net implied, with the current tax revenue requirement, tax rates on other earners that were so high as to have serious disincentive effects. In the ensuing discussion, John McHale suggested that I was being too sanguine about the incentive effects at the top of the distribution and helpfully pointed me towards a literature that I wasn’t familiar with, on the tax rate elasticity of taxable income, and particularly to a paper by Gruber and Saez (J.Pub.Econ., 2002), which finds an average elasticity of 0.4, with higher elasticities for high earners.

There are two reasons why we should be worried if income elasticities for this group are so high. First, a pragmatic one: it suggests that revenue will rise relatively little if we increase tax rates on this group. Second, a more worrying one: this group contains the job creators; if they’re discouraged from taking the risks and reduce their labour market effort, then there are far bigger knock-on effects in jobs that would have been created with lower tax rates, but now won’t be. The latter concern dominates much of the discussion on this matter – see, for example, Greg Connor’s comment here 

And so, an elasticity of 0.4 would indeed have to cause a rethink on my part. So I went off to read the paper.  

The paper is fascinating. It does indeed find an elasticity of taxable income to marginal tax rates of 0.4, with an even higher elasticity of 0.57 for high earners. (Note to explain the counter-intuitive sign: this is actually an elasticity wrt the net-of-tax rate, i.e. if the marginal rate goes up by 1%, so that the net-of-tax rate goes down by 1%, this causes a 40% decrease in income). But the elasticity of ‘broad’ income – income before tax exemptions are taken out – is much lower; it is 0.12 on average, and 0.17 for high earners. The bulk of the difference between these two elasticities is due to changes in what the authors call ‘itemization behaviour’ – in other words, tax avoidance. This point is reinforced by several other analyses in the paper.

One of the two policy conclusions drawn is that 

“[t]he large elasticities that we observe are driven by ‘holes’ in the tax base that allow taxpayers, particularly at higher income levels, to reduce their tax burdens. With a broader tax base we would distort behavior less and could therefore raise revenues more efficiently.” 

[The second is that concern about the distorting impact of high implicit tax rates in the $10k-$50k income range due to changes in effort (hours) “…may be overblown”, and that attention should instead be paid to incentives that reward participation rather than marginal increments to hours worked.]

So the paper’s message is (i) that the effect on (potentially job-creating) effort by high fliers of increasing tax rates is not zero, but is not high and (ii) that getting rid of tax write-offs should be a priority, particularly if marginal rates on high earners are to be raised.