Stimulus is a term being used these days by a wide range of people across the political divide. Unions, business groups, Fine Gael, Labour—everyone has a stimulus plan. Everyone, of course, apart from the poor old government. And, indeed, the vast majority of mainstream economists in the country. Since the term keeps popping up everywhere, I thought it might be useful to open a debate about it here, outlining why I have not joined the public clamour calling for stimulus.
Let’s start with the simplest reason. The most basic measure of fiscal stimulus is the change in the budget deficit—if the budget deficit is being reduced, then one can roughly characterise fiscal policy as being contractionary. With a probably-ambitious budget deficit target of 11.75% and international bond markets concered about our long-term fiscal solvency, the government needs to reduce this deficit. In this broad sense, stimulus is simply not possible.
Of course, this is just a simplistic starting point. Budget deficits are responsive to cyclical movements in the economy. The widening of the budget deficit that has occurred in Ireland has been entirely due to the negative effect on taxes and the positive effect on spending of the weakening of the economy. Our reliance on taxes from property-related sources during an unsustainable housing boom left us particularly vulnerable to a downturn.
All this, however, doesn’t change the implications of the simplistic analysis above. Without getting into the imprecise science of estimating the structural budget deficit, it is clear that we cannot rely on economic recovery to return the fiscal deficit to sustainable levels. Much, perhaps most, of the reduction in the deficit that will be necessary over the next few years will require cuts in expenditure and\or increases in taxes over and above any natural adjustments that will come from economic recovery. In other words, fiscal stimulus will not be possible.
In this context, any reasonable stimulus proposals must be based on arguments about the composition of the fiscal adjustment. For instance, there is no point proposing tax cuts as stimulus without also factoring in the spending cuts that will be needed to pay for them.
Of course, this is a standard territory in fiscal policy discussions—it is perfectly possible that there are ways of changing the mix of taxes and spending in a way that can have a positive effect on the economy. On this issue, standard economic theory argues that direct spending on goods and services is more effective at stimulating demand than tax cuts because some fraction of tax cuts will be saved (In particular, businesses under stress are likely to use tax cuts to boost their cash balances rather than hire new employees).
Perhaps the most effective way to use government spending to stimulate aggregate demand is to spend money on those now-infamous “shovel-ready” labour intensive capital projects. However, once you factor in the need to cut the deficit, going down the shovel-ready route means choosing to spend money on roads and metros that won’t benefit people for some time, while at the same time implementing cuts in current spending that can have negative and disruptive effects today. So, even if the logic of stimulus argues for shovel-ready projects, political reality and common sense may not. In practise, postponing capital projects is one of the most likely ways that fiscal restraint will be implemented in the coming years.
Two other themes that run through the stimulus debate are also briefly worth addressing. First, various proposals for tax cuts or spending increases are often promoted as paying for themselves. However, in reality, when spending projects are assessed or the effects of tax cuts are calculated, one rarely ever finds anything of this nature.
Second, arguments that we can provide stimulus by financing spending from off-balance sheet borrowing or from the National Pension Reserve Fund appear to be based on the idea that our fiscal problems are merely a measurement issue—that the only thing that really matters is the deficit as measured by Brussels. This is not a useful way to think about the difficult decisions required in putting the state on a path towards long-term fiscal solvency.
All of the above assumes, of course, that fiscal stimulus would be highly desirable if only it could be implemented. However, anyone who’s gotten this far into this post almost certainly knows that fiscal multipliers in small open economies are very small, so the gains are much more limited than could be attained in larger economies. And balanced-budget spending multipliers for Ireland may be negative. So while we are not in a position to implement a stimulus package, it wouldn’t be very effective even if we could. (The apparent lack of folk memory of the consequences of Fianna Fail’s 1977 manifesto is a bit surprising to me.)
So why are there constant calls for stimulus? Is it that the various groups calling for it don’t agree with the analysis above? Partly, perhaps. What’s also going on, however, is that calls for stimulus are an excellent way to provide cover for what are, in essence, standard appeals for fiscal favours for various interest groups who are struggling in the recession. Businessmen want targeted tax cuts and subsidies, builders want capital spending, trade unions want measures that look like they are dealing with unemployment, and all in the name of stimulus. And, of course, opposition political parties want to appear to have “positive and innovative” proposals.
Before I get attacked as a curmudgeon (it’ll happen anyway) I want to emphasise that I’m not arguing against genuine efforts to rebalance public spending and taxation in ways that allow us to reduce to fiscal deficit while doing as little damage as possible—both spending and taxation need to be refocused in ways that make them more efficient. But simplistic talk of the need for stimulus is not very helpful.