Stimulus?

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.

19 thoughts on “Stimulus?”

  1. @Karl: thank you for that enlightening post. I wish Michael Taft hadn’t gone on holidays (or wherever he is) because I’d welcome a debate between the two of you.

    I want to disagree with your final sentence: “But simplistic talk of the need for stimulus is not very helpful.” It depends where you’re coming from, though. You could see simplistic talk as an expression (perhaps indeed a defining characteristic) of the popular will. Shouldn’t determining the popular will be the first step in developing any state policy? Should not economics be the handmaiden of politics?

    On a separate point, there may be another reason for the “constant calls for stimulus”: perhaps people would prefer to see the billions (that we would have to borrow) spent on something other than supporting banks and builders. If scarce (indeed non-existent) resources are to be allocated, couldn’t they be spent on something more beneficial? The “poor old government” and the “vast majority of mainstream economists in the country” seem to be convinced that There Is No Alternative to spending whatever it takes on the banks, but I don’t think they have convinced the Broad Mass of the Ordinary Working People. That may be because most public discussion has assumed that banks will be bailed out and has focused on the details, without comparing and contrasting bank rescue with other options. (I accept of course that other options would probably require a revolution, so that we could renege on the bank guarantee and provide some popular streeet entertainment, but what’s wrong with that?)

    bjg

  2. Karl, a thought-provoking post as always. I agree with most of what you say, not least your debunking of laffer curve and off-balance sheet nonsense, and your concerns about the political economy of stimulus plans.

    In the spirit of the debate you call for, I would expand/push back on a few points.

    First, even putting aside the issue of composition, I think equating concerns about stimulus with reducing the budget deficit is too narrow. It is hard to look at the composition of Ireland’s real GDP contraction and not conclude domestic demand is playing a leading role. Even so, I don’t think there are too many people who have argued that fiscal adjustment can be avoided even in the very short term for the reasons you have outlined. The debate has been much more about the time path of that adjustment.

    Second, looking from the outside, Ireland stands out not for the push for stimulus, but the near consensus that deep fiscal adjustment is unavoidable. Of course, a good part of this relates to objective circumstances, not least the large interest rate and CDS spreads that opened up early in the year. But I think that Ireland’s fiscal history also has a good deal to do with it. Now that spreads have fallen back with the modest stabilisation in financial markets, it is worth asking how different Ireland really is. The piece by Martin Wolf linked to by Philip yesterday provides a good illustration of the importance being placed on fiscal stimulus elsewhere. There is certainly no harm in having this debate.

    Third, again compared to other countries, the thinking in regard to how to conduct stimulus has struck me as being narrow. The question being asked elsewhere is how to support near-term demand while making a credible commitment to longer-term adjustment. This also raises the issue of reforming fiscal institutions, including such innovations as legislating multi-year budget plans, instituting an independent fiscal watchdog along the lines of Canada’s new Parliamentary Budget Officer, or adopting automatic fiscal adjustment rules such as indexing retirement age to longevity. We should not be taking the fiscal rules as given but looking for ways to relax the fiscal constraint that forces large adjustment in the midst of a deep recession — on the face of it a massive failure of policy making.

    Fourth, the issue of risk has rightly played a significant role in thinking about fiscal policy. In an extremely uncertain environment it is right to be cautious in accumulating debt. At the risk of stating the obvious, the concern is that debt accumulation is irreversible (ruling out default), so it is sensible to wait for better information before making irreversible commitments. I would just add that we know some of the consequences of a demand-driven recession will also be slow to reverse, including the rise in unemployment to hysteresis effects and the destruction of skills and businesses. Irreversibility cuts both ways.

  3. Karl,

    Your strictures about the negligible scope for a fiscal stimulus and the reality of off balance sheet financing are fully justified. However, since the Government’s equity shareholding in the semi-states presumably appears on the asset side of the Government’s balance sheet – not sure where this exists, it should be possible to realise, at least, some of these assets via privatisation and use the proceeds to kick-start new public sector investment. The new equity investment would simply replace the original equity shareholding in the semi-states – a case of new assets for old assets.

    I have elaborated this possibility (in conjunction with policy and regulatory reform in the energy sector) on this blog at:
    http://www.irisheconomy.ie/index.php/2009/06/16/growing-the-economy/#comments

    Am I missing something?

  4. Thanks Paul. I don’t recall ever objecting to sales of semi-state bodies, where appropriate, so I’m not sure anything I’ve written is an accusation that you’ve missed something.

    That said, at the risk of sounding cranky, I’d prefer not to repeat the whole ESB thing all over again. Yes this is a somewhat important sector of the economy but, to be honest, I don’t really get why it dominates so many of our comment threads.

  5. Thanks, Karl. Fair comment. I’ll have to put my hands up for pushing it not only because it is a cunning subversion of the type of economic regulation that will be required increasingly in coming years, but because it is symptomatic of much wider policy and regulatory failures. However, point well taken. Over and out.

  6. Running a bigger budget deficit than planned, for whatever benefit it brings, is always an option. The benefit may be disappointing as Karl argues, since multipliers are low. But the costs need to be thought about too. Ireland’s adverse yield spread at 10 years against the bund has recently been about 200 bp, and has been (intraday) above 300 earlier this year. Any substantial debt sale at 10 years would cost close to 6% which, with inflation negative, is the highest real interest rate I can remember an Irish Govt facing.

    If fiscal policy were to be relaxed deliberately, the spread would likely widen. For a substantial relaxation, it would widen more. Since much recent debt issuance has been very short, there is substantial roll-over risk, and any higher spreads get payable on historic as well as new debt, and fairly quickly.

    Proponents of ‘stimulus’ seem not to be factoring in the debt issuance and debt-service-cost implications. It is silly to believe in self-financing tax cuts or spending increases. Ditto the Tooth Fairy and the infinitely elastic supply of sovereign credit at prevailing spreads.

  7. I would have to agree Karl that calls for a “stimulus” in an economy already looking at double digit deficits seem anachronistic. This still leaves wide open a debate that looks at the best adjustment paths subject to the fiscal adjustment constraints. This includes looking at things like redeploying the capital programme, switching between different types of taxation, redirecting current expenditure toward more labour intensive projects and so on. Edgar Morgenroth has made one of the most useful contributions to this debate by pointing out the wildly different cost-per-job numbers in different capital programmes and the often poor long-term economic rationale behind existing capital plans.

  8. Since we participate in a monetary union, perhaps something should be attempted at EU level? One could make the argument that it is more important for the Eurozone to hang together rather than hang apart, and therefore, the weaker members should be able to borrow at reduced rates and avoid some of the issues that Colm has rightly raised.

    Is this not in the realm of the possible?

  9. Just a query on Colm McCarthys post:

    He states….”Since much recent debt issuance has been very short, there is substantial roll-over risk, and any higher spreads get payable on historic as well as new debt, and fairly quickly”..

    I dont understand your assertion that any higher spreads get payable on historic as well as new debt.
    Surely ‘historic’ debt is issued at a certain yield and remains unchanged unless it is sold in secondary markets and even that does nt affect the yield the government still services that debt at.?
    If you are referring to short maturities and a large number of these being rolled over and higher yields being demanded I can understand that..

  10. Michael,
    If some EU mechanism could lend at a ‘reduced rate’ who would pay the difference between the reduced rate and the actual rate that reflects the risk and costs involved? A centralised EU budget? This to me looks like a kind of moral hazard situation – we’d be asking countries with a record of sound fiscal management, say Germany, to bail out those that don’t, say Ireland now, or Italy always. That proposal would take mere seconds to go from Angela Merkel’s desk to her paper bin.

  11. Sean O: I should have been clearer, short debt such as T-bills or commercial paper gets rolled over pretty quickly, so any worsened spread begins to cost you soon. Over the (say) four-year time horizon of a fiscal stabilisation programme, this can become material if a lot of your outstanding debt is short, as is now the case. More generally, borrowing very short saves coupon right now (the yield curve has steepened sharply) but it’s not a free lunch, since you are taking more roll-over risk. I am not saying that NTMA has got the mix wrong, these are tricky judgements, the key point is that relaxing the deficit target in current circumstances could shift borrowing terms against the issuer throughout the curve. Issuers such as Ireland now face an elastic supply curve for sovereign debt and I am not sure that ‘stimulus’ proponents always factor in this (very real) cost. This time it’s different!

  12. Karl

    I’m not sure much as been added to the debate about economic management from previous threads, but just to re-emphasise:

    The Fine Gael “NewERA” stimulus plan is based on a number of observations:

    (1) Notwithstanding the slowdown in the economy, there remain major infrastructure constraints to sustainable log-term economic growth in the areas of energy, telecoms and water and waste water (this has been highlighted by the NCC, NESC, eirgrid, the ESRI among many others)

    (2) Investment in these areas will, in our view, yield high returns, and it makes economic sense to bring as many of these investments forward as possible given the spare capacity in the economy.

    (3) The private sector can be incentivised to deliver some of these investments through better pricing alone (e.g. for carbon) and / or by better regulation, but many others will require more direct state action in the short-term because of private sector financing constraints and / or because of the existence of state and / or effective private monopolies in certain areas (water, electricity transmission, telecoms) which cannot be tackled easily in the short-term.

    (4) There is, therefore, a case for driving an investment programme in these areas through new and existing reformed semi-state utility companies. This does not constitute artificially shifting investments off-balance sheet, in the same way that financing the building of schools does. It is regarded as fair and efficient in most advance economies that water, energy and telecoms services are financed, for the most part, by consumers of these services, not by taxpayers. There are no “off balance sheet” delusions to this policy.

    (5) Expanding investment by semi-state utilities in these areas can, ultimately, as Fine Gael have proposed, be financed by the sale of other state assets (“old assets for new”), but requires some inter-temporal mediation from other sources (we have suggested the use of the NPRF, but may have to revisit this when it has all been blown on the banks)

    (6) Expanding investment in these areas in a way that enhances consumer welfare and long-term competitiveness also requires a complete overhaul of management pedigree and working practices in state utility companies and a much stronger regulatory regime. We have set down proposals for both.

    One can, of course, disagree that there are any high return investment opportunities in these areas, or thay they are the ones that we have identified. One can also present the ideological argument that state utility companies can ever deliver these investments efficiently and effectively.

    These are worthy areas for debate. But to suggest that the State or political parties should not be looking at ways to accelerate investment in this economy in a way that supports short-term employment and long-term competitiveness strikes me as rather “bizarre”.

    Andrew

  13. Andrew. The problem as I see it with plans based on “inter-temporal mediation from other sources” is that we’re already intertemporally mediating to the tune of 12% of GDP. Deliberately pushing it further than this doesn’t strike me as a good idea but, as always, there’s room for sensible people to disagree.

  14. Amazed at some of the stuff here. Clearly most of the contributors are in PPP jobs and not in Private Sector employment which is being destroyed on a daily basis as is entepreneurship in the Irish economy. Government may abandon the Private sector at it’s peril with policies of more tax to pay for public sector jobs and bailouts to reckless banks. The Government has choices and ignoring the Private sector which it has done to date in this crisis will have long term repercussions for the Irish economy.

  15. This is a little off topic, but I’d like to see my query dismissed or somewhat quantified.

    I’d consider that most EU countries (excluding CEE) have GDPs of similar composition that can be used to indicate tax raising capacity. The Maastricht Treaty’s 3% deficit rule would tend to support this view. For Ireland, I suspect a large portion of our GDP has an effective tax raising capacity limited to 12.5%. If true, Ireland’s tax raising ability as a percentage of GDP is lower than our European cousins.

    If this is the case, any guesses on what the Ireland to EU (ex CEE) ratio might be? Ideally I’d like to multiply a 10% Irish deficit by x to get an EU equivalent.

  16. Yes, Brian, unfortunately I am away and time is limited to address many of the legitimate points that Karl has put forward. Stimulus conjures different things for differnt people and, therefore, the debate goes this way and that. Lets start with the issue of debt and deficits. Clearly, the deficit is spinning further out of control. Last October the Government imposed income levies and public expenditure cuts to keep the deficit at 6%. The April budget was brought in to keep the deficit at 10.75% because, in their estimation, the 12.75% they were facing into was unsustainable. Yet, that unsustainable number – 12.75% – is esactly what we are getting under government policy. The EU Commission is predicting a 15.5% deficit next year based on current government policy. So before we get into a debate over ´stimulus´ lets at least admit the failure of current policy to control the deficit. If you want high debt, lets keep doing what we are doing.

    The point of stimulus – and here I speak from the UNITE position – is that economic investment should be directed at the those areas in which we need to invest in any case. For instance, we have a degraded physical and social infrastructure, combined with poor social protection. If we wish to be a competitive economy in the future we will need to rapdily and smartly upgrade these areas. We entered the recession with one of the poorest physical infrastuctures in the OECD. GOvernment is proposing to cut investment further while other governments are increasing investment as part of their response packages. On the other side of the recession we will have fallen even further behind in infrastructural quality. How can we expect to compete in such circumstances.

    The same goes for subsidies to for job retention meansures – subsidising short-timing to avoid redundancy. THis is a cheaper option than the dole. THere are a number of measures that fit into these categories – necessary investment and economic activity-protection. This is ´stimulus´ adapted to Irish needs.

    As to financing, one of the few strengths we have is that we are a low-debt economy. Even if the worst EU Commission prediction holds true – a deficit out of control – we will still be relatively low-debt next year. And thats only at gross level. At net level we are lower still. So we have the capacity to borrow and stil remain ´prudent´, that is, below average by Eurozone standards. This investment, therefore, borrowed within prudent parameters, can be used to create jobs in the necessary infrastructural areas such as telecommunications, energy, water and waste, education, health, urban regeneration and social protection. These jobs created will lower the annual deficit – more jobs, more activity, more tax revenue, less social welfare payments. We end up borrowing less for annual purposes. In essence, we incrase our low debt levels to lower high annual deficit levels while at the same time invest in our productive capacity – both physical and labour.

    That is is the essence – but we must follow this through. One of the many casualties of this recession is the low’tax, low-spend, low-insured, low-pay model that has dominated policy. This investment policy is the first step, not to return to normal – there is no normal to return to. Rather it is the first phase towards realigning our economic base along continental lines. This is the ultimate direction.

    Or we can do what we are doing now. Cutting historically low levels of current expenditure, cuting investment with a degraded infrastructure, increasing taxes on low and average income groups – is anyone surprised the economy is declining at double’digit rates and, with it, an out of control deficit.

    Karl has opened up a useful debate. It would be a pity not to explore all aspects before wringing our hands and continuing with a high-deficit, high-debt strategy currently pursued – one that will certainly frighten the investing horses.

  17. In his contribution to the spiked/Clarke Mulder Purdie debate on the future of risk-taking and innovation after the recession James Woudhuysen, Professor of Forecasting and Innovation at De Montfort University, challenges economists to look beyond stylised facts and discuss the importance of stimulating real investment in R&D and technology to reverse its secular decline. He writes:

    In a new 37-page report, the OECD is adamant that the crisis has led to a decline in innovation:

    ‘Corporate reports for the fourth quarter of 2008 in many cases already show a decline or slower growth in research and development (R&D) spending. Forecasts for 2009 confirm the trend…

    ‘R&D is declining because it is mainly financed from cash flow (retained earnings), which contracts in downturns. At the same time, as banks, markets and investors have become more risk averse, firms face difficulties in tapping into external sources of funding to support their investments in R&D. Business R&D is also being re-oriented towards short-term, low-risk innovations, while longer-term, high-risk innovation projects are being cut first.’ (1)

    So far, so predictable. But it seems to escape the OECD that the decline of innovation is a cause, not just a result of the crisis. The report recognises that public R&D in energy has long been in decline, but fails to use figures which the OECD itself produces – figures that show, in the US and Europe and as a percentage of GDP, the stagnation of business R&D, and the rapid decline of all aspects of public R&D (2).

    You can read the rest of this provocative piece here

Comments are closed.