Table 2.1 of the OECD’s recent survey of the Irish economy provides a sobering statistic: when the anticipated adjustment in the December budget is included, the total discretionary fiscal adjustment for 2010 implemented this year will add up to 6.4 percent of GDP. This is an extremely pro-cyclical fiscal policy by any standard. It is also occurring while other industrialised economies are applying discretionary fiscal stimulus. Unnerved as we all are by the escalation in debt and the rise in the risk premium, there seems to be broad agreement among academic and financial-sector economists that Ireland is different and has really no choice but to pursue this fiscal course. Maybe it is my unhealthy suspicion of too much consensus, but I think it is worth asking if the Irish case is really that different.
Borrowing loosely from Albert Hirschman, the arguments against a smaller discretionary contraction than being targeted in the budget might be divided into three: futility, perversity, and jeopardy.
Futility: Potential output has fallen
Few doubt that the property bubble led to a distorted picture on sustainable real incomes. The bubble drew in foreign capital, led to an over-appreciated real exchange rate, and ultimately real consumption wages that were divorced from productivity. Real consumption wages must now fall, with higher equilibrium unemployment the primary mechanism for inducing the necessary wage cuts and improvements in competitiveness.
Associated with the higher unemployment is a lower potential real GDP level (and with it lower real incomes). In its recent survey, the OECD has lowered its estimate of potential real GDP by 7 percent. If the slump was solely due to the fall in potential real GDP then it would indeed be ultimately futile to try to sustain demand. However, the OECD estimates a cumulative reduction in real GDP from it 2007 level of 13 percent by the end of 2010. (The the fall in real GNP is already more than 13 percent.) Earlier this year, the IMF estimated the output gap (the gap between real GDP and potential real GDP expressed as a percentage of potential) would be -5.7 percent for 2010. It seems likely the economy is now undershooting its much lowered potential.
Perversity: Expansionary fiscal contractions
I think most economists would agree the Irish economy is now operating below potential. But few support the “textbook prescription” of demand stimulus. The almost consensus view is that the Irish economy will make a faster recovery with a more front-loaded fiscal adjustment. The most natural line of support for this position is to invoke the possibility of an expansionary fiscal contraction, whereby fiscal contractions lead to an expansion in demand through a combination of small multipliers, expectations effects, and changes in the risk premium. I have found some of the commentary on this a bit confusing, however. There seems to be a pattern to argue that the expansionary fiscal contraction is not supported by the data – including the Irish experience of the 1980s – and then to argue on the basis of a vaguely defined confidence effect that it is better to front load the fiscal adjustment.
I actually find evidence for a weak version of the expansionary fiscal contraction argument reasonably compelling. This is the evidence that adjustments based on current expenditure cuts are less contractionary and their sustainability more credible than adjustments based on tax increases and capital expenditure cuts. This suggests a richer menu of fiscal policy options and in particular the possibility of designing a less contractionary fiscal package combining front-loaded current expenditure cuts with a measure of tax and capital expenditure stimulus.
Jeopardy: The risks of debt exposure
The third argument emphasises risks associated with a high and rapidly rising debt. Putting aside crude scare stories based on rising debt service costs, I take these arguments very seriously. Ireland is already paying 1.5 percentage points over German bonds, and a larger and faster rising debt will push up this premium. [See here (p.64)for a summary of findings on the links between deficits, debts and interest rates.]
But it is also important not to exaggerate the international bond market constraint. For one thing, the timing of the post-crisis jump in the risk premium is better explained by news on the size of the banking related contingent liabilities. While I’m open to being convinced, I do not share the presumption that a small open economy borrowing predominantly in its own currency (which happens to be the second most important currency in the world) faces a significantly tighter borrowing constraint than larger countries. Is the Irish situation so different from, say, the United Kingdom (estimated 2009 deficit = 14.5 percent of GDP) to warrant such a radically different fiscal prescription? (Philip Lane has made the argument that a difference between Ireland and the U.S. or the U.K. is that they control their own currencies. But countries that control their own currency have to convince markets that they won’t try to inflate away their debts. Being in the eurozone seems to me an advantage not a disadvantage here.)
Whatever the short-term deficit target, the government could be doing more to ease the long-term fiscal constraint. It was a mistake to effectively set aside the Report of the Commission on Taxation. A credible commitment to implement the proposed tax-broadening measures over a two- to five-year horizon would have improved perceptions of long-run solvency. Other possible measures to help build longer-term credibility include indexing future state pension retirement ages to life expectancy, putting in place a proper resolution regime for the banks, and a move to multi-annual budgets.
An additional argument for caution in running up the debt is the risk of negative shocks in the future. It is the combination of uncertainty and the irreversibility of debt that argues for a “wait and see” approach. On the other hand, the evidence suggests that today’s actual rise in unemployment could have long-lasting effects on equilibrium unemployment (e.g. see here). Irreversibility cuts both ways.
To sum up, while I very much share the concern about Ireland’s fiscal precariousness, I just can’t see how the case for such a severe pro-cyclical tightening as is being planned is so overwhelming as to justify the degree of consensus among academic and financial sector economists on the issue. Elsewhere, there is a very active debate among economists about the appropriate fiscal response to the crisis. Moreover, advocacy for fiscal stimulus does not seem to break down along a left-right divide in other countries the way it does here. On the merits of the policy issue, I remain to be convinced Ireland is that different.