The Macroeconomic Impact of the Budget

Around the world, there is renewed interest in estimating the macroeconomic impact of fiscal policy. This is notoriously difficult, in view of the myriad two-way interactions between fiscal policy decisions and the state of the economy.  Economic research offers two general approaches: (a) simulations of macroeconomic models; and (b) estimating the impact of fiscal shocks on past data.

There are quite a number of factors to consider in such exercises:

  • What is the exact nature of the fiscal policy?   The macroeconomic impact will differ across different types of government spending and different types of tax policy – there is no unique fiscal multiplier.
  • Is the fiscal stimulus temporary or permanent in nature? If it is the latter, the prospect of higher future taxes (in line with the permanent increase in spending) will act against the short-run stimulative effect of extra spending.
  • Is the increase in spending to be financed by taxes (a balanced-budget fiscal expansion) or through an increase in debt?
  • The interest rate channel.  Under normal conditions, a fiscal expansion will induce a country with an independent monetary policy to raise the interest rate to offset inflationary pressures, limiting the impact on output.  If the level of underemployed resources is high (as at present in many countries), the interest rate may not respond such that the power of fiscal policy is enhanced.
  • Monetary union.  Note that under normal conditions, this suggests that fiscal policy should be more powerful for a member of a monetary union, since the ECB interest rate will not be influenced by conditions in a small individual member country.
  • Trade openness.  The greater the share of imports in total demand, the smaller the boost to the domestic economy from a fiscal expansion.  Moreover, a fiscal expansion will typically induce real appreciation (an increase in relative price of nontradables) that squeezes the tradables sector, such that the composition of activity changes. To the extent that a thriving tradables sector is fundamental for long-term productivity growth, this compositional effect is important.
  • Sovereign risk.  If a fiscal expansion raises investor concerns about debt sustainability, the increase in the sovereign risk premium may neuter the stimulative impact of a fiscal expansion. This is especially the case when the sovereign risk premium also raises borrowing costs for other entities, such as the domestic banks.  In addition to higher borrowing costs, an increased risk profile also leaves an economy exposed to an inability to fund its debt and the consequences of such a ‘sudden stop’ in funding can be catastrophic, with the resolution typically involving a funding package by international institutions.
  • Fiscal dynamics.  The fiscal package in any one year has to be interpreted in the context of past fiscal positions and expected future fiscal positions.  An economy with a structural deficit must cut spending and raise taxes at some point, such that the macroeconomic impact of fiscal tightening must be absorbed – the challenge is to time the fiscal adjustment to minimise the macroeconomic damage.
  • Anticipation effects.  The impact of fiscal policy on private-sector consumption and investment decisions does not wait until budget day – if a fiscal tightening is anticipated, many forward-looking decisions will already have taken into account the prospect of lower public spending and higher future taxes.  Doubtless, the slowdown in consumption and investment in Ireland has in part been influenced by the prospect of major fiscal tightening over 2009-2014.
  • Welfare analysis.  Different types of fiscal policy will have a differential impact on the relative shares of private and public consumption and public and private investment. In addition, the levels of transfer payments and the structure of the tax system will also have significant effects on the distribution of incomes across the private sector.  Such distributional concerns mean that there is no uniquely optimal fiscal policy, since individuals and interest groups will have different preferences across these dimensions.

As I have written about before, it is a matter of deep regret that Ireland should have to undertake fiscal tightening during a big recession.  However, given the size of the structural deficit and the substantial funding risk, it is conditionally optimal to implement such an adjustment.  The goal should be to design the fiscal adjustment such that there is a shift in the composition of spending and taxation in directions that will help the economy to recover as quickly as is feasible.

Finally, it would indeed be helpful if the Department of Finance produced a report that detailed its projections concerning the macroeconomic impact of the budget.  The fiscal plan for 2010-2014 surely incorporates feedback effects between fiscal decisions and macroeconomic aggregates, but the estimates of these feedback effects have not been explicitly spelled out (as far as I know).

Extension: I forgot to make a few more points:

  • One of the lessons from the bubble years, is that it is important to acknowledge uncertainty in making projections – the central forecast must be supplemented by analysis of downside and upside risks to any policy decision.  To me, the main risk is the downside risk of Ireland facing a funding crisis.
  • In assessing the impact of fiscal policy, it is important to work out the impact on future macroeconomic variables in addition to its short-run impact.
  • Given the uncertainties, it is important that fiscal policy choices are robust to changes in specific modelling choices.

28 thoughts on “The Macroeconomic Impact of the Budget”

  1. Philip – a useful breakdown of the inter-relationships betwen fiscal and economic policy (of which there is too little debate). The Government’s Pre-Budget Outlook did publish a scenario of what the fiscal deficit would look like if there were no ‘corrective’ actions taken. This was, according to their admission, a static set of numbers. However, it suggests if we take a conservative extrapolation for 2014 – the new target date for Maastricht compliance – the deficit would decline of its own accord by 35 to 40 percent. This suggests a structural deficit in line with the ESRI’s own estimate – somewhere around 6.5 percent. If so, then the €4 billion contraction (or 2.4 percent of GDP) is excessive and unnecessary.

    Further, the PBO estimates growth at 3.5 percent in 2011 rising to 4.5 percent in the following two years. Never mind that no independent forecasters are coming up with such high numbers (the OECD predicts 1 percent growth in 2011). The issue is what is the impact of fiscal correction on these numbers. Surely, it would undermine these growth numbers. However, because the PBO doesn’t present a dynamic interaction between the two we are in a fog. And the Government’s fiscal strategy is dependent on reaching these high growth numbers. Without them, we will struggle to reach even the new target date of 2014. All the more reason that we need a better set of numbers and deeper analysis coming out of the DoF – ones which others can put to better use than heretofore.

  2. PL: “Around the world, there is renewed interest in estimating the macroeconomic impact of fiscal policy. This is notoriously difficult, in view of the myriad two-way interactions between fiscal policy decisions and the state of the economy.”

    The google mentality does not allow for known unknowns. A poster yesterday asked PL to estimate the macroeconomic impact of public sector pay cuts (rough paraphrase). It is a good question from a reasonable poster but people have to accept that we can not know the answer. It is my experience that people often express dissatisfaction when told that an advised course of action will not yield a definite result.

    Some people think it is smart behaviour to try and shoehorn their advisors into Dumbledore style predictions by adopting the old Morning Ireland questioning technique of “just give me a yes or a no”. Another example might be: “Your brief is to get this result X. I will follow your advice and if I don’t obtain result X then it is your fault and I will hold you responsible.” This may work well in putting people under pressure and concentrating their minds but that is about it.

    It strikes me that there is general unity amongst experts as to the course of action Ireland might take. Total unity may be somewhat unhealthy but given that we are dependent on international and market sentiment the course is now plotted. The macroeconomic impact is relevant insofar as one of two things come into play:
    1. That the economic or political cost of avoiding sovereign default outweighs the cost of defaulting, or
    2. That our position improves to a degree that allows us to make a lesser or greater adjustment.

    PL: “Finally, it would indeed be helpful if the Department of Finance produced a report that detailed its projections concerning the macroeconomic impact of the budget.”

    Is the DoF competent to produce such a report considering its poor record at predicting revenue take over the last ten years?

  3. Greek bonds are getting wiped out this morning, 10yr bond yields up 20bps today after 15bps increase yesterday. Yet another reminder that while the spending cut backs may have a deflationary effect, not reining it in could cause a catastrophic affect on our funding costs and ability.

  4. @ Philip Lane

    This is a very useful post.

    There are indeed a number of difficulties in estimating the macroeconomic impact of fiscal policy, especially given their interaction. In terms of the econometric models, the results can be highly varied even where the assumptions underlying them are highly comparable. And those assumptions themselves are frequently contestable. For time-series analysis over the medium-term the key difficulty arises from structural changes to an economy, especially when those structural changes can be abrupt.

    However, it does seem entirely appropriate to ask the DoF to produce a report that detailed its projections concerning the macroeconomic impact of the budget, precisely because of ‘feedback effects’ between fiscal decisions and macroeconomic aggregates. Not only have these estimates of these feedback effects have not been explicitly spelled out as far as anyone can tell, but the approach in the Pre-Budget Outlook is to simply lop €4bn off the deficit. Despite all the uncertainties around modelling and forecasting, it is fairly certain that does not correspond to the actual course of events.

    We know that multipliers operated on the way down:- a 13% decline in activity became a 32% decline in taxaton revenues.

    What is amazing, though, in an era of cost-benefit analysis, key performance indicators, etc. the government has embarked on a series decisive policy actions without having published any serious assessment of their likely impact.

  5. Philip: on sovereign risk, it matters more the more sovereign-guaranteed debt there is, and the shorter the duration of sov and sov-guaranteed debt. We tick both boxes.

    Michael: GGB deficit next year will be in double digits even after the €4 bill adjustment. Ten-year spread back up to 162 bps yesterday’s close. You have nerves of steel!

  6. @ Colm

    No nerves of jelly, really. What really worries me is that the austerity policy is making matters worse, as far as Irish bond yield spreads are concerned.

    I have posted on this elsewhere, and will provide the link as soon as it is up.

    The essential point is that, compared to average European yields, Irish spreads have widened while austerity is the order of the day here, yet spreads have narrowed elsewhere, in countries that are reflating. In fact, they started to part company in October 2008, the first such emergency measure supposely designed to “reassure the markets”. Like the hoped-for deficit-reduction itself it has been a miserable failure.

  7. @ Michael

    “compared to average European yields, Irish spreads have widened while austerity is the order of the day here, yet spreads have narrowed elsewhere, in countries that are reflating.”

    I’m sorry, but this is plain wrong. Please look at Greek government debt over the last month, and in particular this week. Not accepting their fiscal reality and trying to “reflate” themselves (ie borrow even more) has cost them billions in additional interest payments, and could yet see an EU or ECB bailout this side of Xmas.

    Literally on the wires right now:

    *GREECE DOWNGRADED TO `BBB+’ AT FITCH; OUTLOOK NEGATIVE

    A very Greek tragedy is potentially unfolding right before our eyes. Thank God we have decided that painful decisions now should bring better days in the future.

  8. I wholeheartedly agree with Philip’s statement that projections should be accompanied by bounds related to the uncertain environment in which most decisions are taken. In fact, since many decisions are (partly) irreversible Philip is spot on to focus on the downside risk. This is the only risk that matters. After all, if you postpone a policy and it turns out that it would actually be good for the economy you can always still implement it. If, however, you take a decision and it turns out to be a bad one you’re left with the wreckage. Ben Bernanke had a good paper on this as far back as 1981,, in the QJE.

  9. @ Eoin

    I think the comparison with Greece is plain wrong.

    No-one knows what the fiscal position in Greece is, which is what has led to a collapse of confidence, as the outgoing government lied to the European Commission about the fiscal position. This might raise a question mark over the Commssion’s role as accountants, let alone policy advisers. The new Greek government has not attempted reflation, it is simply trying to come to terms with its inheritance, while the ratings agencies bring to bear their usual standards of foresight.

    Ireland has decided on very painful decisions and seen….what? Higher deficits, lower growth and higher yield spreads versus the rest of Europe. All of which are related.

  10. @Michael Burke

    The evidence that the April budget has resulted in ‘lower growth’ is scant. In fact, the mystery must be why such an aggressive tax raising budget has had so little effect. Our volume of retail sales have moved in line with the rest of the Europe as they engaged in fiscal expansion, and is now higher than it was on Budget day. Further, unemployment seems to be stabilising. Other than give the mop-up explanation that the savings rate might now be falling, it is hard to explain this, though it certainly favours the arguments of those seeking a significant fiscal consolidation tomorrow.

  11. @Philip Lane
    When you say “Is the fiscal stimulus temporary or permanent in nature”

    I assume you’re referring to our very own homegrown fiscal stimulus whereby we overpay the under productive public service ? 😉

  12. @ Ronnie O’Toole

    The repeated fiscal contractions have led to just that- contraction. Every official forecast for growth and the deficit has been superseded by a lower growth forecast and a higher deficit forecast.

  13. @Philip Lane
    I haven’t seen much comment in the media about this statement by Brian Lenihan:

    http://www.independent.ie/national-news/budget/news/eu-saved-country-from-total-collapse-1962416.html

    “THE Irish economy would have collapsed during the banking crisis last year had it not been for the support of Europe, Finance Minister Brian Lenihan admitted yesterday.

    Support from the European Central Bank, after the banks were guaranteed in September of last year, helped save our bacon, he added.

    “Were we not in the euro zone in the last year, our banking crisis could have resulted in a general collapse of the State,” Mr Lenihan said in Brussels.”

    This effectively confims what Willem Buiter said.

    http://blogs.ft.com/maverecon/2009/11/the-intrinsic-unimportance-of-dubai-world-and-the-important-wider-message-it-conveys/

    “When Ireland was about to be swept away by a wave of global financial mistrust triggered by the Irish government’s decision to guarantee effectively all liabilities of its banks, the then German Finance Minister Steinbruck made the amazing statement (which he obviously had not checked with his coalition partners, his Chancellor or his voters) that the Eurozone countries would not let one of their own go into default.”

    Brian Lenihan has now confirmed that the reckless and inexplicable bank guarantee almost caused, in his words, “a general collapse of the state”.
    This deserves a blog surely?

  14. Michael Taft

    I would hope that you are correct, but with Nama we now need to fund 54,000,000,000 in repayments with a real interest rate of anywhere from 5
    5 to 10% over twenty years!

    The pain will continue. See what Stuart Blythman suggested: a deficit of 12,000,000,000 currently! Adding in that additional borrowing requirement, at that rate, we need …..? Mind bogglingly bad. Someone is taking revenge for The Baltic Exchange!

  15. E65Bn plus economic costs & NO extra lending!

    I beat ya to it!

    Yes, the admission by the greatest living patriot is dismal! Confidence?! Howareya! If we still had to vote on Lisbon, until we got the correct answer, I could understand! He has the government jet so he is not fatigued. Yet he says this! These guys could have and should have manipulated the markets top buy up bank debts via Michael somers but now, that the funding is in place, they say this!

    UGH!

  16. Michael Burke

    I agree! But perhaps you want to answer your own implicit question? Don’t be afraid of being called a conspiracy theorist if that is what is holding you back?

  17. Hi Jacco

    Are you a neighbour of Brian Lucey’s? You would know a lot of good Corkman jokes? 😉

    In times of crisis, any good management changes management! The previous swashbucklers got us into the mess so we need persons with a different outlook, on the downside, to get us out without unnecessary damage. In a rising economy, anyone can make money, the real test is when the tide is flowing out.

    As it does before a tsunami …. Then we need Kal El.

  18. Philip

    Thanks for the post, but the people who need to study it are probably not going to and they will continue spin against the hapless public service. Which they have just found out is badly overpaid!!!!

    I look forward to your critique of the actual attempts by this crowd. I hope you are in full agreement with it but somehow I doubt it!

  19. Good post but what about monetary economics?

    Why do Irish economists devote so little attention to banks, credit, interest rates etc given that it is these factors which are at the epicentre of the depression we now endure?

    Is it that fiscal economics allow economists – forced to discard the trainsets of childhood – to turn the national economy into their plaything in adulthood? Is it that monetary economics force us all to play a subordinate role to markets and pricing?

    Look at the DEW agenda in Kenmare over recent years. It’s all about economists playing with trainsets!

  20. @ Michael Burke

    “I think the comparison with Greece is plain wrong.”

    Well im glad you think it, but any chance you could actually come up with a better reasoning than that?

    Greece has now owned up to having a budget deficit in and around 12% this year, and is now expecting something similar next year. As a result, the ratings agencies have had to massively downgrade their fiscal stability and outlook.

    From Fitch: “the downgrade reflected concerns over the medium-term outlook for public finances given the weak credibility of fiscal institutions and the policy framework in Greece.”

    From S&P: “The decision reflects our view that the fiscal consolidation plans outlined by the new government are unlikely to secure a sustained reduction in fiscal deficits and the public debt burden”

    The Greeks do not have a credible plan to get their budget deficit under control anytime soon. They have been downgraded already and could be downgraded further. Their debt may no longer be eligible for use at the ECB repo. Their situation is bordering on a debt compound issue that could bring the entire state down.

    There is very little mention of “growth” in either of the pieces from Fitch and S&P, its all about bringing the deficit under control and not being credible in how they are both tackling and being honest about their deficit. The situation in Ireland is the polar opposite, with various positive mentions from different banks and economists about how impressive our “confronting the problem” (per GS yestrday) has been and how we are on the road to fiscal recovery while Greece, and possibly some others around the Eurozone, have not even begun. Our debt levels have been remarkably constant over the last few months, despite the blow ups in both Greece and Dubai in recent weeks. People believe what we are saying, they believe we have a handle on the problem.

    Your focus on the short term impact of the spending cuts almost completely ignores the long term benefits of a lower deficit, particularly when comparing against the doomsday scenario we are now potentially seeing being played out in Greece.

    By the way, Greek debt levels up another 20-30bps this morning again…

  21. @ Michael Burke

    just read your piece.

    its rather bizarre in the extreme that in a reasonably chunky article about Irish government debt levels, and the effect on them since October 2008 (!), there is not one mention of the bank guarantee scheme. In fact, the word “bank” appears only once, and that is when referencing the Credit Suisse Private Banking comments. And remember, i’m a NAMA-phile who, while ultimately feeling that NAMA/the guarantee is part of a long term process to stabilise the financial system, completely accepts that is has hurt the short term debt situation for the state (though equally if not more so this was caused by the deficit). You either forgot about it, you don’t feel it is relevant, or you decided to purposely not refer to it. You decide which it is.

    By the by, literally just out…

    *FITCH’S PRYCE SAYS IRISH GOVERNMENT IN CONTROL
    *FITCH’S PRYCE SAYS GREEK BUDGET DOESN’T MAKE BIG ENOUGH CHANGES
    *FITCH’S PRYCE SAYS `NOT CONVINCED’ GREECE WON’T DEFAULT

  22. @Pat

    The logic of Bernanke’s argument hasn’t changed. In fact, one could argue that an important part of the problems that have been created is that people spent too much time looking at the upside potential instead of watching their backs. To my knowledge, even though Bernanke, and many other I might add, have been writing about these issues in academic journals for decades, current practise still hasn’t fully picked up. So, my only aim was to point out the existence of this literature, obviously leaving me wide open for ivory tower criticism. So be it.

    And last time I checked Brian hadn’t moved in next door 🙂

  23. @ Eoin

    Would Fitch & S&P be among those ratings agencies that gave AAA ratings to a load of asset-backed toxic waste? Perhaps it is the madness of crowds, but you would need a psychologist, not an economist, to explain why financial markets continue to take them seriously.

    The focus of the piece is the relationship between debt yields and the opposing policies of reflation and fisal contraction.

    However, you are right. Bank bailouts do matter. Ireland’s is equivalent to 232% of GDP and Belgium’s is the next highest in the Euro Area at 92% of GDP.

    So on the one hand we have a very large bank bailout and fiscal reflation (Belgium) and on the other an enormous bank bailout and fiscal contraction (Ireland). And the bond market is far happier to lend to Belgium than Ireland, and at lower interest rates. Belgian yields have risen as a result of the crisis, but nothing like as much as Ireland’s.

    Bond investors are far happier to lend governments money when they are confident they will get it back.

    Belgium’s reflation makes that more likely as it it increases the tax base and reduces the deifict. Ireland’s fiscal contraction makes that less likely an has increased the deficit. In both cases, pouring borrowed capital into zombie banks makes repayment somewhat less likely. Hence Belgian yields have risen, and Ireland’s yields have risen far more.

  24. @ Michael

    whether you like it or not, the ECB still follows their ratings, and hence the discussion about what another downgrade for Greece might mean, as their debt may not be able to be used at the ECB repo. As such, its incredibly relevant. Like the bank bailout which you completely ignored in your original post and are now paying merely lip service to. You also completely fail to take account of the fact that the biggest 1wk jump in Irish govt debt yields took place immediately after the Anglo nationalisation, which should again underscore how much of a factor it is on our debt yields. Given the scale of the Irish government guarantee, it ever getting called in would create such a large liability that no scale of reflating would ever allow us to repay it. This, combined with a massive structural deficit which would never be closed without a cut in spending, are the two issues which are driving the market outlook of our debt. Read all the different reports on Irish debt currently out there from banks and economists – very very very few of them highlight worries over growth being impaired from the cut in spending. Yes it will have a negative impact on it, but there are far more concerns out there of us following the same path as the Greeks. As i said above, to ignore the bank guarantee in your analysis of yields smacks of deliberately leaving it out in order to come up with your pre-conceived opinion.

  25. @ Eoin

    The charge of leaving out the bank guarantee to fit a preconceived opinion is unwarranted, I think. We simply disagree whether bank bailouts or fiscal policy are the main determinant of government bond market performance.

    The focus of my piece is bond yields and reflation versus fiscal contraction. I didn’t discuss the bank guarantee as I wanted to focus on this topic, because it is in my judgement the primary driver of the trend in yields.

    If the relative size of the bank bailouts were the primary determinant of the trend in yields, Ireland’s would be higher than those of Greece, as the bailout here is much bigger. Greece has one of the smaller bank bailouts (see below).

    Let’s assume the yield spread over Germany directly correlates with the size of the bank bailout relative to GDP. Then the yield spreads would be ranked as follows, in line with bailout costs/GDP ratios shown:

    Ireland 232%
    Belgium 92%
    Netherlands 52%
    Austria & Slovenia 33%
    Finland 28%
    Germany 24%
    Luxembourg 20%
    France 18%
    Spain & Portugal 12%
    Greece 11%
    Italy 1%
    Slovakia and Cyprus 0%

    (Source: European Commission, Euro Area Report, October 2009, Table 2.1, page 36).

    But in the real world, the yield spreads aren’t anything like that.

    “So on the one hand we have a very large bank bailout and fiscal reflation (Belgium) and on the other an enormous bank bailout and fiscal contraction (Ireland). And the bond market is far happier to lend to Belgium than Ireland, and at lower interest rates. Belgian yields have risen as a result of the crisis, but nothing like as much as Ireland’s.”

    If you want me to say that NAMA is a disaster, I do readily. If you want me to say that it’s the entire cause of Ireland’s deficit, and the problems for the Irish bond market, then the facts speak otherwise.

    Irish fiscal policy has made a bad situation far worse, has increased the deficit and has driven yields higher. How do we know? Because, from exactly the same starting-point, Belgium (and many others) took the opposite course and the opposite happened.

  26. I think Cormac Lucey’s point about monetary policy being neglected, however fair or unfair in relation to Irish economists, is valid at the more political or mass media level. In many ways the Irish economy is being crucified on a cross of Euro* – we are going through an incredibly painful, socially divisive and uncertain process of deflation because we have no interest or exchange rate flexibility. All in relation to a bubble partly caused by inappropriately low interest rates for our economy – again due to EMU.

    Yet there appears to be very little criticism of ECB policy in this country. Why on earth is the ECB still holding onto the 100bp it still has to play with? With China still pegging the Yuan to the US dollar, is Europe to take the entire brunt of a rebalancing of the US trade account?

    I’m sure Patrick Honohan is saying all the right things around the table in Frankfurt. But otherwise we’re pretty silent on this. My worry is that if the likes of Ireland aren’t putting pressure on Trichet then where will the pressure come from. Not to mention the grim prospect of Jurgen Stark replacing Trichet…

    *With apologies to William Jennings Bryan: http://en.wikipedia.org/wiki/Cross_of_Gold_speech

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