Considine and Duffy on Expansionary Fiscal Contractions

Paul Krugman continues his campaign against the expansionary fiscal contraction hypothesis here.    In making his case, he links to a 2007 paper by UCC’s John Considine and University of Portsmouth’s David Duffy.   I don’t think the paper provides the slam-dunk evidence Krugman contends, but it is a very interesting read. 

 Abstract:

It is ironic that the potential expansionary effects of fiscal contractions have become known as non-Keynesian effects. This paper highlights the fact that Keynes and his contemporaries were aware of such potential perverse effects. It is clear that the important indirect effects of budgetary policy via expectation were known in the 1930s. Moreover, the economists of the time recognised the possibilities before they occurred. This paper supplements the existing research on the Expansionary Fiscal Contraction hypothesis by comparing two periods in economic history, Britain in 1930/1 and Ireland 1986/7, and the accompanying economic thought.

12 thoughts on “Considine and Duffy on Expansionary Fiscal Contractions”

  1. A more direct approach would be to look for systematic empirical evidence that multipliers are negative (good luck). But we are dealing with a belief-system akin to religion, not with people interested in empirical evidence. Another issue is whether ‘the markets’ believe that multipliers are negative — if so, they must be feeling more reassured right now about the European periphery given the way things are going. Here are the data as of a week ago:

    http://www.calculatedriskblog.com/2010/06/update-on-european-bond-and-cds-spreads.html

  2. A 10 per cent devaluation was hardly very significant in the context of an agreement with trade unions on industrial peace and a cross-party consensus to tackle the public finances.

    In 1989, US chipmaker Intel became the most significant overseas investor in Ireland since Henry Ford located a plant in Cork and the Intel decision prompted a surge in big US companies locating in Ireland.

    It is unlikely that Intel would have opted for Ireland, four years before.

    Danish economist Jacob Funk Kirkegaard, at the Peterson Institute, has responded to Krugman’s earlier post on Spanish/Irish bond spreads.

    http://www.piie.com/realtime/?p=1624

    However, Kirkegaard says Irish private external debt is almost 1o times GDP because of inclusion of IFSC data.

  3. @Michael: the agreement by the unions to restrain nominal wage demands would have made devaluation more effective, since the big argument against devaluations is usually that they lead to an increase in wages and other domestic costs.

  4. @Kevin
    “the big argument against devaluations is usually that they lead to an increase in wages and other domestic costs.”
    I can think of some other big arguments against them – in the long run the bond market earns it money back and then some.

    In a country that imports its standard of living (measured in consumption goods), a devaluation is an absolute and universal reduction in the standard of living. The larger the proportion of income in the devalued currency that is spent on imported goods, the larger the decline in standard of living. Take a look around you, find me a half dozen items in your house that were made in Ireland.

  5. @Yoga: exactly! One way of thinking about devaluations is that they lead to a reduction in real wages, for precisely the reason you mention, which is what is required in countries with high unemployment. If workers push for higher nominal wages to combat the decline in their living standards, the strategy won’t work, which is why a nominal wage freeze would be so helpful in such a context.

  6. But Kevin, what is the difference between that and what is happening now? Except, perhaps, that a nominal wage freeze would not differentiate between ‘successful’ sectors and those that are uncompetitive? So our ability to attract talent to the much vaunted knowledge economy would be damaged. I also don’t see how it could be implemented in practice. Do you say to both a factory worker and a senior counsel that their wages are capped? Social partnership might be able to enforce it on the factory worker, who is going to enforce it on the senior counsel?

    Short of a command economy, how do you go about doing this in a fair and equitable way?

    Aside from the theory, I haven’t seen how a deflation is different to a devaluation in practical terms. In particular, in practical terms as it relates to Ireland.

  7. I think the extent to which wages in Ireland are falling across the board now is overstated Yoga; they have increased in parts of the sheltered sector as we know. With a devaluation everyone takes a hit, and it can be a big one if the devaluation is big. Nominal wages are quite sticky downwards, this is the big difference IMO. (Another one is that the workers’ debts are also reduced, although not of course the foreign currency debts of the banks.)

  8. But the inequalities that gave rise to wage rises in the sheltered sector will remain. Unsheltering the sheltered sector still has to happen, otherwise we end back where we were – the workers in the export sector looking for wage rises as they have to compete with the workers in the sheltered sector.

    The sheltered sector will continue to command a premium versus the rest of the economy. The increases in costs to the sheltered sector (as a result of the devaluation) will be passed on to the rest of the economy; wages in the sheltered sector will be unaffected, as the nominal wage cap will also be a nominal wage floor. The likely result, therefore, is that the wage inequality in the economy will increase.

    Indeed, this is sort of what we are seeing with regard to those on welfare and those above means test limits (some families are better off with nobody working than they would be with one and certainly with two parents working).

    Besides, I don’t accept that everyone needs to take a hit, just as I don’t accept that everyone was to blame. The IT services sector, for example, is competitive in the world economy. Salaries in export companies are already lower than their protected or local-focused equivalents. We already have an economy that has been skewed towards churning out local high-skill workers (in construction and related disciplines, for example), to the detriment of IT, I believe.

    The situation where a job in the sheltered sector was prized above all else that pertained in the ‘seventies and still continues today must be addressed.

  9. There is also an excellent QA piece* with Professor Rajan today on the NYTimes economic blog. Rajan makes clear that he disagrees with Krugman: he argues convincingly that the social housing programme in the USA – based on the CMO system and extremely light regulation of mortgage lending – played a big role in the credit crisis. Krugman misses this I am afraid. Despite his brilliance as an economic theorist sometimes Krugman is afraid to offend the doctrinaire left , such as his spouse, also an economist. but too doctrinaire and closed minded.

    * http://freakonomics.blogs.nytimes.com/2010/06/17/predicting-the-financial-crisis-a-qa-with-fault-lines-author-raghuram-rajan/

  10. thanks for posting this link Gregory, this piece is really worth reading. On reading it I am rather surprised that your summary of it implies that Rajan suggests an alternative to Krugman’s ‘doctrinaire left’ position. Rajan’s analysis identifies growing income inequality as the key driver of the financhial crisis suggests that government should try to promote greater income equality via improved social security and education provision. His criticism of what you call the US ‘social housing programme’ is predicated on the argument that government shouldn’t promote wider access to owner occupation as a mechanism of addressing income inequalty, if they do they achieve perverse outcomes such as sub prime lending.

  11. @Michelle Norris – I agree with your “should” statements but I meant rather Rajan’s “did” statements. The USA system of CMOs + unregulated-mortgage-industry was intended (not should be, was) to aid lower-income housing without using any direct government cash outlays, and this flawed system did have a big role in generating the credit crisis. It effectively served as an unfunded social housing system and then crashed spectacularly. Krugman denies this, since any criticism of a social housing system – even if run by Republicans – is anathema. He does sometimes seems too doctrinaire in his descriptions of the facts and likely causes when the evidence gets in the way of his doctrines. Rajan clearly contradicts him on this – but this is about “is/is not ” rather than “should/should not” issues.

    Similarly, Krugman conflates Ireland and Spain (with quite different fiscal profiles due to the enormous bank guarantee in Ireland) in order to argue against expansionary fiscal contractions. Again, this is based on EFC being not conventionally Keynesian enough.

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