One by-product of Paul Krugman’s latest intervention on Ireland is that it will provide further ammunition for the many people who believe the government should abandon fiscal austerity and provide a stimulus package of new spending to boost the economy. Stimulus advocates believe that budget cuts are self-defeating and that, by contrast, a stimulus package will pay for itself and actually improve our budgetary situation.
I know that the majority of Irish economists don’t agree with this idea but perhaps we’re not doing a very good job at communicating why, so here’s a brief explanation.
Like Krugman, I was in favour of the US stimulus package last year and believe he was correct that the stimulus should have been bigger. Here’s a document worth looking at: It’s the Obama administration’s own calculations of the effects of its stimulus package, written by White House economists Christina Romer and Jared Bernstein. Keep in mind that this is written by people who advocate stimulus.
Page 12 of the Romer-Bernstein paper sets out their assumed multipliers for spending and tax cuts. They assume that a government purchases of 1% of GDP raise output by a peak amount of 1.57% after 8 quarters. Tax cuts have a lower multiplier of about one.
Now suppose for a second that these multipliers could be applied to the Irish case. The Irish government takes in about one-third of GDP in tax, so an increase of GDP of 1.57% would produce higher taxes equal to 0.33*1.57= 0.52% of GDP. In other words, the stimulus package would increase spending by 1% of GDP and increase tax revenues by 0.52% of GDP, so it would raise the deficit by 0.48% of GDP.
But, of course, Ireland is not the US and fiscal multipliers here will be smaller because much of the stimulus will be spent on stuff that is made in other countries. If you’re reading this, there’s a pretty good chance you’re familiar with the elementary multiplier formula 1 / 1-c, where c is the marginal propensity to consume. In the open economy case, this is 1/(1-c+m) where m is the marginal propensity to import. Stick in reasonable figures for Ireland and the US and you’ll see why our fiscal multipliers are likely to be far smaller.
These considerations mean that any attempt at fiscal stimulus will see the Irish budget deficit increase, not decrease. So what, I hear some of you say? We can pay back the debt over time. Well, you need to find someone to lend the money to you. Right now the bond market is very jittery about Ireland’s ability to pay back: For this reason, we’re paying three percent more on our debt than the Germans.
And like it or not, bond market participants go along with the boring mainstream analysis I described above: They believe stimulus packages would raise the deficit. If they see the Irish government acting in a way that, rather than reducing the deficit, would raise it for a number of years, they will just pack it in. Borrowing rates would either rise enough to offset any positive effect of stimulus or the bond market would just give up on lending to Ireland altogether.
Note that this isn’t a neoconservative conspiracy—the average market participant will always adopt the mainstream analysis, which in this case just means believing that stimulus packages tend to raise budget deficits.
To sum up, stimulus packages tend to raise budget deficits. This is particularly true in small open economies like Ireland. With our current budgetary path looking barely sustainable to the international lenders, there is no room for a discretionary policy involving higher budget deficits.
By the way, it gives me no joy whatsoever to write this. I would love to be in a position to recommend fiscal stimulus. The vast majority of us dismal mainstream economists believe that fiscal policy should be counter-cyclical, so that deficits are run up during recessions and run down during expansions. We would love to be recommending stimulus programs. However, the extent of the fiscal mis-management of the country means that there’s no room to do this.