Karl Whelan makes a convincing case against the idea that a fiscal stimulus would lower the deficit (see Unpleasant Fiscal Arithmetic). But there is another fiscal free lunch idea that I see as even more influential—and probably just as wrong. This is the idea that discretionary fiscal contractions increase economic growth, which in turn reinforces the improvement in the deficit. The key mechanisms behind what is sometimes called the “German view” are Ricardian-type expectations effects and a reduced risk premium on borrowing (the latter recently emphasised in ESRI Recovery Scenarios paper). I doubt that there are many Irish economists who would claim to hold this view if pushed. However, it seems to me to be implicit in the widely held view that a more front-loaded fiscal adjustment will speed economic recovery.
Economists are programmed to be suspicious of free lunches of any kind. While it is unfortunate that the nature of macroeconomic data makes it difficult to definitively rule out either of the free lunch claims, I think the most reaonable position is that there is a trade off between tackling the deficit and the speed of recovery, and in fairness this is assumed in both the ESRI and DoF short-run forecasting models. The big advantage of thinking in terms of a trade off is that it leads one to look for policies that might improve the trade off. One discouraging feature of the fiscal debate is that this type of analysis has been strangely lacking.
Ireland faces two pressing macroeconomic challenges. The first, most forcefully articulated by Colm McCarthy, is the fragility of the creditworthiness of the Irish State. The second is the collapse in domestic demand that has forced output well below potential, reflecting a huge waste of resources and unevenly distributed hardship. While estimating potential output is even more difficult than usual at a time a massive structural adjustment, the IMF recently estimated an output gap for this year equal to 6.3 percent of potential (Ireland 2010: Article IV Consultation—Staff Report, Table 3, p. 30).
Although I initially hoped it would be possible to have a more gradual adjustment, the European debt crisis and the government’s success at building credibility around its adjustment timeline make it wise to keep to the current targets. But I think modern inter-temporal macroeconomics points to policies that can improve the trade off, allowing for some combination of more creditworthiness and less contraction while meeting those fiscal targets. These policies include: bringing forward capital spending plans (or, more practically, limiting the postponement of existing plans); clear commitments to begin the process of putting in place low-distortion revenue sources such as a property tax and water charges (where some delay in the actual payments could an advantage rather than a disadvantage); a clear and well-advertised timeline for implementing the national pensions framework, and especially the phased increase in the retirement age; the fast tracking of an independent fiscal council to increase the credibility of fiscal commitments that are delayed to a time where politicians will be under less pressure (and have less cover) to implement austerity measures; and implementation of a special resolution regime for severely undercapitalised banks to limit any obstacles to loss sharing with bondholders. We surely can do better than being for or against fiscal stimulus.