Fiscal Free Lunches

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. 

37 replies on “Fiscal Free Lunches”

I’m not sure I agree with the characterisation of reducing the interest penalty which the market imposes on the Irish state for the deadweight loss associated with sovereign gluttony as a “free lunch”.

That’s sort of like saying, “You are buying a lunch and throwing it into the Irish sea. If you stop doing this, you get an extra lunch. But I don’t think this strategy will work, because, after all, there’s no such thing as a free lunch!”

Great post John. The one thing everyone ought to be able to agree on is policies which improve fiscal credibility in the long run without further depressing demand in the short run, and the examples you mention are bang on target — especially in my view pensions reform.

Francesco Giavazzi makes a similar point here, albeit in the context oof economies with more fiscal space than ourselves:

By free lunch here I just mean that the risk premium reduction following a cut in the deficit is large enough so that aggregate demand does not fall.

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.

Interesting. Here’s Colm McCarty on this blog

“Any attempt by Government to stimulate will run up against Ricardian Equivalence anyway, even more so in the UK version, where the tax reductions are accompanied by specific commitments to increase taxes later. If the private sector is determined to improve its balance sheet through cutting consumption and investment spending, fiscal easing will either fail, in which case it is pointless, or ’succeed’ at the cost of frustrating the unavoidable private sector adjustment.”

Maybe Colm McCarty has developed a more sophisticated view since, now that he is looking at how to advise the government on shrinking the state further as a boost to the private sector.

I havent seen arguments around “the idea that discretionary fiscal contractions increase economic growth”. A gross exaggeration? I think the arguments for maintaining a massive fiscal deficit – the widest in the eurozone – are strong if the downturn can be characterised as cyclical. But not if the hits to income and wealth are likely to prove permanent. It is not a question of “fiscal contractions increasing economic growth”, but rather of taking the pain on the chin, instead of wafting on a cloud of analgesics.

I am sorry if our recent publication was unclear. We did not suggest anywhere that Ricardian equivalence effects would turn fiscal retrenchment into a tool for stimulating the economy.

Giavazzi and Pagano, 1990, put forward the suggestion that Ricardian equivalence effects explained what happened in Ireland in the late 1980s and early 1990s and that there was what they termed “an expansionary fiscal contraction”. Essentially it was suggested that as a result of fiscal retrenchment the Irish private sector responded to expectations of a lower debt and tax burden in the future by raising domestic demand in the short term, overturning the deflationary impact of the cuts. John Bradley and Karl Whelan dealt effectively with why this was not sensible, at least in the case of Ireland. (Bradley, J. and K. Whelan (1997). “The Irish Expansionary Fiscal Contraction: A Tale from One Small European Economy”, Economic Modelling, 14(2), pp. 175-201.)

The mechanism which we believe is possibly significant today is rather different. It is clear that the risk premium attaching to all lending to the Irish government and banks is affected by the level and or change in government borrowing, government debt and government contingent liabilities. The amount of information available to us is not sufficient to estimate this relationship with any degree of certainty.

It is interesting to compare Spain and Italy. Today Spain is paying about 0.5% more than Italy. It has a much lower debt than Italy and, like Ireland, a history of keeping to the SGP between 2000 and 2007. However, Spain stimulated its economy in 2009 and they have a much higher level of borrowing than Italy who did not. Was it the stimulatory fiscal stance or the high borrowing (or possibly worries about banks) that have resulted in Spain paying so much more than Italy? Once again we do not have enough evidence to answer this precisely.

In modelling fiscal multipliers it is normal to consider the monetary stance at the same time. A recent IMF paper by Doug Laxton and co., referenced earlier this year carries out a fairly standard analysis using a range of different models for the US and a range of different economies. They show the standard result that where monetary policy is not accommodative a fiscal stimulus results in higher interest rates, which significantly modifies the multipliers.

In the case of Ireland the monetary stance is clearly exogenous; nothing Ireland does will affect the ECB’s behaviour. However, it is clear that Ireland faces a big risk premium relative to Germany and that this risk premium has its roots in the Irish public finances, broadly defined. If the effect of government borrowing on the risk premium is small then it will reduce the normal fiscal multipliers but will not reverse them – rather similar to the IMF results using a monetary policy reaction function. If the risk premium is almost infinite, as in the case of Greece, then it will reverse the effects of any fiscal stimulus.

Because of the uncertainty of the precise response of interest rates to fiscal stance we experimented with different risk premia. In one simulation, we found that, if the government had done nothing to address the fiscal debacle in 2009, the magnitude of the problem would have snowballed. While in the short term, if the risk premium and interest rates had only initially risen in a moderate manner, growth might have been slightly higher, the combined effects of rising debt interest payments and rising interest rates would rapidly have reversed this. If left continue for a decade the long-term impact would have been to reduce the level of GNP by an absolute minimum of 10% below where it would be assuming the current fiscal adjustment. In fact, when you look at the explosive debt trajectory which that would have implied, it is clear that the risk premium would have gone infinite long before 2020.

Thus when you contrast the extreme case of no fiscal retrenchment with one based on the current retrenchment trajectory you find that very quickly the tighter fiscal policy pays off in terms of much higher output and income levels.

I know that this is an extreme case. However, we are in a very uncertain world. What I conclude from this analysis is that the risk premium is endogenous (affected by fiscal stance). This will reduce fiscal multipliers, though over reasonable ranges it may not make them negative. We do not understand well what drives these risk premia and, as a result, in deciding on the fiscal stance for the next few years it is better to be safe than sorry.

Ciaran, I am surprised you have not heard of the widely discussed idea of “expansionary fiscal contractions.”

Significant reform if it is ever going to happen will only occur if there is the pressure of a crisis situation.

For example the argument in May that Greek debt should have been restructured then because it may realistically have to be done at the end of the 3-year EC-IMF program, ignored a crucial political reality that an endemically corrupt system cannot be changed in slow motion.

In Ireland, it appears that the expectations of significant public sector reform from the Croke Park deal are low at best. Academics, the politicians and everyone else on the public payroll of course would not wish to see a change in for example pension arrangements and with the ESRI holding out the prospect of full employment by 2015, nothing much should be expected.

So the choice is likely to be front-loading or what the IMF termed consolidation ‘fatigue.’

Besides, Eamon Gilmore is likely to defend the existing conservative status quo from 2012, if not earlier.

Thanks for the lucid review of your argument. For the record, I have little doubt that a “no fiscal retrenchment” policy would have been contractionary, though they may have been some scope for a short adjustment delay in terms of a credible mulit-year adjustment programme. (As an aside, I am less convinced by your very different contention that the 2011 adjustment should be increased from €3 bl. to €4 bl., which I don’t see following from your analysis.) But my broader point is that more attention should be given to structuring the fiscal adjustment to increase the creditworthinness boost and/or decrease the contractionary effect. I feel this gets far too little attention. Of course, the nature of the adjustment does receive attention, but it tends to be more from a distirbutional than a macroeconomic perspective.

While I (may) have your attention, there is one other aspect of the ESRI analysis that puzzles me a bit. One thing that distinguishes the ESRI view is a relatively optimisitic view of medium growth prospects, even though I know you have scaled these back. As I see it, the argument for backloading fiscal adjustment is stronger the steeper the GDP curve. But you seem to be among the most supportive of the front-loading strategy. I would be interested to know how you come to this position given your underlying view of the growth prospects of the economy.

I think we all agree that the effective sovereign borrowing rate is endogenous to the perceived fiscal stance, and John FitzGerald raises the question of what the supply curve of external credit looks like. If it’s flat, the debate about speed of fiscal contraction is about multipliers, the (exogenous) real interest rate and intertemporal welfare maximisation etc.

The lesson from Greece is that it ain’t, but slopes sharply away from the high borrowers, and that there may be a severe kink at debt ratios above say 110% of GNP. This is the general area to which we are headed on the ESRI’s figures. So an announcement of a materially slower fiscal adjustment programme could turn out to be deflationary. This has nothing to do with Ricardian Equivalence effects, which may or may not be present, and could be operative even with a flat credit supply curve.

The discussion in Ireland in 2008/2009 about possibly targetting a slower fiscal adjustment proceeded at times as if this curve was flat, or at least shallow. I think we must now accept that, in this respect at least, This Time It’s Different.

In Prof. Krugman’s defence, maybe it’s not for America (yet). Why does he insist on rattling on about Ireland? Why do we pay attention?

I agree that the composition of the fiscal adjustment matters. However, I have learned from experience not to have too may messages in a publication.

Here are three arguments for faster adjustment than currently planned and three arguments for sticking to the €3 billion for 2011, around €2 billion for 2012 and €2.5 billion for 2013 and 2014 – total €7.5 billion.

Stick to current plans:
1. Changing plans mid-stream can upset everybody. It could sound like panic to change now.
2. It may not affect the cost of borrowing because it is the banking system is the real problem.
3. When the economy has returned to growth the cuts may feel less painful.

Move faster:
1. If it significantly reduces the cost of borrowing then it will significantly reduce the long-term cost.
2. Doing €2 billion in the 2012 budget with an election to come within six months may prove tricky. Also if growth follows our “low” scenario or worse then more than €7.5 billion will be needed.
3. When people know that their living standards are secure – no more tax increases, cuts in expenditure, job losses etc. precautionary savings may fall and investment rise. Bringing forward this time could prove beneficial.

Together these make six arguments for doing at least the €7.5 billion. As things become clearer in the Autumn about the bond markets the nature of the Irish recovery, etc. the balance between these arguments can be re-examined.

@Colm: I think the reason PK talks about Ireland is that the Austerians are holding us up as an example to be followed by others — not just by the Greeces of the world but by countries where the bond markets are showing no signs of panic. With our GNP down 20% and our bond yields dangerously high, I think he is right to question this advice.

Come on chaps, knowing that you aren’t going to be paying more direct and indirect taxes in a couple of year’s time? Knowing that there aren’t going to be university fees for your children so you don’t have to start saving for them? Knowing that road tax and petrol tax isn’t going to keep increasing so you can buy a slightly larger car?

Ricardian equivalence is everywhere. It informs most business decisions (why do you think bonded warehouses ‘bet’ on what is going to be in the budget – buying or running down their stocks of cigarettes and alcohol – something that will ripple (however small) through to GDP). Think about what suspicions of a change to CAT or inheritance tax would do to those figures in the period preceding?

Many think about future costs. Those who don’t, really don’t matter. They aren’t discrete in their spending – they spend everything they can borrow. Those that do consider future costs are likely to cut spending (and borrowing) when the future tax rates and in particular when the future charges (like school and university fee) environment is uncertain.

Yes, it’s anecdotal stuff, but whatever theory you come up with to model the future has to cope with those anecdotes.

@ Hogamahew
Important points..
The Snip Eile report gave a snapshot of future local and national government sources of revenue. The discipline in which the budget may impose/correct the national situation maybe undone by the other hand of government taking wherever it can.

And these efforts will be just to pay the salaries and pensions of state employees, we wont be getting much else for our contributions.

This is the nub of the problem, the Govt is cutting back to the point where all it is doing is paying salaries! Each employee will be neutered in the ability to function from cutbacks, but each will be paid.

It is illogical to start from anywhere but what Govt is to demand and provide and work from there.
But in a political system that establishes the citizen as a client to the party political caste who can provide for the citizenry, it will take a politican willing to sacrafice their future to point out to the public that it may be better off with getting less from Govt.

Pity the nation…

+1 on Hoganmahew’s point on Ricardian equivalence.

Anecdotally (no basis for certainty, but it’s what I have), many people have serious concerns about the outcome of several longer term investment questions.

People simply don’t believe that sensible investments (in career, savings, education, business) won’t be punished whenever it’s convenient for some future government. This is a general concern in most countries by now, but particularly serious in times like this in a country in Ireland’s situation. At the extreme end, and although I’m not 100% in agreement with his reasoning on many occasions, didn’t Constantin G calculate that any education past secondary was a bad investment under the current tax regime, at least in the private sector?

Remember also that the cuts we’re discussing are intended only to stabilise a bad fiscal situation, not to actually result in a good fiscal situation, so there must be suspicion that there’ll be another shoe dropping somewhere down the line.

Unfortunately, although civil servants and TDs seem to be successfully able to claim that they had “legitimate expectations” for high pensions and payouts, legislative changes in tax rates trump any “legitimate expectations” that normal people might have about their income or savings or investments.

IMHO the particular current context makes John Fitz’s point 3 on the move faster list a serious – and seriously underestimated – factor.

@ Hugh

On point 3, recent horror stories by Morgan Kelly and Dave McWilliams come to mind too.

@ Al

There have been a few allusions here to David Ricardo who paid £4,000 and lent £25,000 more to Lord Portarlington on mortgage for the privilege of representing 12 electors of Portarlington in the House of Commons.

Politics comes cheaper today and there is no sector of the economy that is not dependent on the public purse.

The end of 40 years of EU foreign aid is looming in 2013 when Ireland becomes a net contributor to the EU budget for the first time.

The culture of grabbing as much as possible while the going is good or even bad, is not going to change.

Public work is important for the some of the highest earners as it usually provides a consistent income stream.

Taxes remain low but how can quality services be delivered?

Total tax revenue was estimated at 47.1 percent of Sweden’s economic output in 2008, second to Denmark’s, at 48.3 percent, according to the OECD. Ireland was at 28.3 per cent.

Sweden had the European Union’s smallest budget deficit to GDP at 0.5 percent in 2009, the European Commission said last May.

Almost 15 and a half hours since it was announced officially that BoI and AIB have passed the EU stress tests, and not a single reference to said fact, let alone a new thread, on, even though the banks’ problems have been the most prominent topic on the site since it was set up. I suppose the kindest interpretation is that many of the site organisers and site posters went out to celebrate the banks’ triumph last night and so may need a little time to recover before posting their congratulatory comments.

Ah, good morning jtoptomist. I don’t have privileges to initiate threads but if I did it would be
Eu says nearly every bank, no matter how small, too big to fail. Markets already knew it.
But if you want to celebrate a process wherein a promise to be really really good, no ‘honest,’really good, the aib story, is seen as cash in hand, good for you. Aib either eviscerates itself or more probably the taxpayers here pump in more billions. We may end up paying, say, 4b for the remaining parts of aib wow let’s throw a party.

Kevin, Krugman is right to question the Austerians advice for countries where the credit supply curve is flat, but not for countries like Ireland. He is being unprofessional. I am coming round to the view that creating a Nobel Prize for Economics was a mistake.

Oh, and Jto. Check twitter wherein I commented last night. Off you go now and be thankful you live outside the jurisdiction and won’t have to pay for the folly of September 2008

@Colm: I think you are confusing positive and normative here.

Positive: has Ireland’s austerity plan boosted GNP, as the negative multiplier confidence fairy crowd suggest? I think not. GNP 20% down and still falling as of Q1 ought to dispense with that one; and we are not regarded as particularly credit-worthy by bond markets either. This is the important point for PK I think — you cannot use the Irish example to argue for pro-cyclical fiscal policy in the rest of the world. As John says, there are no fiscal free lunches out there. (BTW, I thought Marty Feldstein’s piece in the FT yesterday was admirably honest, and I wish more people on his side of the debate would be the same way.)

Normative #1: could Ireland have done any different? Not from the moment we put in place an incredible bank guarantee opening the possibility of a fiscal-cum-bank run, that was immediately followed by those enormous projections of deficits. But this is a very sui generis Irish story.

Normatiive #2: do the Germans, Brits etc have to embark on austerity now, and will this boost their GDP via negative fiscal multipliers? See positive above.

My take on the lessons of Irish experience is that (a) pro-fiscal policy is a really bad idea, in both good times and bad; (b) insisting on paying back nearly all debtors of insolvent banks is also a really bad idea. I doubt that either yourself or PK would disagree with either of those lessons.

“I am coming round to the view that creating a Nobel Prize for Economics was a mistake.”
Much like Mr. Nobel himself… 😀 it’s a good thing that a bank thought it was a good idea. (“Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel”).


Paul Krugman seems not to care that throwaway remarks about Ireland or Ruritania in the NYT will be accorded more attention than they deserve, by Irish (or Ruritanian) journalists because he won a gong. I think this is unprofessional (by both parties). What do you think?

You going to Modena?

@ all

Excellent debate.

John McHale recommends

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
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
and implementation of a special resolution regime for severely undercapitalised banks ‘

Those are some of the things which ought to have been done when we had the necessary economic headroom. Sadly, our political leaders, parties and institutions were unfit for purpose in that respect. I guess the impetus will now have to come from outside, and only after the threat to national solvency become very explicit.

@ Colm McC is right to focus on national solvency, but @ Hugh Sheehy has raised equally critical issues of trust, governance and the social contract:

‘Unfortunately, although civil servants and TDs seem to be successfully able to claim that they had “legitimate expectations” for high pensions and payouts, legislative changes in tax rates trump any “legitimate expectations” that normal people might have about their income or savings or investments’

‘Normal’ people includes many younger professionals who have not managed to get stake in the old game and also are saddled with negative equity. People have been sold a pup. One way to respond is to go. The other is to stand and fight back.

Professional education can, and should, be used to design fairer and more productive economic relations, including, and especially, taxation arrangements. State reform is inseparable from professional reform, and with the greatest of respect to the expertise on this blog, the problem is political economic. Economics can contribute to solutions, but cannot deliver them.

We have a major agency problem in Ireland. As has happened so often thoughout history, the function of the principal has been usurped by the state’s agents. While spectacular looting has been carried out by the banker/developer nexus, @ Michael H has pointed, in very plain terms, to a fundamental perception in our polity:

‘The culture of grabbing as much as possible while the going is good or even bad, is not going to change.
Public work is important for the some of the highest earners as it usually provides a consistent income stream’

Our state has never escaped the grip of vested intererests, including the professions. Professionals have been able to leverage their self-governing status to secure privileged terms of state employment and state contracting.

Public officials and politicians have, in turn, levered their own set of corporate benefits, as fellow professionals, from this cosy arrangement with the ‘liberal’ professions. That unspoken ‘deal’ sets the standard of social aspiration and social responsibility for our aspiring middle class.

The result is that ‘management’ controls over public work are, in practice, ceded to corporate professional interests within and around the state.
Public sector trade unions are, in large part, modeling themselves on self-governing, and self serving, professional classes. Gouging, dissembling, croneyism, and swinging the lead needs is recognised for what it is. Unsocial conduct.

Feldstein’s FT article correctly – I think – differentiates between the short term and longer term impacts and seems quite sensibly expressed.

Now one could read all the theoretical material on multipliers until you were blue in the face, but under current Irish conditions it seems only possible to conclude that a borrowed stimulus would lead to a short boost but a mid term disaster (potentially quite soon). A fiscal contraction may well lead to a short term overall contraction and some painful years, but seems the only way to avoid really painful years later on. So, whether or not PK is theoretically generally right about the short term he’s almost certainly wrong about Ireland in particular and whatever your view on the impact of fiscal contractions, I don’t see that Ireland has any other choice right now.

As J Fitz said, the composition of spending will be critical, which is why cuts in infrastructure spending is worrisome. We may not need more highways, but there are lots of other things that would have a positive impact on the economy.

Meantime, the parallel concern for me is that the incentives in the Irish economy have now been skewed away from sensible investment for a long time, and are again increasingly skewing away from rewarding hard work and prudent decision making. Could you honestly argue to foreign high skilled workers (outside the medical field) that they should come to Ireland and pay our taxes, levies and housing costs while simultaneously trying to get their kids into the local school by trying to pretend that they’re good Catholics? Could you honestly argue that personal investment in the kind of education that we hear we need for the economy’s long term future will have a good personal ROI?

Under current conditions John Fitz’s 2nd point 3 leads to scary conclusions, particularly if you make it more forward looking and more investment related. If you ask whether or not it makes sense to invest in yourself (and the country) right now or to stop investing in yourself and/or to leave the country then the right answer for many people is not one that will be good for Ireland Inc.

(sorry to be so long winded)

@Colm: I don’t think the fact that PK has won a gong means that he should censor himself or not participate in public debates.

Whether they should be giving Nobel prizes in economics is however another matter which deserves to be debated. And I think that *everyone’s* arguments should be evaluated on their merits, not on the basis of their proponents’ cv’s. (Irish public debate involves much too much ‘proof by appeals to authority’ in my view, and that is a reflection of the poor level of the debate in general, and of peoples’ understanding of technical matters. Perhaps also of the Hist/L&H backgrounds of many of the people involved. I am constantly struck when I listen to Danish radio thanks to the wonders of the web how much calmer, better-informed and less ad hominem debates are over there.)

I am not even going to Tallaght on Thursday since I am away!!! Can’t believe it! If Bono wasn’t screwing things up I might have gone to Turin, it’s 2 hours away, but Modena may be a train or two too far for me.

My concern about PK is the shallow analysis of Ireland, which gets placed in juxtaposition with the hard work of ESRI. If I write something casual about Kazakhstan, the Kazakh Times won’t pick it up, so it does’nt matter. Not so with PK, and he has a greater responsibility to be careful.

Might go to Modena if tie still alive.

Thanks for pointers to the Giavazzi and Feldstein pieces. They are both very interesting in the context of developing a richer fiscal strategy. I especially liked Giavazzi’s mountain climbing analogy:

“The golden rule in mountain climbing is that your hands always need to have a good hold. If you have a good grip, you can take some license with your feet– for example, make an attempt to reach a ledge that’s still covered with the dew, or scale a crossing that might be a little too wide for your legs. But if your hold is uncertain, you can take no risks: a single error could be fatal.

A mountain climbing analogy seem apt given that the upcoming Kansas City Fed’s Jackson Hole conference is focusing on fiscal policy. It also helps us understand what the stance of fiscal policy should be at this point in the crisis. It suggests that governments should commit to future spending cuts large enough to stabilize debt levels over the medium term. But, once future sustainability is locked in, they could afford to take some risks with current deficits. They could delay removal of the fiscal stimulus, or even add some additional stimulus if private demand is slow to recover.”

I have little doubt that the credit supply curve slopes upwards (by which I take you to mean a graph of the interest against the debt to GDP ratio). My main point is that there are policies that can be pursued that affect the postiion and shape of the curve. We need to broaden the fiscal debate.


the curve slopes away from the borrower for sure but the lesson of 2010 is that there is a vicious kink at some unknown point in a range surrounding our likely exit gross debt ratio.

One issue that needs to be addressed is the net versus gross debt, and deleveraging. It is plausible that, for a given net debt, the curve is less favourable the greater the leverage. If I would lend you €1 mill at 5% and zero net debt, I should take a different view if you geared up another mill to punt on external assets, for example. What degree of leverage is there in the State’s overall balance sheet (including deferred and contingent liabilities), and are there low-pain methods of managing it down?

@John: an interesting empirical issue then is, are capital markets sufficiently rational to give credit to countries for such long term adjustments?

(But, if they are not sufficiently forward-looking, then the basis for Ricardian equivalence arguments would also be undermined!)

@Colm McCarthy

There are just as many people out there who question why your economic preference is given a large media platform as there is Paul Krugman.

@ All

I was wondering why Krugman was interested in Ireland. Google search linked to the following previous piece:

The key area of interest seems to be how there are lessons to be learned for US financial regulation from the nearly-contemporary but very distinctive Irish credit crisis.

Quoting his article of 19th April 2009 from the NYT, “And the lesson of Ireland is that you really, really don’t want to put yourself in a position where you have to punish your economy in order to save your banks. “

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