Self-defeating deficit reduction?

Nice model but completely implausible in the absence of real-economy empirics. The proof of the pudding is in the eating. Substantial cuts will slow growth which will in turn remove the capacity for real consolidation. The evidence is overwhelming.

@Paul

The model is more robust to non-linearities than you allow. From Figure 1, all that is needed to generate the basic result is that the GDP curve slopes upwards and the deficit curve slopres downwards. Besides, having to depend on non-linearities is always a good sign that an argument is non-robust.

There is one requirement for deficit spending:

The funding for it has to be available. There are two sources: Use savings or borrow from someone.

Irelands savings are not sufficient for continued deficit spending.
Irelands ability to borrow can be seen as severely limited.

If deficit spending is not possible, what can be done?

Increase revenues (taxes) and decrease spending.

Debates on the multiplier on possible deficit spending are interesting but for Ireland I believe they are only of academic interest.

The deficit sooner or later has to be turned into surplus otherwise borrowing can’t be repaid. (True irrespective the size of the GDP)

Anyone considering lending to Ireland might be looking at the taxation system and how money is spent to see if Ireland will get a surplus in the foreseeable future. The questions for a potential lender are:
-Will future taxation system raise sufficient revenue for the current spending?
-Will future spending be reduced to the level of revenue the current taxation system raises?
-(or a combination of the above)

Anyone believe that tax-revenues will go back to what they were in the bubble years without a change in taxation system?
Anyone believe that Ireland can afford not to make ALL easy savings? (like stopping the lunacy of unvouched expenses)

John – just take your GDP curve and make it steep at the start then flatten out to have a small slope when it crosses the deficit line. You’ll see the deficit to GDP (represented as the slope of a line from the origin) will rise with fiscal cuts over regions where the GDP curve is flatter than the slope of that line from the origin.

Your comment: ” Besides, having to depend on non-linearities is always a good sign that an argument is non-robust.”

I wasn’t arguing my point was robust, rather your conclusion is not robust (if we add very simple non-linearities to your model). I think your point is well-illustrated in any case – the slope of the GDP line is unlikely to get so flat for reasonable parameters, but, such claims are complicated in a world where strikes and riots can make that slope awfully flat for sustained periods.

An alternative way to state your point is that “as long as cuts are large enough, they are bound to bring the deficit down”. That comes from the undeniable point that if we abolish all government spending we must have a zero deficit/GDP ratio.

@ Kenneth: “You cannot cut your way to recovery. You cannot deflate your way, but you can invest your way.”

Spot on! Except those pesky rates is near zero! And there is that little problem of the FIRE economy. This must be snuffed out PDQ.

“Milton Friedman once said “Only a crisis produces real change. When that crisis occurs, the actions that are taken depend on the ideas that are lying around”

Yep again. “… on the ideas that are lying around.” Ah, but whose ideas might them be? The usual suspects I suspect. Its their Frame! They be very ‘loss averse’, they be!

“The economics profession is captured by the neo liberal framework.”

Maybe, but I reckon its more likely they were exposed to a particular dose of ‘received wisdom’ and may not have taken the bother to subject their economic beliefs to genuine scientific scrutiny. If they had done so, some would have been most unhappy, but they would have been in the minority. And we know what happens to minorities! Think Soddy and Georgescu-Roegen.

“Our task is to persuade progressive politicians to ignore mainstream economists, who peddle toxic ideas.-”

Jeeze Kenneth, do you know any of these politicians? I assumed they were extinct by now. And bye-the-bye, toxic ideas will always trump common sense. Don’t give up. Don’t assault the glacis – seek out the weak spots.

Brian P

Anyone who thinks that they can reduce fiscal debt and somehow miraculously in the future think that bank credit can flow again from the surplus created is just plain crazy.
This is not the mid 1980s – there is no more surplus capital in the world to run down in this monetory system.
Capital will have to be revalued upwards by a massive amount to re balance to a new equilibrium.
This development will not come from Ireland – we should not sacrifice ourselves on a austerity alter as any surplus we create will be extracted by other regions.

This is clinical insanity or a lack of understanding of money and its flows which is just a energy token.
Ireland should game the system like everyone else – we are like a honest poker player sitting on rigged table full of sharks.

Curiously our saviour could be Uncle Ben – there will be no more QE as we have come to know it – The CBs are going to revalue Gold to the Moon.

US dollar capital will stop flowing east – oil will fall dramatically in Gold terms.
After 40 years of capital rundown in America its infrastructure will be rebuilt as capital will again flow inwards to the States.
China will be a economic wasteland – the global wage / tax arbitrage system is coming to a end.
Ireland should be aware of these coming developments and postion ourselves accordingly – lets not sacrifice our old sick and vulnerable on the alter of a dying monetory system.

fofoa.blogspot.com/2010/10/its-flow-stupid.html

@Mickey
Do you think if we can cut far enough we can offset the consumption increases in China ?
This is now the ECBs problem not ours – but do you want to facilitte the raping of Ireland so that London , Frankfurt and Paris can get two more years of interest income from Ireland ?

@grumpy

The two are indeed rather different. But I believe the statement above applies to both.

@Kevin

Apologies for irritating you with that closing sentence. It was unnecessary. For what it’s worth, let me say something about where I am coming from. I see myself as a Keynesian on macro issues, and have a degree of sympathy for the TASC position. Until quite recently I have been an advocate of backloading the adjustment. I believed that advocates of front loading were underestimating Ireland’s creditworthiness; and also that if the projections of a reasonably rapid return to a strong underlying growth rate meant there was some scope to smooth the shock. While I continue to believe that the market’s default pessimism is overdone, in the end there is no arguing with the fact that investors do not view Ireland as creditworthy. I have also become a bit more circumspect about the underlying medium-term growth path rate given the way that impaired balance sheets are weighing on spending (and lending) across the economy. Thus if we want to steer our way through this while retaining economic sovereignty, I reluctantly have come to the view that we have to stick to the four-year timeframe and three percent target. I am still hopeful that if we can put in place a credible plan — which requires commitments to real measures, not some vague outline of options –we can avoid hitting the economy hardest when it is at its weakest in terms of the size of the output gap. Unfortunately, the more we look like we don’t have the political capacity to push through the needed measures, the more unpleasant it will be.

@ KC
China’s role in this is that it has triggered a Schumpeterian recession/depression in the developed countries starting with Japan where property values are now what they were in 1983. China is not alone it is acting with Taiwan, Korea, Malaya, Singapore and the sum total is devastating to the US and the EU. The ECB has been more than generous to Ireland and if our gov’t had a splink of sense they would have turned things around before we became so risky an investment that our cost of money increased dramatically. Nobody held a gun to the gov’ts head and forced them to back stop our banks, cronyism, nepotism, greed and force of habit did that. We have to stop pointing fingers and looking for external scape goats we have enough blame to place domestically that it will keep us going for the rest of the century. Every gov’t makes mistakes the difference is that most of them face reality and do what needs to be done. In our case we are in a state of denial, it is a pity the British left in 1921 everything could be neatly place at their door.

@John, thanks.

I do wonder if investor confidence is low because of the lack of political will to do things that need to be done. Things like dealing with corruption – unless you have connections, investing in Ireland can be tricky. When I’ve asked about why public transit systems don’t get more investment vs. roads, I’ve been told that well-connected local people can do the latter but not the former for instance. Dealing with waste – the HSE is apparently administratively heavy; electricity prices and services are poor; etc.

http://www.cfeps.org/pubs/wp-pdf/WP52-Forstater.pdf

Abba Lerner the brilliant Russian-British-American economist did some very clear thinking about what makes currencies credible. His ideas have been put into practice around the world, most recently in 2001 in Argentina where states and cities issued scrip to pay their contractors and employees under a system known there as Pocones. It would help if more people knew what alternatives are available. The Kingdom of Kerry could issue scrip with the Killorglin puck goat surrounded by a golden halo on one side and St. Brendan on the other. Good quality linen paper with a hologram and we would be off to the races. Who needs Dublin or Frankfurt. It would need to be endorsed by a serious economist, Karl Whelan for example. Is the O’Brien that used to sign the British notes still around?

@John Mc
First, thanks for the paper. Interesting reading. Now, I’ll ask some silly questions and probably show how long it’s been since I did partial derivatives.

First, like hoganmahew and others (if I paraphrase), I guess I’d like to see some sigmas as well as all the deltas. The cumulative position is the one that quickly dominates.

If I assume that taxation as a % of GDP (or GNP for Ireland, but let’s not quibble) has some limit, then don’t we simply reach a point where the accumulated interest payments overcome the stimulus effect of deficit unless the deficit increases continuously (and geometrically?) Don’t we already know this?

Is the most interesting equation the one you didn’t do, a variant of Eq1? Should that be something like Y=Yo+mD-iSigmaD-P, where i is the interest and sigmaD is the accumulated deficit and P is a capital repayment, although we might set P to zero for the short term? The interaction between i, m, b and SigmaD makes it all beyond my late night maths, but still..

The other point that I wonder about, and one that may be pertinent when considering the keynes approach, is that in many ways Ireland thought it was running a balanced budget in the period around the middle of the decade but was actually engaging in a deficit funded stimulus. We just picked up the bill quite late in the day when we bailed out the bank’s creditors, retroactively picking up the tab for spending in the previous several years.

If we were actually running a stimulus in the run up to the crash, does this tell us anything about the stability of multipliers? Now it was private creditworthiness that collapsed and state credit may still be good, but it’s interesting nonetheless.

I’ll have to re-read in the morning! Thanks for making me go “d what?” for the first time in a while.

@ Mickey Hickey

China’s role in this is that it has triggered a Schumpeterian recession/depression in the developed countries starting with Japan where property values….In our case we are in a state of denial, it is a pity the British left in 1921 everything could be neatly place at their door.

Ireland is a failed state in denial as Greece was until it had no choice but to face some home truths that had been ignored for decades.

It’s striking that despite the economic emergency, not one collective interest, representing workers, business and the professions, have seriously embraced urgent change in response to the bursting of a bubble that had resulted in most sectors of society being overpaid.

Bodies such as the universities have also failed to respond to the new reality. Reintroducing fees could be a solution but as with the unreformed country, who could have confidence that the money would be spent wisely? Can excellence only be achieved through lavish spending while revenue whether from tax funds or fees comes from a virtual monopoly situation?

In Sept 2009, Minister for Health Mary Harney said Irish GPs were being paid almost five times more to administer the seasonal flu vaccine to patients than their counterparts in the UK. The litany could go on and on but what illustrates how rotten the system has become is that Harney herself in common with others, were like children let loose in Willy Wonka’s chocolate factory, in their lavish misuse of public funds on themselves.

An Bord Snip proposed over €5bn in cuts; 88 planning authorities seems a little excessive and so on.

There can be a case made for some targeted stimulus projects including infrastructure but what’s the case for turning a blind eye to wanton waste and feather-bedding or protecting public staff pensions of more than €50k from cuts?

China and other Asian countries have used a model similar to Ireland’s to develop.

The US consumer binge was financed through equity release loans on homes and consumption rose to a record 72% of real GDP in 2007.

Should China be blamed or the US which wants public services, cheap imports and low taxes?

Foreign-invested enterprises in China account for 22% of tax revenues, 28% of added industrial value and 55% of foreign trade and 45m jobs.

Ireland is over-dependent on FDI which accounts for 90% of tradeable exports. It is also over-dependent on US chemical firms which face revenue losses of $100bn in the next 5 years.

Irish exports from such firms have grown in recent years but job creation has been almost static.

This week, IBM said it would shift 190 jobs from Dublin to China; H-P said it would create 120 jobs for people who have multilingual skills; Google was reported to be routing UK revenues through its Irish unit for onward transfer to Bermuda.

While FDI employment is back to the 1998 level, many of the jobs in companies such as Microsoft and Google are taken by foreign workers because of the language skills required.

We couldn’t even revive our own language, because like much else, we chose the easy option.

A lot of economic theory is about incentives, for consumers, for firms etc. I was thinking about the Fine Gael announcement during the week (reported in the Irish Times front page on Thursday) that the Department of Finance is ‘not fit for purpose’ and that FG intend after the election to clear out Finance’s senior management and replace them with political nominees.

Well, right now, those same senior mandarins are preparing the four year plan and the Budget and if Michael Noonan is to be believed are holding regular meetings with the European Commission and ECB to stave off Ireland being bailed out by the IMF and European Stabilisation Fund. Yet these self same senior mandarins know they probably will be out of a job in six months or so (or moved sideways to the vehicle licensing centre or some other similar public sector quango).

What kind of incentive system does that create for the mandarins ?

Well done Fine Gael – you seem to have managed to give the Finance mandarins every incentive not to care if we end up in an IMF / ESF bailout.

Why does this matter – well just look at what the IMF do when they go into countries.

Across the board cuts of 25% in university budgets anyone ?

@ Joseph O’Toole

Well done Fine Gael…

Well done for defending the status quo, a broken system and appealing to the self-interest of academics!

What should Richard Bruton advocate? Baby-steps that the forces of conservatism and self-interest would also oppose?

This is what was reported:

Bruton was particularly harsh in his criticism of the Department of Finance and said the party was committed to a radical shake-up of it in its forthcoming proposals. He described the department as “unfit for purpose”.

First, the most senior officials would be “hand-picked managers from the top echelons of the private and public sectors”. Second, named officials would be responsible for all major change initiatives. Finally, the new structure would be scrutinised on an ongoing basis by a “high-level, expert and credible advisory and implementation board”.

Of the six other divisions in the Department of Finance, Fine Gael believes that the Budget and Economic Policy division is key. Mr Bruton says that in order to regain lost credibility it would be necessary to have an open recruitment process to appoint its director. This person would then have the power to “hand pick his or her own team”.

@Michael

Who will do the handpicking of the mandarins ? The Minister of the day most likely.

We will be essentially moving to an american style of administration – with the senior ranks of the public service political appointees for fixed terms.

This may be a good system.

@John McHale
In one sense I think it boils down to whether or not you academics think you owe a duty of care to the Irish economy.
When you write down a model that spells out the logic of deficit reduction and the arithmetic possibility of reaching a specific target you do nothing wrong or anything that violates economic theory. But I think it simply isn’t good enough to give an academic shrug and say nothing else. It’s the truth but it certainly is not the whole truth.
I think you need to make explict the economic consequences of the size of the cuts that you say are absolutely necessary because of the Brussels/Bond market constraint. I think you need to tell us what your simple models say will be the unemployment consequences.
In addition, again in the spirit of telling the whole truth, you need to explore that binding constraint. Sure, the Brussles constraint is explicit. But, from a funding perspective, the only one that matters is the bond market. Is it not theoretically possible that we could return to the bond market next year at acceptable rates if we follow a deficit reduction plan different to the one imposed by Brussels?
I ask this because spreads in the bond market indicate, logically, that it wants either a different plan or that the government cannot pursue the brussels plan. Either way, something very serious is up with the credibility of Irish fiscal policy.
And here’s the thing. I think the bond market is smarter than you and Karl (no offence). It realises that the economic, particularly unemployment, consequences of what you propose render those proposals incredible.

@John
I think you may have misunderstood me. I, nor anybody else as far as I can see, find no fault with the proposition that reaching the 3% target is a matter of arithmetic. Both you and Karl have made that point and made it well.

But I also thik that if these points are to be made, they need to be complete. There is no point responding to a request for directions with a simple ‘turn left, turn right go straight for 5 minutes’ if what you leave out is ‘and by the way, you have walk on broken glass for most of the journey which might mean you bleed to death before you get there’.

My point is this: you run the risk of seeming to believe that getting to 3% is a simple matter of cutting large, cutting quick and then sitting back to enjoy a nice cup of tea.

I’m guessing that you don’t mean that at all, but I think we need to be explicit and play this game of consequences to the fullest possible extent.

@John
Again, thanks for the non Sunday paper reading material.
On your suggestion that values for m and b could be as high as 1 and 0.5, while I understand that the discussion on m could be open ended, can’t we make a better stab at b? Isn’t it related to the overall tax take? For Ireland, whether we’re talking of GNP or GDP, can’t we set a tighter band around that one?

Then, while I’d set m at a low number (0.5, maybe less) I understand that others believe in very high numbers. Either way, can’t we also consider the mechanisms whereby increases in D, and particularly SigmaD, could cause m to be negative at specific times for any positive deltaD?

We may be already approaching such a moment, where unless deficits fall we see not only a decrease in private investment but also an actual disinvestment where money flees the country. Even if enough bond lenders will lend to us at 6.5%, it doesn’t mean that all the money already in the country believes in the same scenarios. Although our MoF doesn’t believe this can happen – we’re an island, apparently – there is anecdotal evidence that deposits are fleeing Ireland and private investment is certainly pretty low. Confidence, to put it in non mathematical terms, may be inversely correlated with overall indebtedness. Once any significant part of the confidence distribution loses faith you’ve got a major problem.

Pat,

yes taxes will go up but spending on lavish and excessive unfunded PS pensions will come down.

Reflecting on that neat Model by JMcH I started to wonder; perhaps this is how many economists frame reality – as a virtual model whose logic is nearly flawless, whereas real reality is an irrational mess. If you persist in this belief, then things may not turn out as your model predicts.

That ‘Multiplier’ thing has me puzzled. Maybe a biochemical analogy will illustrate my miunderstanding.

You isolate and perfuse a whole tissue (an intact liver is a reasonable analogy for an economy). The tissue in a ‘steady state’. You infuse 100 units of energy (stimulus) and and a little later you notice an energy output of 101 units.

1.

Looks like I have a slight glitch in my uploading module!

contd: …

1. Liver cells are exempt from Laws of Thermodymanics. Not possible.

2. The input stimulus activated an intracellular (endogenous) energy source and it was responsible for the energy output – please note that you have to account for the frictional losses of energy assimilation and production!

3. The pre-existing intracellular resources showed no change. Hence, there is, as yet, an undiscovered intracellular energy source.

OK. So now to those Multipliers. What exactly are they – their component parts, and how do those component parts interact, following a stimulus, to produce an amount of output greater that the input amount? Or vice versa. Output is less that input.

If we are considering that the whole system is a mathematically modelled virtuality – then I can understand it. However if it is a real system … …?

Brian P

Simpleton,

I am confused as to what you are are advocating. at one point you agree that “the Brussles constraint is explicit”, which I take to mean that we have been ordered to strive to get to 3%& that is binding. At another point you seem to imply that the bond markets would fund a policy with less austerity or as you call it more credibility. Or is that too much of a stretch.

From my point of view that would involve a dispute with EU. The bond markets would just say no thanks at that point.

In either event,we are back to the same point. We are not coming back to the bond markets next year. We are heading down the same route as Greece. That will involve painful fiscal correction. It is possible that it might not be as painful as outright default, since that would surely involve a zero primary deficit now.

I think you are wrong on the guarantee as well, The EU/ECB would not have allowed us not to stand behind the banks, given that it operated and still does operate a no senior bond holder left behind. Our fate was sealed by the decision not to regulate the system from around 1999. A less blanket guarantee might have been better and saved a few bob but it would not have changed the maths. But we have been down that road before.

@John
Again, excuse me if I’m repeating questions that are standard in the field…deficit financing wasn’t a big part of my macro classes. We focused on trade more than national accounts.

Anyway, earlier I wondered before if your eq1 should be something like Y=Yo+mD-iSigmaD-P, where i is the interest and sigmaD is the accumulated deficit and P is a capital repayment.

Should it perhaps be Y=Yo+mD-(1+m)iSigmaD-(1+m)RP, where R is now either a factor related to the speed at which principal is being paid back or a sort of Ricardian equivalence factor. If we arbitrarily set P to be SigmaD/50, then R would be a bit of a fiddle factor. I suppose you could set it as anything from 0 to maybe 1.3 or 1.5.

Anyway, as I say, this may be all very well understood all ready so sorry if I’m only catching up! Also, not sure if those should be (1+m) or just m.

In any case, wouldn’t such an equation be a simple way of forcing a discussion using our actual circumstances? Most numbers will probably sit within a narrow range, so even if the ESRI model is too complicated to understand a simple equation like yours ought not be too hard – even for solicitors and barristers maybe….and me.

This might sound a bit left but it’s not meant to be.
In the UK cuts were announced with a clear declaration of values – NHS and education were to be spared. It is good for people to hear this.
There has been no declaration of values here. The only value I have seen expounded is – as long as somebody else is taking the pain that’s alright with me.
A simple mission statement could be
1: Everybody is entitled to a good quality primary and secondary education (after that they can fend for themselves)
2: Everybody is entitled to affordable good quality healthcare (need not and probably should not be free).
3: Everydoby is entitled to have crimes dealt with fairly and capably.
The focus on cutting services and not increasing taxes will lead to a society where the rich will buy the services they need and the rest will have to make do. This is actually a perfectly reasonable position to have. But it is now clear that Fianna Fail being the Republican party has much more to do with American connotations of that word than the Irish.
If there are painful decisions to be made it is really imortant that we have guiding principles so that our society ends up like a crafted sculpture rather than the aftermath of the Texas Chainsaw Massacre with BL calling to a public service near you!

Just a note to say that once again the discussions on this blog are very worthwhile reading. I don’t have much to add to the debate apart from saying that I think we need to manage the cuts in a way that shapes the kind of society we want – protecting children, encouraging business both from home and overseas, investing in education and infrastructure and doing away with all waste and excessive pay. I think we have to make deep cuts to show our creditors we are serious about getting our finances in order. But more important is how we do that and how we set about reforming this country not just in the next few years but for the rest of the century and beyond. If we can get set out how we would like to see the country in 5, 10, 15, 20 years and beyond and decide on how best we can govern ourselves then this crisis will not have been wasted. Real political and public sector reform is required. Thanks again to those who contribute and post so frequently to this blog it is good to read real debate and detailed discussions on economic policy. And I’m sure there must be many more readers like me out there who read this blog and who only post infrequently or not at all that get a lot of value from it.

@John McHale

I think the linear model is too simplistic. Let’s say that current GDP is Y1 and current deficit is D1. Then on a linear model m is equal to (Y1-Y0)/D1 and b=(D0-D1)/Y1. When we now substitute into your formula for Y* and D* lo and behold we find that they are equal to Y1 and D1 respectively i.e. there is no possible equilibrium other than the current one.

Obviously that is ridiculous as is the conclusion that as m and b approach infinity we still have positive first derivative of the deficit ratio to the deficit.

There has to be very significant higher degree effects in any credible model. At the boundary, for example, Y cannot fall below 0 and so linearity has to break down to satisfy this boundary condition.

Intuitively I believe that there can be a situation where the correction causes the economy to implode and the deficit/GDP ratio to spiral.

This seems to me all about managing those higher degree effects. Too quick on the first derivative and the higher derivatives could take over.

@ John McHale

I’m afraid the model is fundamentally mathematically flawed. You have two relationships one for Y on D and a second for D on Y. That can’t be right. There is one single relationship between Y and D depending on m and b and other factors.

dY/dD exists at any time as the tangent to the Y-D curve. m impacts it positively, b negatively but it seems reasonable to posit that overall it is positive.

The sign of d(D/Y)/dD is that of Y/D – dY/dD. A priori this can be positive or negative. If we assumed that dY/dD was reasonably stable then the lower Y/D (higher the deficit ratio) the more likely that reducing the deficit is self defeating. However, it is not that simple because the very reason the deficit ratio is high might be because dY/dD has fallen i.e. the non government savings ratio has risen.

To summarise, in the current situation, reducing the deficit will be self defeating if dY/dD is higher than 1/13% i.e. c. 7. It seems difficult to believe that it would be that high.

Michael Burke,

Many thanks for taking the time to respond.

You will probably not be too surprised to hear that I don’t think we have quite converged yet.

I have two disagreements with your response:

1. Your calculation of the b parameter in the model, which you calculate based on 2009 data as 0.91. This was a year in which capital transaction related taxes collapsed due the continuting deflation of the property bubble. I don’t think we can get a good measure of b (the sensitivity of the deficit to GDP) from that year. I still think that putting it at 0.5 is actually on the high side.

2. Focusing on the case where the multiplier is equal to 1 (to minimise disagreement), your calculation of the actual deficit reduction does not capture the complete outcome. Identifying the full comparative static effect is an advantage of the model. In terms of Figure 1 from the model, you essentially take the discretionary adjustment (€10.6 bl.) then calculate the fall in GDP assuming a multipier of 1, and then identify the rise in the deficit related to the fall in GDP. In the figure, these steps be traced following a cobweb type pattern. The figure is useful in showing that this is not the end of the process, as a larger deficit itself stimulates the economy, etc. The model shows us where this cobweb pattern leads. Even if your estimate of 0.91 for b was correct, the overall impact on the deficit would be roughly half the discretionary adjustment. (This rises to two thirds if we put the multiplier at 0.5, again assuming for the sake of argument a b coefficient approximatly equal to 1.)

I doubt if you are convinced yet. But as I see it, the main space between us is that you are using two high a number for b, and you are not following through to the final equilibirum effect on the deficit after the discretionary deficit cut takes place. The formula 1/(1+mb)allows us to identify htis equilibrium change.

It is encouraging to me that we really are approaching the issue in the same way, so hopefully we can eliminate the disagreement soon.

Michael Taft,

I hope your conference went well yesterday.

Thanks also for the useful comments. Taking the points in reverse, you may well be right that it is better to do the analysis in terms of GNP. The model goes through either way, though of course the multiplier (m) and automatic stabiliser (b) parameters are likley to be somewhat different. I must admit that I don’t have a good empirical sense of how the change to GNP would ffect the results, and particularly the size of the key 1/(1+mb) measure.

On the point about the dynamics, there is no doubt that the multiplier will change over time. I would think that in the present depressed environment multiplier effects are likely to last longer than would be the case if we were operating closer to potential. Generally we think of impact multipliers being highest with the effects of (sustained) deficit changes fading over time. It is possible, however, that the size of the multiplier might rise initially, and so it could be that the reduction in the actual deficit as a share of the discretionary reduction falls initially, before rising later on as the size of the multiplier falls back. I think you raise an interesting point in relation to these dynamic effects, but I don’t see it as changing the basic conclusion of the model.

Again thanks for the engagment.

@ John

Maybe some day we can have a math challenge.

Meanwhile, let’s look at your “simultaneous” equations

(1) dY/dD = m
(2) dD/dY = -b

Only possible if mb = -1. Interesting theory but I would like to see an economic justification why mb would always equal -1.

The following is a mathematical truism quite independent of any model for the economy or indeed what Y the dependent variable or D the independent variable stand for.

The sign of d(D/Y)/dD is the same as that of [Y/D – dY/dD].

So to answer the question put by your opener, deficit reduction will be self defeating in terms of reducing D/Y iff dY/dD > Y/D. Y/D is about 7 so that would need dY/dD to exceed 7. I suggest, admittedly without any of your expertise in econometrics, that this is unlikely. Do you accept the econometric criterion? If so do you think that it is met?

What I know about simultaneous equations is that they produce unique answers. That is exactly what your model produces. The only equilibrium answers for Y and D are the ones which are currently in equilibrium, according to this linear model.

@ John

I general I respect your views, otherwise I would not have looked at your attachment. Maybe partial dY/dD is not the inverse of partial dD/dY. But certainly the linear model breaks down badly over the full range. Maybe it is a good approximation over the short range, in which case your conclusions would be valid.

But what I absolutely stand over, from by O-level math without having a clue about economics, is that the sign of d(D/Y)/dD is the same as that of Y/D – dY/dD. And that is what this thread is all about. Is d(D/Y)/dD positive or negative. The mathematical truism shows this to be equivalent to asking “is dY/dD less than or equal than Y/D”? Y/D is a bit over 7 so this translates to a fairly tractable question. Is the elasticity of GDP to the deficit greater than or less than 7. I would guess that any empirical studies would support one’s instinct that it is less.

In short, reducing the deficit almost certainly reduces the deficit/GDP ratio, a conclusion which your model supports, but it also reduces GDP. There is a trade off.

Colm McCarthy warned in a radio interview on Thursday that it’s an illusion to pretend there is a choice already there.

The people who lend us money are volunteers.

http://www.rte.ie/news/av/2010/1021/esri-business_av2841101.html#

@ All

A model to help answer the question.

Let Y0 and D0 by the GDP and Deficit before budgetary adjustment.

Let B be the budgetary adjustment (were positive means an increase in the deficit)

Then

1) Y = Y0 + mB

2) D = D0 + B – bmB

where m is the multipler effect of the adjustment and b is the stabiliser effect of a change in GDP.

Then after a bit of algebra we get:

Sign (dR/dB) = Sign [(1 – bm)/m – R0]

where R is the Deficit/GDP ratio.

The answer to the question then is that a negative budgetary adjustment will reduce the ratio if (1-bm)/m > R0

We can make a number of observations:

It is not at all clear a priori that the answer is yes.

If R0 is high, as it is, a yes answer is less likely

If m is high again yes is less likely.

If bm is greater than 1 then there is no way the answer is yes.

A plausible set of values which would leave the question right on the cusp would be m=1.6, b = .5 and R0 = .125

John

Thanks again forthe time taken. I actually think the differences between us are far greater than you believe, not least because ofthe inherent flaws of equilibrium models (including DSGE models). But that is a far larger topic and less pressing than the one at hand.

Re point 1. I have seen the assertion many times that the collapse in taxation revenues in 2009 was uniquely related to the bursting of a tax-rich property bubble. But I have yet to see it in evidence.

Construction collapsed by €3.9bn in 2009 while GNP fell by €16.5bn (real terms)- the fall in transport and services sectors combined exceed the building and construction slump. In terms of expenditures, imports fell by €13bn and personal consumption by €6.7bn. The total decline in GFCF far exceeded the construction slump, €12.3bn to €3.9bn and brought in not only transport equipment of all knds but also machinery and business equipment.

This is reflected in the tax heads, where VAT is the main contributor to the slump in taxation, not stamps or CGT, and is followed by income tax.

2. The cobweb pattern is not convincing, even within the limits of equilbrium based models without a multi-year dynamic, which I’ll come back to below. The cobweb reminds me of Soros’ ‘reflexivity’, although he places himself rather than government spending at the epicentre of economic activity.

In advanced economies, where social safety nets exist, the automatic stabilisers tend to shelter private consumption from the worst of the recession, and indeed become a factor in shortening it. When Keynes wrote the General Theory he used employment and consumption almost interchangeably, as, absent a safety net, they pretty much were. In the OECD database, household consumption was just 21% of the Great Recession as those stabilisers set to work, and the recession has long ended, if not its effects.

By contrast, policy here was to shut down the stabilisers by cutting PS pay and welfare payments. On the same OECD data, the fall in household consumption here is equivalent to 53% of the Irish Depression, which is ongoing. We cannot know the impact of that consumption slump on factors such as investment, but it is hardly likely to be a positive one, in my view.

In essence, therefore we agree that there is a web or interrelationships between the components of GDP. However, in your construction, the sign magically changes direction after first-round effects. That is, to take a concrete example, a PS pay cut of €N bn somehow becomes less than half of that as private agents do what, exactly? Maybe run down their savings rates and consumer prices fall? Perhaps, and yet the fall in private consumption was €6.7bn.

In Daniel Leigh’s research for the IMF, highlighted here, he estimated that the typical multiplier from govt. spending is 1: 0.5. But the offsetting factors typically arose from lower interest rates, a weaker currency and a greater share of buoyant overseas demand. In the atypical conditions which apply currently, he argues that the inability to lower either rates or the currency doubles the multiplier to 1:1 and that the simultaneous fiscal retrenchment elsewhere double it again to 1:2.

That alone ought to be sobering enough for advocates of further spending cuts.

But a neglected aspect of the research, and a common failing in discussions here, is to ignore entirely the dynamic, multi-year effect of a one-off cut in government spending. When both adverse conditions apply on rates & generalised austerity, there is a cumulative effect over 5 years where the multiplier aggregates to 1:6.

He further says that year 6 represents a ‘beak-even’ point for austerity and in year 7 onwards there are positive growth effects. Perhaps. But given the current economic and fiscal crisis we need that output curve to be sloping upwards now, and downwards only in 7 years’ time. That would only be possible by increased governent spending.

hoganmahew

you confuse cause and effect.

Cuts have been made, but no savings were made. Dissavings occurred.

Either that, or the capex spendinn cuts, cuts to PS pay, levies, cuts to jobseekers’ allowance and single parents all pased you by. Surely you remember the cut the allowance for the blind, though? Certainly stuck in my mind.

Here’s a reminder, before we start to go down the road of ‘mac the kife is a myth’ mythology.

http://www.moneyguideireland.com/welfare-benefits-cut-in-budget.html

John,

No problem. This is not a handbags occasion. I think the algebra is fairly important. Your algebra points to it being very unlikely that a deficit would be self defeating, mine points to it being not at all clear cut.

I will as you say look again at your workings. Meanwhile consider the following thought.

My very first simultaneous equation went as follows: Jack is 2 years older than Jill; Jill is half Jack’s age. Answer Jack is 4 and Jill is 2. I think, but I will take a closer look, that in you stating two simultaneous functional relationships it is like saying Jack is always 2 years older than Jill (of course that is possible) and Jill is always half Jack’s age – which is impossible.

@Michael Burke
“Here’s a reminder, before we start to go down the road of ‘mac the kife is a myth’ mythology.”
I don’t doubt for a moment that changes have been made to where the government spends it money. The wrong changes, in my view. But that is neither here nor there when we are talking about aggregates.

In aggregate, the government is spending more in real terms in 2009 than it was in 2008. As it is raising less in tax, in real terms, it is taking a reducing amount of tax out of the economy.

I say that both of these are a result of the collapse of the asset bubble and the effects that has had on growth and economic activity. You reckon that the decline in economic activity is due to the government cutting spending and raising taxes to the tune of 10.4 bn.

I don’t see evidence for this. I don’t think we are in that situation yet, though I believe it is coming. I also believe the wrong choices will be made – cutting welfare absolute amounts, property tax, water charges. For me, the cuts have to come from tax rebates, particularly those on deferred spending (pensions and savings), the administrative levels of the PS (with redundancy paid over a number of years to ease the cost to the exchequer) in particular the quangos, and large capex projects that are not labour intensive. All income should be taxed, including benefits (that’s where the ‘cut’ comes in), with a cap on total benefit and a sliding scale of income earning to reduce benefit traps. Social security contributions must cover the cost of the social security system. Capital taxes must be increased (there’s no justification that I can see for capital tax offsets either). And so on.

And this is just to get us to the point where we can reform how the health system is paid for, pensions, overall welfare etc.

@Brian Woods II
@J McHale

The above exchange is interesting if a bit tetchy!

Could I respectfully suggest you consider those arguments in the context of the US throughout the thirties and fourties.

The public debt vs public debt/GDP split — where they go in opposite directions is key and a fact that is generally politically unpopular with many.

This is more or less the position which bond investors suspect may apply in Ireland, at the point they decide the target or loading doesn’t matter. That is when the bond market closes.

wrt another point (possibly Smpleton) above about whether it is possible for the bond market to accept a different target and open to the Irish State next year – the answer is yes, of course it is, if that provides a more likely eventual non-default outcome. But they would need persuading.

Michael B,

I fear you are right that we are not going to reach agreement.

In attemting to respond to your previous comment, I over-complicated things by bringing up the cobweb pattern.

I actually think the issue is quite straightforward: if you believe the multiplier effect is positive and the automatic stabiliser effect is negaative — which I believe you do — then as a matter of logic the actuall deficit and the discretionbary deficit move in the same direction.

This result does not depend on the sizes of m and b.

I am happy to let you have the last word.

@tull,

If bond market participants were to begin think that the EU insisting on plan A, is a bad idea, preferring plan B – then the situation is roughly this:

For plan B to open up the market, the perceived advantages would have to be so clear that they would more than make up for the additional risk to holders from an EU less likely to offer a bail-out subsequently. This is unlikely unless plan A was clearly a non-runner.

However, if the bond market was signalling a preference for plan B over plan A, it is highly unlikely that the EU could easily ignore this “advice”. Pressure from the market would probably force a different view from the EU, hence plan B would become available.

Currently there is an element of defining a line, in order to see if Ireland is willing, generally, to tow lines. That is why there is waffle from the government about starting on a target and then, maybe, it might get turned into something else at some point down that line, in the future, going kind of forward-ish.

@ JMcH. Will do.

If additional credit or existing savings are brought in, and used appropriately – this might increase added value output? Would additional debt creation be a factor? In what direction?

Brian P.

@grumpy. I am kind of interested in the actual processes of these Multipliers – they do have a measurable effect – but what is the mechanism? You can use biological analogies for economic activity – they share all sorts of interesting parallels!

Brian P

John,

you’re the soul of courtesy.

I actually think the multipliers from both government spending and the automatic stabilisers are positive, just that the former are much higher (and that it was disastrous to block the latter via welfare cuts).

I even think the values of, say, 2, for government spending in the first year alone and 1.2 for the stabilisers would provide a satisfactory explanation of the course of the economy and government finances in 2009, maybe even using your model.

That would also fit with this IMF research, which I think is the most authoritative of all recent model-based analysis

http://www.imf.org/external/pubs/cat/longres.cfm?sk=23671.0

Thanks again for the willingness to engage.

@Jules
“For example payment to Anglo senior bondholders is probably pretty close to 1 as the cash will nearly all go to large entities abroad or very wealthy individuals who will bank it. I suspect expenditure on people on social has a multiplier effect pretty close to 2.5 in the year as they spend a lot of their cash on locally sourced food, alcohol and services and bank very little.”
Well, in the first case, money that flows abroad is probably 0 or maybe even negative?

In the second case, what locally sourced food? Heinz beanz? Noodles? Rice? Pasta? Pasta sauce? By value, more food is imported than is produced locally. The figures are worse for alcohol. Then who owns the companies that do this?
So I’d say the multiplier there is at best 0.5 and probably lower.

This is not to say that you are wrong in your assertion that welfare recipients are more likely to spend some of their welfare in a positive multiplier way, but I don’t think it is at all clearcut that it is a high value. Some of the spending may indeed be at very low positive values or zeroes, for example, clothes, shoes, books, music.

“This overemphasis on the % deficit is illusory. It is like calling a family bankrupt because they had a income deficit of 200% the year they got their mortgage.”
This is just not the case; you are mixing up debt and cash flow. If the family couldn’t pay the monthly payment without borrowing it, would you call them bust? That is the position we are in. The state’s cash-flow is deeply negative. It can’t afford the debt it has, because it is spending too much. If it wasn’t spending so much, the debt wouldn’t be a problem.

Yes, our problem is different from Greece, but only this year. Add up all the years until the deficit is roughly balanced and we are in the same situation as Greece.

@John Mc
Having wandered in the park earlier, when it wasn’t the middle of the night, I realised that my attempted complication of your equation was on a path towards impossible overcomplication, so while I’m sure we’d all love to have a grand unified equation I’ve reverted to your neat and minimal outline.