Improving the Fiscal Trade-off

Apologies for what Paul Krugman would call a “wonkish” post. 

As we enter some critical weeks for Irish fiscal policy, there is still wide disagreement about the nature of the creditworthiness-demand trade-off facing the government.   At one of the spectrum are those who think Ireland is placed to have an “expansionary fiscal contraction”: a cut in the discretionary deficit would raise confidence and lower the risk preimum sufficiently so that we could simultaneously improve creditworthiness and demand.   At the other end are those who think that discretionary cuts will slow the economy so much that the actual deficit will rise, leading to both a shrunken economy and shrunken creditworthiness.   I think I share with most economists the view that we are actually in the boring middle – deficit cuts will slow the economy but will improve creditworthiness.

Readers might find this graphical representation of the trade-off useful in putting the different views in context.   It attempts to capture the potentially complex relationship between creditworthiness and demand, allowing for different trade-offs over different ranges.   (The “dismal” vicinity around point C has been subject to notable discussion on this blog, where the government is seen as effectively powerless to avoid bailout or default.   At least this is how I interpret commenters such as Simpleton, Paul Hunt and Tull Macadoo, though I’m sure they will correct me if I’m wrong.)

An economist should never see a policy trade-off without immediately thinking about how to improve it.   Whatever the decision about how much to cut for 2011, we should be trying to push the creditworthiness-demand trade-off outwards. 

As I see it, there are two main mechanisms for shifting the trade-off: (1) making credible commitments to out-year fiscal adjustments; and (2) choosing the mix of the immediate fiscal adjustments.

A credible four-year plan would shift the trade-off outwards.   The DoF’s announcement during the week about the plan was less than encouraging in this regard.  But Cliff Taylor’s reporting today in the Sunday Business Post gives some hope that the government has got the message about the need for something that approaches four one-year budgets in their degree of specificity (no link yet).   In his Business and Finance article (link in post below), Karl Whelan downplays the four-year planning element.   However, if I read him correctly, he is not disregarding the value of a credible plan, just questioning the likelihood that such a plan could be achieved.   I’m sure he would be more than happy for the government to prove him wrong. 

The importance of the mix of adjustments has also been subject to some confusion.   Not surprisingly, the political parties talk about doing deficit reduction while at the same time talking about stimulus to try to neutralise the criticism that they are destroying jobs.    I think we can have a more fruitful debate on the mix of adjustment if it is clearly stated that doing less adjustment along one dimension means more along another.   For example, if you want to protect the capital budget, then you must have larger cuts in current spending or larger increases in taxation.   There are a number of dimensions along which the mix could matter in terms of the trade-off: the propensities to spend out of transfer/after-tax income; the supply-side implications of the adjustments; or whether the adjustments are viewed by potential investors as permanent or temporary, etc. (For what its worth, taking these dimensions into account, I think we should be on guard against overdoing the relatively painless political choice of deferring needed capital spending.)

20 thoughts on “Improving the Fiscal Trade-off”

  1. This is a classic case of imposing “reality on the ground” as the Israelis might say and then working around this supposedly natural occurrence.

    I am sorry but I cannot accept a structure where goverment paper is somehow inferior to the shadow banking construct.

    This is a abomination and a all out attack by the ECB against this state and its so called citizens.

  2. This is a classic case of imposing “reality on the ground” as the Israelis might say and then working around this supposedly natural occurrence.

    I am sorry but I cannot accept a structure where goverment paper is somehow inferior to the shadow banking construct.

    This is a abomination and a all out attack by the ECB against this state and its so called citizens.

  3. Keith,
    That all sounds intriguing, but I have no idea what point you are trying to make. You might expand a little.

  4. @John
    Well it is very simple really – the state / people can only achieve a certain level of wealth creation at any given time – in a imaginary simpler world without equity or wages all of this surplus would be expressed in interest.

    If we follow this lodgic then in times of scarcity when you have static or declining money supply some of these interest coupon holders would take a loss as without a loss mechanism this system would not be in equilibrium.
    The ECB wishes to transfer all or most of the losses off its clients to the state by maintaining 100% value on its senior bonds at all cost – this creates turbulence withen a static money supply as the wealth engine cannot repay all holders of interest coupons – the system can maintain integrity by transferring losses via Goverment defecits until equilibrium is restored via tax rises or cuts to services.
    Remember the interest bearing vehicles that Irish banks used to extend further credit had / have no direct bearing on the credit created but existed to justify large credit creation.
    I was always under the impression that these were merely capital buffers to be used in event of loss and were rewarded for this risk by being paid a higher risk interest premium.
    This is blatantly putting the cart before the horse but has one advantage in that it displays to the Irish people the chain of command withen this rotting stinking carcass of a state.
    I am afraid this is very simple stuff that even a peasant such as myself can understand and I am bamboozled by apparently sane rational economists who can game this system which in crisis created new false parameters in the interests of powerful interest groups

  5. @ John

    “As I see it, there are two main mechanisms for shifting the trade-off: (1) making credible commitments to out-year fiscal adjustments; and (2) choosing the mix of the immediate fiscal adjustments.”

    A good point, and it will be on such nuances that the state fails or succeeds.

    However, in relation to point (1), it will be difficult to make any credible commitments regarding “out-years” as this government will not be in power.

    IMO there is room for manoeuvre in relation to point (2). For example, reducing the pensions of wealthy ex-civil servants and the numbers of HSE middle management, would probably not have too much of a negative effect on demand as a sizeable % of such money is put into savings anyway. If only a small fraction of these cuts could be redirected into some form of reskilling or employment generation for unemployed construction workers, the funds would be much more productive.

  6. The problem with most economists is the divergence from their models from reality.

    Without doubt Ireland has entered a phase in its economic development were the continuation of the current regime is going to lead to bailout or default.

    The international markets and more importantly the people have lost faith in the current administration and it is this psychological fact more than anything else means that the deficit reduction program announced by the minister is domed to fail. We are not little automata who say ohh my god the government has increased the VAT so I won’t bother starting my business.

    Currently in Ireland we have a combination of problems nearly all of which are attributable to the actions of tthe ff/greannie alliance. The major problems with the exception of the deficit, which we all know about are;

    1. government debt/% of GNP. Any actions taken on this front by the regime are domed to failure as a deficit reduction of say 15 bn will crash the economy decreasing the GNP by a factor greater than the deficit reduction pushing this critical parameter closer to to the critical 120%

    2. Savings. We are currently saving to much as the average joe is shitless. Every economic projection of the regime has been wrong, could they not hire David McWilliams. People do are scared of the future.

    3. Taxation. Garet the good called this well. There is a basic disconnect in the Irish psyche between the taxation they pay and the services they get. Taxes have to go up by about 10% overall immediately.

    4. Costs. The cost of basic foodstuffs, electricity, rent, government services etc. are all about 50% higher than any of other of our serious competitors. The failure of the Government to deal with vested interests in the supermarkets, the professions etc. is unbelievable. Croagh FatTrick is just another example of this.

    5. Investment. Unless there is an immediate change in the way in the way the government handles investment with an emphasis to job creation we are domed to an endless circle of deficit reductions leading to a reduction in GNP leading to increased indebtness and finally poverty for all citzens. The IDA/Enterprise island/ local entprise boards budgets have to quadrupled overnight.

  7. @ John McHale

    An economist should never see a policy trade-off without immediately thinking about how to improve it.

    Indeed.

    There are a lot of references to pain these times and it’s likely that those making decisions on cuts in departments and organisations will exempt their own perks.

    There must surely be a huge amount of featherbedding and scrounging to squeeze from the system.

    Gene Kerrigan comments in the Sunday Independent today: “Why should this ostentatious display of privilege generate a wave of public anger, when so much else is so meekly accepted? Not a murmur from the public about the Galway academics who spent €1.3m over three years on travel — €154,000 on conferences in Crete and €108,000 on hiring private jets.”

    @ jules

    The IDA/Enterprise island/ local entprise boards budgets have to quadrupled overnight.

    We could start with a credible jobs strategy stripped of the usual spin and with an honest assessment of the challenges.

  8. Paul Krugman is a shill and a poor economist in the real world. In academia he is a God of economics.

    Naturally, therefore, you buy into the idea of more borrowing. Those who lend, control a large part of the economist employment sector. All advocates of borrowing are under a cloud of suspicion after the credit bubble.

    Can you explain why borrowing is so good for the borrower? We know it is good for the lender.

    The government has had many opportunities to borrow and invest in capital spending. These opportunities were squandered by a stupid government. Get over it? The natural level of GNP is far smaller than before, inflated as it was by the bubble. Why not get wonkish and forthright and tell us your estimate of that level?

  9. For details of the human cost of bubble economics see: http://www.philmacgiollabhain.com

    If the natural level of GNP without a 1+ money multiplier (the multiplier is clearly less than one for the foreseeable future), is such that it cannot afford to pay interest and repayments of borrowings then default is inevitable.

    What is Ireland’s natural GNP level, John? What level of borrowing can such an economy with such a multiplier, afford? Clearly the answer depends upon the interest rate imposed. Where is the cutoff, John? Have we reached it already? Do you know?

  10. @ObsessiveMathsFreak 🙂

    @Pat Donnelly. +1

    @jules
    1. government debt/% of GNP. You need to start with an honest appraisal of what is Irelands GNP and work from there. Unfortunately extreme levels of debt has been already incurred so the % is already critical.

    2. Savings. So the solution is to pay off the economists who have gotten it right? Bribe them to tell the people to start spending by giving them a job? Surely Pat Donnely can be given a few bob to stop posting 🙂

    3. Taxation. Taxes have to go up by about 10% overall immediately.
    Along with 50% reductions in wages. The Irish public service has forgotten we are a small poor country on the periphery of Europe which must have a competitive cost base to be successful.

    4. Costs. The failure of the Government …. There are plenty of well paid, well connected people employed regulating the system. Who are merely overseeing the cartel

    The IDA/Enterprise island/ local entprise boards budgets have to quadrupled overnight.

    Wrong way. Budgets for those who are working in the domestic agencies need to be halved. With a culling of staff employed there. The priority should be on encouraging businesses, not building up a dependent state sponsored entrepreneur industry populated by employees who have never taken a decision or risk in their lives.
    The structure can be suitable when dealing with major international companies who are evaluating where to invest but not for starting up.

  11. Research for the FT carried out by Eswar Prasad, a former International Monetary Fund official who is now a professor of economics at Cornell University, finds that the rich economies will owe a rapidly rising share of public debt worldwide, while contributing relatively less to global growth.

    Ageing population with rising costs of welfare and health systems in advanced economies is happening at a time when public debt has jumped in most rich countries during the recession.

    Prasad reports that average per capita government debt per person of working age rises from $31,700 in 2007 to $68,500 in 2015.

    In Ireland debt per person of working age rises from $11,600 in 2007 to $52,900 in 2015.

    In a sample of more than 50 countries, the US, which has a relatively positive demographic profile, goes from having the 11th heaviest debt burden per employee in 2007 to the third highest by 2015.

    The Burden of Public Debt: Interactive Feature

  12. @John McHale,

    Many thanks for this. It’s far from wonkish and should help to focus the debate. It’s also appropriate to consider it on Samhain – the Festival of the Dead. It’s amazing how little is understood about the impact of fiscal expansion or contraction. The Economist’s Buttonwood has an interesting piece on this:
    http://www.economist.com/node/17363445
    which refers to Ireland and highlights some new research. (I know The Economist’s ‘teenage scribblers’ have their own agenda, but they don’t shy from evidence – unlike many in the Irish policy-making firmament.)

    My point about the scale and nature of the fiscal adjustment that’s being contemplated in Ireland is that we run the risk of being driven into your CD range because key sectors (the public sector, the semi-states and the private sheltered sectors) are economically dyfunctional – almost beyond belief. While these remain unreformed they will transmit the required fiscal adjustment into an unsustainable burden on the productive sectors and on to the most vulnerable in society. For various reasons, the macro analysis doesn’t capture this effect.

    Meanwhile, Colm McCarthy is doing his patriotic duty to encourage people to take the pain to pretect sovereignty:
    http://www.independent.ie/opinion/analysis/in-keeping-with-halloween-heres-a-scary-one-2401299.html
    and uses the IMF as the bogeyman.

    He can do no other; any traction he might have with the policy-makers would be destroyed if he were to advocate throwing in the towel and entering the EFSF treatment room. He also talks about reputational damage, but I’ve lost count of the areas the NESC has identified where Ireland has suffered damage. The Government is determined to throw the fiscal dice in its do-or-die gamble to keep Ireland outside the treatment room – and, similarly, will use the IMF bogeyman to instil discipline on the backbenches.

    But this will only be the start of a white-knuckle roller-coaster ride over the next three years with the bond market while the EU tries to implement Chancellor Merkel’s desire to put the EFSF on permanent footing with a rock-solid mechanism for orderly debt restructuring – while the economy sinks deeper into the mire.

    The irony is that the EC/ECB are calling the shuts on the fiscal adjustment and would look for no more if Ireland were to enter the treatment room, but the IMF would have the opportunity to tackle the dysfunctional economic sectors (as it is doing in Greece) that are amplifying the detrimental impact of fiscal adjustment. No sustainable recovery will be possible until these sectors are tackled. A government that is just hanging on will never do it – and the likely alternative will never agree on what needs to be done.

    It sounds cruel and unpatriotic to say it, but it might be better if the NTMA were shut out of the market when it tries to re-enter.

  13. @michael. I think the actions of the NUIG academics you refer to is indefensibe and based on my own experience of managing academic research contracts I am amazed that they had the authority to spend such large amounts of money on items obviously unrelated to their research. However, it is important to acknowledge that in this case both the institution and the individuals involved did take responsibilty for their actions. Science Foundation Ireland, which funded the research, picked up on this misspending during auditing and refused to reimburse NUIG. Furthermore according to media reports one of the individuals involved did not have his/her contracted renewed, the other had his/her contract terminated. So this is not an example of no one taking any responsibility for their actions. My concern is whether the people involved took enough responsibility – ie. did they have to repay the money?

  14. @John
    Your valiant efforts to think your way through this problem are to be commended. As you rightly identify, improving our credit-worthiness is the issue. But I wonder whether framing the question in this way still hints at a deeper problem: as a counrty, the penny still has ot dropped. We have no credit-worthiness to improve. Technically, we can still improve from zero (or, more, properly, the circa 50% probablility of default implied by market prices) but we have to start with the fundamenatl fact that nobody will, right now lend to us.
    We can spin around debating the mix of capital and current spending cuts and tax increases but the graphic on p21 of yesterdays SBP is extremely revealing, and I wonder whether the penny has dropped.
    From 2004, current public expensiture has increased by Euro 14.5bn to 2009. That’s a near 50% increase. Did the Irish State witness a 50% improvement in the provision of public services during those brief five years? Since 2002, recent enough in memory, current public expenditure has risen by 73% or euro 19.bn, to 2009.
    Of course, some of the increase is cyclical, but the rise in public expenditure since since 2004, a five year period, is intriguingly close to the euro 15bn that has to be found over the next four years.
    Defenders of the public sector will sense another attack on workers in that sector but to point to something unsutainable and unjustified is not to personalise an attack. There are many victims of this crisis – and many, many, perpertrators – but the public sector worker who was hired over the past decade and/or given unjustifiable wage increases is a victim as much as anybody else in this tragedy.
    The money to pay these workers is no longer there. It’s an absolute constraint.
    Efforts to raise a signifcant proportion of the 15bn through taxes will prove futile (that’s what the bond market thinks) and the political will to incur the very real pain of current expenditure cuts is absent (tht’s what the bond market thinks). Some politicians know what needs to be done, but by their deeds they reveal, still, a cluelessness that is scary. Bond markets join the dots in ways that our masters do not. If you still don’t know how to deal with banks (AIB the latest farce) you don’t know what to do. Period.
    As Vincent Brown memorably accused Brian Lenihan, to his face, not too long ago: “you don’t know what you are doing, do you?”

  15. krugman is a danger to himself and entire nations. case in point: Japan and its BOJ: 20 plus years in the money printing business, and still, no result. unlike the irish however, the BOJ and the Japanese government had a pool of domestic savings from which to borrow, a free ride, that is soon coming to an end. they too will taste the wrath of the bond vigilante’s for their promiscuous monetary behaviors aka, keynes, krugman, and the slew of robotic incestuous “economists” closed world departments have graduated over so many decades.

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