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.)