A comment on Holland and Portes
This post was written by John McHale
As the note by Holland and Portes linked to earlier by Stephen is likely to be influential in the fiscal policy debate, it is worth taking a closer look at the findings with the Irish case in mind. The note is based on a more detailed (and very useful) analysis by Dawn Holland (available here).
Although the main message on the impact of (coordinated) fiscal adjustment is quite negative, the fact that Ireland is the only country for which the adjustment leads to a (small) fall in the debt to GDP ratio might appear to give some comfort. But I don’t think we can take comfort on the score. Not surprisingly, the reason Ireland stands out as an outlier in this analysis is because of relatively small (normal-case) multipliers. (The multipliers are assumed to be higher in the context of the current crisis, but the precise “crisis multipliers” used for Ireland are not given in the paper.) The assumed normal-case multiplier is -0.36 for a decrease in government consumption and -0.08 for an increase in income taxes. I would guess that the relatively low assumed normal-case multipliers for Ireland reflect Ireland’s high imports as a fraction of GDP. But as discussed here, a large fraction of imports in Ireland are used as inputs into the production of exports. As a result, the high import share can give a misleading view of the marginal propensity to import out of domestic demand. Controlling for exports, a simple regression shows that a one euro increase in domestic demand is estimated to raise imports by 0.23 euro, indicating substantially less leakage from expansions in domestic demand than the crude import share would suggest.
While I don’t think we can get any comfort from Ireland being an outlier in the analysis, I do have concerns about the broad conclusion of the paper. This conclusion is that fiscal adjustment has actually raised debt to GDP ratios. To the extent that the debt to GDP ratio is critical for creditworthiness, this suggests that efforts have been self-defeating on this central measure.
The problem comes from focusing on the impact on the debt to GDP ratio at some near-term date—2013 in the case of the paper. It is of course true that fiscal adjustment measures can raise the debt to GDP in the near term. The negative effect on the denominator can swamp the improvement in the numerator. But the standard equation for the change in the debt to GDP ratio shows how the effect of a given year’s fiscal adjustment on the debt to GDP ratio evolves over time.
∆d = (r – g)d-1 + pd.
Note: d is the debt to GDP ratio, r is the real interest rate, g is the real growth rate, and pd is the primary deficit as a share of GDP.
As assumed in the analysis, a fiscal adjustment will lower the growth rate and lower the primary deficit. But even if the adjustment has a permanent effect on the level of GDP, the effect the growth rate should disappear. However, the effect on the primary deficit will be permanent. (The Holland paper shows that even the coordinated adjustments have reduced individual-country deficits – see Figure 6.) Of course, any initial increase in the debt ratio will be carried forward, but even for very modest improvements in the primary deficit, the debt to GDP ratio will fall over time. Simulations done by IFAC for the Irish case using a simple model that allows for two-way feedbacks between GDP and the deficit show that, all else equal, the deficit multiplier would have to be higher than 3.8 for the debt to GDP ratio to be higher in 2015 as a result of a fiscal adjustment done in 2012.
One potentially important factor left out is the possibility of the “hysteresis effects” highlighted by DeLong and Summers (see here). They argue that today’s fiscal adjustments can leave a shadow on future output. For example, workers made unemployed today due to fiscal adjustment suffer permanent loss of skills and employability. These effects can lead to a permanent increase in the primary deficit. Brad DeLong provides a useful example based on a temporary fiscal stimulus in a comment (at 9:59) here. I think the jury is still out on how important such hysteresis effects are in practice. One concern with the DeLong and Summers analysis is that they assume the hysteresis effects are permanent. I think it is more plausible to assume that they decay over time (see here). Even relatively modest decay rates could overturn their self-defeating result.
So where does this leave me: I think there is little doubt that fiscal adjustments slow the economy – and the contractionary effects are likely to be abnormally large under current conditions. For countries that currently do not appear to have a creditworthiness problem – such as the UK or Germany – the argument for slower fiscal adjustment looks compelling. Less contractionary policies in countries with “fiscal space” would also help their trading partners. But I don’t think the evidence supports a conclusion that fiscal adjustment – even coordinated adjustment – worsens the medium-run path of the debt to GDP ratio and thus creditworthiness.