Year: 2012

Paul Krugman has an interesting column in Sunday’s New York Times; it is also appears in the Business section of today’s Irish Times.   There is much that I agree with in the article regarding the boarder European crisis resolution response.   But I think his comments on Ireland’s adjustment policies are off the mark.   Paul complains about Ireland being used as a misleading data point in the international debate.   I think Paul is himself guilty on this score. 

Here’s what he says about Ireland:

What’s wrong with the prescription of spending cuts as the remedy for Europe’s ills?

One answer is that the confidence fairy doesn’t exist – that is, claims that slashing government spending would somehow encourage consumers and businesses to spend more have been overwhelmingly refuted by the experience of the past two years. So spending cuts in a depressed economy just make the depression deeper. Moreover, there seems to be little if any gain in return for the pain.

Consider the case of Ireland, which has been a good soldier in this crisis, imposing ever-harsher austerity in an attempt to win back the favour of the bond markets. According to the prevailing orthodoxy, this should work. In fact, the will to believe is so strong that members of Europe’s policy elite keep proclaiming that Irish austerity has indeed worked; that the Irish economy has begun to recover.

But it hasn’t. And although you’d never know it from much of the press coverage, Irish borrowing costs remain much higher than those of Spain or Italy, let alone Germany.

A number of responses:

1.   As far as I can see, those involved in the design of Ireland’s adjustment programme do not believe in the “confidence fairy”.   It has been explicitly recognised that fiscal adjustment slows the economy.   The programme has been designed in order to balance the need put Ireland on a fiscal path consistent with debt sustainability and regaining the country’s creditworthiness, while securing needed official lender support, and minimising the adverse effects on the real economy through a official-lender supported phased adjustment approach.

2.  Ireland’s growth performance has been disappointing.   But the causes of the poor performance go well beyond the effects of fiscal austerity.   The weight of impaired balance sheets in a post-bubble and a weak international environment are also major drags on growth.   Of course, Paul is far too good an economist not to realise this.  

3.  It would be true that Ireland’s adjustment effort is failing if the fiscal measures were directly self defeating in terms of improving the underlying fiscal situation.   There are a number of relevant measures: Are the fiscal adjustments leading to an improvement in the underlying primary deficit?   Are these adjustments improving the underlying path of the debt to GDP ratio and putting Ireland on a path to debt to GDP ratio stabilisation?   And are these adjustments helping to restore Ireland’s creditworthiness? 

On the underlying primary deficit, the number has come down from 9.7 percent in 2009 to 6.0 percent in 2011, with a projected further fall to 4.2 percent in 2012. 

On the debt to GDP ratio, the calculation is more complex because we have to see how adjustments affect the path of the ratio.   For plausible multipliers, it is certainly possible that the debt to GDP ratio rises in the year of adjustment due to a strong adverse effect on the denominator.    For example, using an automatic stabiliser coefficient 0.4 – a key parameter in determining the possibility of self-defeating adjustment – simulations show the debt to GDP ratio would rise this year as a result of a (permanent) additional €1 billion of adjustment with a deficit multiplier of 1.  However, this ignores the positive effect on the future debt ratio of lowering the nominal primary deficit this year, which will lower the nominal debt and thus interest payments in the future.   Simulations show that the multiplier would have to be as large as 3.8 – completely implausible for a small open economy – for the debt to GDP ratio to be actually higher in 2015, all else equal. 

On creditworthiness, the impressive recent work of Delong and Summers introduces the possibly adverse effect of “hysteresis” on creditworthiness.   (The effect here refers to the fiscal shadow cast by lower output today due to persistent effects on output.)    This is harder to get an empirical handle on due to the difficultly in observing these effects.   However, notwithstanding the fact that Ireland’s bond yields are above those in the Germany or even Spain, the improvement in Ireland’s market creditworthiness has been dramatic since last summer as Ireland’s adjustment programme has gained credibility.   (The evolution of Ireland’s 2-year bond is shown here; the 9-year yield here.)  This has occurred despite increasing evidence of the damage done to the economy by the bubble, despite the euro zone crisis remaining in flux and despite the clamour to abandon the adjustment programme and default. 

The success of Ireland’s adjustment programme is too important for it to be used as misleading fodder in a debate over appropriate fiscal policies for creditworthy countries.

Thanks to Jagdip Singh for pointing to Michael Taft’s response to an earlier post of mine on the implications of fiscal rules – including the structural balance rule – on the need for additional austerity post 2015.  

It is worth reiterating two critical points before responding to Michael’s critique.   First, the Fiscal Compact does not imply additional constraints beyond what we are already signed up to under the revised Stability and Growth Pact.   Ireland already has a medium-term budgetary objective of a structural balance of 0.5 percent of GDP.   I believe the No campaign is being disingenuous on this point.  Second, the main driver of austerity measures in Ireland is not the fiscal rules: it is that Ireland has a large deficit, substantial debt that needs to be rolled over in the coming years, and is not creditworthy.   The only reason Ireland does not have substantially greater front-loaded austerity is that we have been able to obtain official-funding support at low interest rates.   However, this support is conditional on pursuing a phased deficit-reduction programme. 

Michael’s main objection to my post relates to the definition of the structural balance.   He claims that the only way to reduce the structural balance is through additional discretionary measures.  However, what he does not note is that his assumed baseline of “no policy change” involves expenditure rising at a rate equal to the underlying nominal potential GDP of the economy.   Assuming total tax revenue rises at the same rate as potential GDP growth, expenditure rising at this rate would keep primary structural deficit constant as a share of potential GDP.   Using the European Commission’s coefficient of 0.4, in the absence of expenditure growth, the nominal structural deficit would fall by 0.4 times the change in nominal potential GDP due to the rise in tax revenues at constant tax rates as the economy expands.   In my calculation, I allowed for expenditure increases equal to half the projected rise in tax revenues, so that the nominal structural deficit falls by 0.2 times the increase in nominal potential GDP.   I think most people view austerity measures as involving higher tax rates (or new taxes) combined with cuts in expenditure.   What my calculation shows is the even with nominal expenditure rising (though at a slower rate than nominal potential GDP), the structural deficit target could be met by around 2019.   As Seamus Coffey emphasises, the annual rate of improvement would be approximately 0.7 percentage points of GDP per year, which is above the SGP’s requirement of 0.5 percentage points. 

In sum, if your definition of austerity involves government expenditure – public-sector pay rates, social welfare rates, etc. – growing at a rate less than nominal potential GDP, then you should agree with Michael that hitting the structural deficit target will involve additional austerity measures.   However, if your definition is what I see as the more natural one of additional cuts and tax rises, then, even with relatively conservative assumptions about growth, moving back to structural balance would not require additional austerity.

The site is live here, the programme looks excellent, and the guest speakers are world class. From the site:

2012 is a special year for us. It will be the 10th year of running the INFINITI Conference on International Finance, in conjunction this year with the Journal of Banking and Finance. Over the last ten years, we have been privileged to have had keynote speakers such as Ike Mathur, Raman Uppal, William L Megginson, Edward Kane, Andrei Shleifer, Robert Engle, Maureen O’Hara, and Elroy Dimson. We have also been fortunate to have been joined by many other leading academics, students and practitioners who have openly shared and discussed each others’ latest research.

Our keynote speakers for 2012 are Carmen Reinhart and Iftekhar Hasan.

We hope that you will be able to join us this year, and to that end are pleased to announce that the Call for Papers has been sent out and the online paper submission facility is now open. Please see the full call here.

We would also like to draw your attention to a call for papers for a special issue of RIBAF.

2012 will be a great year, and we hope to see you here at Trinity College Dublin for yet another fantastic INFINITI Conference on 11-12 June.

A DRAFT of the conference paper sessions is available at https://www.openconf.org/infiniti2012/openconf.php. Note however that this is not finalised, and that it omits as yet the details of a number of special sessions on the future of the euro, financial regulation etc.

Jeff Sachs explains his position in this FT piece.