Ashoka Mody offers another thoughtful perspective on Ireland’s crisis resolution effort on today’s This Week programme on RTE radio (audio here; scroll down to last item). Although he covers a good deal of ground, much of which I agree with, his main recommendation is that Ireland should consider scaling back its fiscal adjustment effort. As I note in a piece for the Business section of today’s Sunday Independent, reasonable people can disagree on the optimal speed of the adjustment given the tradeoffs involved. But Ashoka raises the old issue of the adjustment effort being self defeating. At the risk of repetition of past posts, I cannot see how the evidence in the Irish case bears this out. There is, of course, wide agreement that fiscal adjustment lowers growth. But it is a significant step from here to a claim that the adjustment is self defeating on its own terms of improving the fiscal situation. I think it is worthwhile to continue to scrutinise this claim.
The self-defeating hypothesis comes in a number of forms depending on the focal outcome variable. For convenience I label the main forms as: the strong form (underlying primary deficit); the semi-strong form (debt to GDP ratio); and the weak form (creditworthiness). Ashoka’s main focus is on the semi-strong version, but it is worthwhile to briefly review the case for each.
Ireland’s underlying General Government primary deficit has fallen from a peak of 9.3 percent of GDP in 2009 to a projected 2.5 percent this year. This occurred despite the massive non-austerity related headwinds the economy faced. All else equal, if there had been no adjustment from 2009, simulations show the underlying primary deficit would have reached 14.5 percent of GDP this year. The underlying actual deficit and debt to GDP ratio would have been 20.5 and 160 percent of GDP respectively. Of course, something would have given before these ratios were reached, but it is useful to consider the crude counterfactual in assessing what has been achieved. (These simulations assume a reduced-form deficit multiplier of 0.5 and an automatic stabiliser coefficient of 0.4. The underlying model being used is sketched here. )
Turning to the semi-strong form (Ashoka’s main focus in the interview), it is well known that for multipliers around unity fiscal adjustment can lead to a short-run rise in the debt to GDP ratio. The reason is that the negative effect on the denominator can swamp any positive effect on the numerator. But this static analysis can give a very misleading picture of the impact of the adjustment on the path of the debt to GDP ratio.
This is most easily seen using the classic equation for the evolution of the debt to GDP ratio: ∆d = (i – g)d-1 + pd, where d is the debt to GDP ratio, i is the interest rate, g is the growth rate, and pd the primary deficit as a share of GDP. The debt to GDP ratio may rise initially due to the adverse effect on g. But the effect of this year’s adjustment on g should be temporary while the impact on the primary deficit should be permanent. The permanent effect should quickly swamp the temporary effect, leading to an improvement in the debt to GDP profile as a result of this year’s adjustment. (One thing that could overturn this result is that today’s adjustment leaves a long negative shadow on the level of GDP (what is known as hysteresis), but that would again require that today’s adjustment causes the primary deficit to rise rather than fall.)
Simulations for Ireland show that an additional €1 billion of adjustment in 2014 would only lead to a higher debt to GDP ratio in 2015 for values of the reduced-form deficit multiplier greater than 2.3 – above any reasonable estimate for the highly open Irish economy. Reduced austerity might well improve growth performance, but it seems highly unlikely that it would improve Ireland’s debt dynamics as Ashoka claims.
Turning finally to the weak form, it is possible the direct adverse growth effects from fiscal adjustment on investor confidence could swamp any positive effect through the deficit and debt. This might happen, for example, if investors worry that the deeper recession would undermine political support for the adjustment effort. It is thus possible that despite the positive fiscal impacts, creditworthiness (as measured by secondary market bond spreads) might deteriorate. This is ultimately an empirical question. But the fall in Ireland’s 10-year bond yield from 14 percent in mid 2011 to below 4 percent today hardly suggests that Ireland’s fiscal adjustment effort has been self-defeating on even this weak definition.