Author: John McHale

Why we should hope fiscal multipliers are large

One of the frustrating things about doing macroeconomics during the crisis is that it is so hard to pin down key empirical parameters.    The size of fiscal multipliers is probably the main case in point.   The combination of short time series and a wide range of conditioning factors – confidence effects, the state of credit markets, import leakages, etc. – make it hard to identify the causal impacts of changes in taxes and government spending.  

While there is a widespread view that Irish fiscal multipliers are small (mainly due to the openness of the economy), I have always believed this is exaggerated given offsetting factors such binding credit constraints, an almost completely accommodating monetary policy and a large negative output gap.  At a time when I thought Ireland could retain its creditworthiness, this led me to believe we should pursue as gradual a fiscal adjustment as the State creditworthiness constraint would allow.    But with creditworthiness proving more fragile than expected, there is now little choice but to move expeditiously to close the deficit. 

With significantly more fiscal adjustment to come – probably at a minimum the €9 billion planned for in the EU/IMF programme – there is an obvious reason to hope fiscal multipliers are small.   But there is also a reason to hope they are large.   With the IMF reducing its growth estimate for 2011 and the exchequer returns hinting at a weaker than expected recovery, we would be better off if the fiscal adjustment is a significant source of the observed weakness in domestic demand.  

It is the underlying rate of potential output growth that really matters for Ireland’s debt sustainability.   Uncertainty about this rate is a significant part of our creditworthiness problem.    As others have pointed out, there are competing narratives about Ireland’s medium-term growth potential.   On the positive side is the strong growth in net exports (which added about 3.5 percentage points to Ireland’s real GDP growth in 2010).  On the negative side is the combined impact of the fiscal austerity and the drag from impaired balance sheets (which subtracted about 4.5 percentage points from growth in 2010).  

While unfortunately we are in for a good deal more austerity, it will eventually end; the more of the current drag on domestic demand that is coming from the austerity, the higher is the implied underlying potential growth rate.   Even if the fiscal adjustment is making less headway now in reducing the deficit due to relatively high multipliers, the large changes in taxes and social welfare rates should allow for a rapid improvement in the deficit once the austerity ends and decent overall growth returns.    The hoped for growth narrative – which I think we have good reason to believe is true – is that Ireland has an economy with a strong underlying export-driven growth potential that is being temporarily held back by unavoidable fiscal adjustment. 

A Jobs and Creditworthiness Special Budget

The new government’s difficult navigation through the crisis took significant steps forward last week with the stress tests and strengthened lender of last resort commitment.   While we can hope for some easing of the bailout terms, the next milestone is likely to be the upcoming “jobs budget”.   For a new centre-right/centre-left coalition government, this will be an opportunity to demonstrate political capacity on the fiscal side.  Unfortunately, market assessments of Ireland’s chances of avoiding default are less favourable than we might have hoped when the EU-IMF programme was agreed (see Colm McCarthy’s post and article below).   With this inescapable reality in mind, it is worthwhile considering case for sending a strong signal on adjustment capacity by accelerating some of the planned deficit reduction. 

I do not make this suggestion lightly.   As Karl Whelan has emphasised, Ireland has already engaged is a truly massive discretionary adjustment (roughly €20 billion euro, or about 13 percent of GDP), involving huge sacrifice.   I have also no doubt that the austerity measures have deepened the recession.  Additional austerity is thus doubly unwelcome.  However, a demonstration of adjustment capacity by a new government that is still being assessed by markets and official funders could be a well-timed “investment” at this stage.   This could be combined with the planned improvement in the mix of policies designed to spur growth and employment, though realistically these measures would probably only the edge off any accelerated austerity.    A “jobs and creditworthiness special budget” (it clearly needs a better name) would allow the new government to show it is taking control of the situation, rather than passively following a course laid down by its predecessor, and build the sense that the adjustment-with-assistance strategy provides a clear path to exiting the crisis. 

Wolfgang Münchau: Politics will bedevil resolving the euro crisis

Wolfgang Münchau has an interesting take on the bailout/default debate that is relevant to recent posts (see here).

Colm McCarthy: Ireland Has Lost Capacity to Borrow

Colm McCarthy has yet another important article in the Sunday Independent: see here.   I would be somewhat more positive about what was achieved this week with the stress tests (and associated recaptialisations), and also the strengthened commitment from the ECB to continue to act as lender of last resort.   But Colm is right that the critical next step is to demonstrate the capacity to push through with the fiscal adjustment.  

Ireland has lost the capacity to borrow and has been forced into rescue by official lenders. Any country in this desperate position should be making every effort to get the deficit down as quickly as possible.

The decision by the coalition partners for a relaxed programme of deficit reduction is a cop-out on, critically, the one dimension of macroeconomic policy entirely within our own control.

There is no shortage of wishful thinkers offering snake-oil solutions, including unilateral default or leaving the euro. There are no useful unilateral options available to my knowledge but the surging debt mountain is controllable.

A relaxed timetable for deficit reduction means the eventual debt will be higher, and the debt service costs costlier, for the debatable benefit of postponing adjustments which cannot be avoided. Government revenue must increase, and government spending must fall, in any plausible scenario, which means higher taxes and further spending cuts. Higher taxes are coming, everyone knows it, and no useful purpose is served by pretending otherwise. The 2011 levels of current and capital spending cannot be sustained even with large further tax increases. The soft option of borrowing indefinitely is not available unless the IMF/EU, the only lenders, decide that Ireland should be financed into further insolvency.

S&P Rating Downgrade

See here for the reasons behind S&P’s downgrade (registration required).   See here for Irish Times report; here for Bloomberg report. 

This is noteworthy:

The downgrade reflects our view of the concluding statement of the European Council (EC) meeting of March 24-25, 2011, that confirms our previously published expectations that (i) sovereign debt restructuring is a possible pre-condition to borrowing from the European Stability Mechanism (ESM), and (ii) senior unsecured government debt will be subordinated to ESM loans. Both features are, in our view, detrimental to the commercial creditors of EU sovereign ESM borrowers.