Author: John McHale

Self-defeating deficit reduction?

Karl’s post yesterday led to an important exchange about the possibility of self-defeating deficit reduction, with particularly important contributions from Michael Burke and Michael Taft.   If multiplier and automatic stabiliser effects are sufficiently large, the understandable concern is that cuts in the discretionary deficit could actually raise the deficit overall.  We end up with the worst of both worlds – a deeper recession and a larger deficit. 

Effectively, the argument is that the deficit reduction measures slow the economy, and this leads to automatic stabiliser effects (falling tax revenues and rising expenditures) that offset the discretionary effect (i.e. the underlying change in the deficit holding GDP constant).  

While plausible, I believe the claims for self-defeating deficit reductions are wrong – or at least wrong in the context of the simple (and I believe essentially correct) model that I think all the main participants in the debate are using.   I sketch this model here.   Using the model, it can be demonstrated that a discretionary deficit cut will lower the overall deficit for any (non-negative) values of the deficit multiplier and automatic stabiliser coefficient.   Moreover, it can be shown that the deficit as a share of GDP also falls with a reduction in the discretionary deficit, even as this reduction slows the economy through a multiplier effect. 

Of course, a simple model cannot provide the last word on the issue.   But hopefully it will at least help us pinpoint better the sources of the disagreement. 

Those arguing against the need for austerity point out that the underlying deficit has grown with previous rounds of austerity.   While I agree that these measures have slowed the economy, I do not believe that they have actually caused the deficit to rise.   Unfortunately, there are other contractionary forces at work, not least the overhang of debt that is curbing business and household spending and also bank lending.   With bond yields where they are, I assume we all agree that we cannot avoid a bailout/default without putting the deficit quickly on a downward path.   I don’t see we have any choice now but to pursue tough deficit reduction measures.   It is not going to be pleasant. 

Abandoning the four-year plan

The publication of the Autumn QEC certainly has created a stir this morning.  Having been an advocate of front-loading the adjustment – albeit with nuance – the ESRI have now expressed doubts about the four-year time frame.

I am bit puzzled by the shift in their position.  Based on the Institute’s evolving view of the economy, I would have thought the case for back-loading was actually stronger a year ago.   While already stressed, international credit markets were then more favourable to the “peripherals” than they became after the Greek crisis.   In addition, the ESRI were then forecasting what was effectively a V-shaped recovery.   This suggested room to avoid an excessively pro-cyclical adjustment.   (A basic principle here is that there is more scope to smooth temporary growth shocks than persistent shocks.) 

Now that credit markets have turned extremely unfavourable and the underlying output path looks closer to the dreaded L-shape, I actually see less room for manoeuvre.   (It is interesting that the ESRI are now focusing on their low-growth scenario from their Recovery Scenarios update, which itself might be viewed as in line with a modest V-shaped alternative, with average real growth of 3.2 percent between 2011 and 2015.)  Moreover, the need to establish credibility around a focal adjustment path has if anything increased – the most obvious being the 4-year path already agreed with the European Commission and the major political parties.   

From media reports, it appears that outside observers consulted by the ESRI are increasingly concerned by the poor outlook for growth.   But the main reason for the worsened outlook is the drag caused by Ireland’s balance-sheet recession.   While a contractionary fiscal policy will slow growth even further, I can’t see how extending the adjustment period is the best route to convincing investors that we can steer our way through this without default.   

Fairness and Fiscal Strategy

In addition to the budgetary strategy itself, I hope the Government are hard at work on the political strategy for the four-year plan.   Unfortunately, it seems chances are fading of a limited degree of political consensus to support the credibility of the plan.   As I have written before, I think it will be essential that people focus on the overall fairness on the package rather than on individual measures that particularly target them — there will be lots of the latter for all of us.   The ESRI’s SWITCH model is the best tool available for establishing the allocation of burdens for the plan as a whole.   Tim Callan and co-authors show the power of the model at today’s Budget Perspectives conference:  paper here; slides here.

In the UK the new government appear to realise the importance of the overall perception of the fairness of package, and the debate there is more advanced.   Philip Stephens has a nice piece on the politics of fiscal adjustment today’s FT.   (As a read it, it is hard not to think of the damage done by Mr. Sutherland’s fly-in pontificating.)  Using the example of changes to child benefit, Stephens captures well the challenges involved with coming up with a package that is widely viewed as fair:

Fairness, of course, lies in the eye of the beholder. Though it might seem entirely reasonable to most people that those earning more than £44,000 a year or so should lose child benefit, the anomalies thrown up as between two- and single-earner couples appear less so. What will ultimately matter, though, is how the nation comes to see the spending package as a whole.

We may know more after the weekend. The title of Brian Lenihan’s Keynote Address at the DEW 33rd Annual Economic Policy Conference in Kenmare is “Current Issues in Political Economy”.  

McCarthy and Varadkar on Fiscal Strategy

Colm McCarthy makes an important contribution to the fiscal debate in today’s Irish Times.   I agree with most of it: the precariousness of creditworthiness, the rebuttal of Ray Kinsella, and the reputational damage associated with an IMF/EU bailout. 

But Colm continues to provide the best analysis around of half the challenge facing the government – creditworthiness.   The other half is the collapse in domestic demand.   Colm is right that there is a tradeoff between the two.    What he doesn’t offer is suggestions on how the tradeoff can be improved, such as measures that increase the credibility of the four-year plan that would limit the necessary degree of front loading. 

Leo Varadkar’s piece in the Sunday Business Post is interesting in this regard.   On its face, it might seem that he is advocating an extreme front-loading of the adjustment.    The twist is that he advocates using the NPRF to maintain investment spending.   Thus he combines a large upfront and permanent improvement in the deficit with measures to limit the deflationary impact.   Of course, this could also be achieved by directly protecting the capital budget and imposing bigger burdens on current spending and taxation.  But that does not appear politically possible.   Deputy Varadkar’s proposal would obviously also be very difficult to pull off.   But it is worth debating. 

Unlike many others, I think the NPRF had value for its stated purpose of pre-funding future pension costs.   But that ship has sailed.   More recently, it has served as a valuable liquidity backstop against a self-fulfilling fiscal crisis.   It is worth considering now how the fund might be used to improve the creditworthiness-demand tradeoff.   

More on Taxes

The debate on taxation policy has heated up in recent days.   Readers might find KPMG’s Income Tax and Social Security Rate Survey 2010 of interest.   It is available for free download here.  The Economist has a piece on the survey, but does not include Ireland in its main comparison figure for the effective tax rate at an income of USD 100,000 (gross).   The effective rate for Ireland is 30.3 percent, which puts us in the middle of the pack (pages 11 & 12). 

Some other tables and figures in the survey show that we should not exaggerate the extent to which Ireland is a low tax country for middle to higher earners.   See the table for the highest rate of income tax (2003-2010) on pages 9 & 10; and also the figure showing the US dollar income at which the highest rate kicks in on page 28.   I’m sure our tax experts will have some quibbles with the calculations.   But it does help to put tax rates for higher earners in a useful comparative context.