Author: Karl Whelan

Trichet on Ricardian Equivalence

Jean Claude Trichet’s Jackson Hole speech is here. This bit caught my eye:

The economy, it is sometimes argued, is at present too fragile and thus consolidation efforts should be postponed or even new fiscal stimulus measures added. As I pointed out recently, I am sceptical about this line of argument. Indeed, the strict Ricardian view may provide a more reasonable central estimate of the likely effects of consolidation. For a given expenditure, a shift from borrowing to taxation should have no real demand effects as it simply replaces future tax burden with current one.

The written version of the speech cites two papers by Robert Barro as supporting evidence for this position.

I think it’s worth noting that the Ricardian equivalence idea put forward by Barro—that consumers see deficits and taxes as basically the same thing—has been tested many many times. And the general consensus on this, as I understand it, is that there is very little evidence to support the idea.

Moreover, though the idea works in one very simplified model set up, there are lots of reasons why the proposition does not hold in reality (liquidity constraints, people having finite lives, people not having rational expectations, uncertainty about the path of government spending—see this extract from David Romer’s textbook.)  Very few economists emerge from graduate schools believing in the Ricardian equivalence idea.

There are, of course, lots of arguments in favour of European governments setting out their long-term plans for the restoration of fiscal stability. However, it is a pity to see economic theories that are known to have little support regularly rolled out as arguments for fiscal austerity.

Trichet follows up on his Ricardian equivalence comments by arguing that expansionary fiscal contractions “are not just a theoretical curiosity” with the footnotes citing the old Giavazzi and Pagno paper with its two examples: Denmark in the mid-1980s and, of course, Ireland in the late 1980s. I’ve already said my bit about this, so I won’t repeat it. Suffice to say, this is pretty weak evidence that Trichet is serving up.

High Earners and Tax: Media Misinterpret DoF Report Again Department

The Irish Times reports:

For example, the latest official breakdown on the 423 highest earners in the State showed that for 189 individuals who earned €500,000 or more in 2008, the average tax rate was 19.86 per cent.

I’m afraid this isn’t true. This report does not relate to the 423 highest earners in the State, as I’ve written about here, here and here. It only relates to a subset of the highest earners who would have paid less than 20 percent because of tax loopholes but who are not doing so now because of the introduction of a minimum rate.

To be fair, I don’t blame the journalists because the relevant document is so poorly written.  At this point, however, I really think the folks in the Department of Finance responsible for this report should consider issuing an official clarification.

Update: In comments, Joseph O’Toole reckons I’m being mean to the Department of Finance because this is a Revenue Commissioners report. Well, I found the report here on the Department’s website, which suggests that they are responsible for its release. But, yes, the report is put together by Revenue Commissioners staff.  So let me rephrase my point: Whoever is responsible for this report might think about issuing a clarification.

FT: Pluck of the Irish

The international media are gradually noticing that our plethora of banking sector policies have not worked to restore the Irish banking sector to health but are threatening the health of the public finances. An editorial piece from the Financial Times is highly critical. It concludes:

It is time to staunch the bleeding. As Irish state guarantees near their expiry date, some banks will not be able to refinance their balances. The government should prepare insolvent banks for forced debt-for-equity swaps, which would instantly recapitalise the banks in question and cap the government’s exposure. This cannot be done frivolously; European institutions are exposed and EU partners must be consulted. But someone must put an end to the practice of handing banks blank cheques. Some Irish pluckiness would benefit us all.

I take it the FT will now be dropped from the long list of august international institutions that the government rolls out to claim support its banking policies.

S&P Downgrade Irish Debt, Put on Negative Watch

Standard and Poor‘s have downgraded Irish sovereign debt from AA to AA- and their outlook for the rating (not the economy) is negative. S&P cite the rising cost of the banking bailout as in their statement and project a debt-GDP ratio of 113% in 2012.

On the banking costs, they state

We have increased our estimate of the cumulative total cost to the government of providing support to the banking sector from about €80 billion (50% of GDP; see “Ireland Rating Lowered To ‘AA’ On Potential Fiscal Cost Of Weakening Banking Sector Asset Quality; Outlook Negative,” published June 8, 2009, on RatingsDirect), to €90 billion (58% of GDP) …

We have increased our estimate of the cost to the Irish government of recapitalizing financial institutions to €45 billion-€50 billion (29%-32% of GDP) from €30 billion-€35 billion (19%-22% of GDP). 

Our estimate includes two main components: the upper end of our estimate of the capital we expect to be provided by the Irish government to improve the solvency of financial institutions, and the liabilities we expect the government to incur in exchange for impaired loans acquired from the banks.

Irish ten year bond yields have risen above 5.5 percent this morning and the spread against their German equivalent, at about 340 basis points, is the highest it has been in recent years. The NTMA have objected to the downgrade, arguing that S&P were using an “extreme estimate” of the cost of the banking bailout.

The Enduring Influence of Ireland’s 1987 Adjustment

When I was a junior economist in short trousers, the first research I ever did was inspired by Ireland’s successful 1987-89 fiscal adjustment.  Many international researchers looked at Ireland and decided that our successful adjustment stemmed from consumers stepping into the breach filled by the government spending cuts. The story was that increased consumer confidence, fueled by expectations of lower future taxes, was the key to the recovery.

From the research I did on this topic (both on my own and with John Bradley) I came away fairly convinced that this was not what had happened. Rather, the 1987 boom seemed to be fueled more by strong exports to the UK thanks to Nigel Lawson’s tax cutting exercise.

However, Ireland’s 1987 experience continues to pop up in discussions of fiscal austerity. I have to admit that I’ve not been too impressed by Alberto Alesina’s work (here and here) on how fiscal adjustment can be expansionary—work that has had a lot of influence this year. Well, sure enough, Paul Krugman now cites work from Arjun Jayadev and Mike Konczal showing that the only country that ever cut its way to growth in a slump was, you guessed it, Ireland in 1987. The power of this datapoint endures.