Author: Philip Lane

Honohan on Systemic Risk

His remarks at this week’s Vienna conference are available here

Ireland: Confronting the Problem

The opinion of the economics team at Goldman Sachs is important in shaping market views of the Irish economy and the Irish fiscal position:  see here for the latest briefing note by Kevin Daly.

The Macroeconomic Impact of the Budget

Around the world, there is renewed interest in estimating the macroeconomic impact of fiscal policy. This is notoriously difficult, in view of the myriad two-way interactions between fiscal policy decisions and the state of the economy.  Economic research offers two general approaches: (a) simulations of macroeconomic models; and (b) estimating the impact of fiscal shocks on past data.

There are quite a number of factors to consider in such exercises:

  • What is the exact nature of the fiscal policy?   The macroeconomic impact will differ across different types of government spending and different types of tax policy – there is no unique fiscal multiplier.
  • Is the fiscal stimulus temporary or permanent in nature? If it is the latter, the prospect of higher future taxes (in line with the permanent increase in spending) will act against the short-run stimulative effect of extra spending.
  • Is the increase in spending to be financed by taxes (a balanced-budget fiscal expansion) or through an increase in debt?
  • The interest rate channel.  Under normal conditions, a fiscal expansion will induce a country with an independent monetary policy to raise the interest rate to offset inflationary pressures, limiting the impact on output.  If the level of underemployed resources is high (as at present in many countries), the interest rate may not respond such that the power of fiscal policy is enhanced.
  • Monetary union.  Note that under normal conditions, this suggests that fiscal policy should be more powerful for a member of a monetary union, since the ECB interest rate will not be influenced by conditions in a small individual member country.
  • Trade openness.  The greater the share of imports in total demand, the smaller the boost to the domestic economy from a fiscal expansion.  Moreover, a fiscal expansion will typically induce real appreciation (an increase in relative price of nontradables) that squeezes the tradables sector, such that the composition of activity changes. To the extent that a thriving tradables sector is fundamental for long-term productivity growth, this compositional effect is important.
  • Sovereign risk.  If a fiscal expansion raises investor concerns about debt sustainability, the increase in the sovereign risk premium may neuter the stimulative impact of a fiscal expansion. This is especially the case when the sovereign risk premium also raises borrowing costs for other entities, such as the domestic banks.  In addition to higher borrowing costs, an increased risk profile also leaves an economy exposed to an inability to fund its debt and the consequences of such a ‘sudden stop’ in funding can be catastrophic, with the resolution typically involving a funding package by international institutions.
  • Fiscal dynamics.  The fiscal package in any one year has to be interpreted in the context of past fiscal positions and expected future fiscal positions.  An economy with a structural deficit must cut spending and raise taxes at some point, such that the macroeconomic impact of fiscal tightening must be absorbed – the challenge is to time the fiscal adjustment to minimise the macroeconomic damage.
  • Anticipation effects.  The impact of fiscal policy on private-sector consumption and investment decisions does not wait until budget day – if a fiscal tightening is anticipated, many forward-looking decisions will already have taken into account the prospect of lower public spending and higher future taxes.  Doubtless, the slowdown in consumption and investment in Ireland has in part been influenced by the prospect of major fiscal tightening over 2009-2014.
  • Welfare analysis.  Different types of fiscal policy will have a differential impact on the relative shares of private and public consumption and public and private investment. In addition, the levels of transfer payments and the structure of the tax system will also have significant effects on the distribution of incomes across the private sector.  Such distributional concerns mean that there is no uniquely optimal fiscal policy, since individuals and interest groups will have different preferences across these dimensions.

As I have written about before, it is a matter of deep regret that Ireland should have to undertake fiscal tightening during a big recession.  However, given the size of the structural deficit and the substantial funding risk, it is conditionally optimal to implement such an adjustment.  The goal should be to design the fiscal adjustment such that there is a shift in the composition of spending and taxation in directions that will help the economy to recover as quickly as is feasible.

Finally, it would indeed be helpful if the Department of Finance produced a report that detailed its projections concerning the macroeconomic impact of the budget.  The fiscal plan for 2010-2014 surely incorporates feedback effects between fiscal decisions and macroeconomic aggregates, but the estimates of these feedback effects have not been explicitly spelled out (as far as I know).

Extension: I forgot to make a few more points:

  • One of the lessons from the bubble years, is that it is important to acknowledge uncertainty in making projections – the central forecast must be supplemented by analysis of downside and upside risks to any policy decision.  To me, the main risk is the downside risk of Ireland facing a funding crisis.
  • In assessing the impact of fiscal policy, it is important to work out the impact on future macroeconomic variables in addition to its short-run impact.
  • Given the uncertainties, it is important that fiscal policy choices are robust to changes in specific modelling choices.

Public Sector Reform

Peter McLoone writes an opinion piece in today’s Irish Times: you can read it here.  He details the reforms that were on offer during last week’s negotiations and it is an impressive list  – the scope for substantial efficiency improvements in the public sector seems quite substantial.

In terms of analysis,  eliminating inefficiency in the public sector will help raise living standards across the economy over the medium term.  The union movement has recognised the potential for such fundamental reform and implementing these reforms would be a very positive contribution to the renewal of the economy.

In terms of the short run,  Mr McLoone criticises the deflationary impact of public sector pay cuts. Since the union movement has agreed to a target of €1.3 billion in payroll savings in 2010 (albeit with the protection of the standard hourly rate of pay), I would be interested to know Mr McLoone’s views on the  short-run macroeconomic impact of the alternative package proposed by the union movement.

In today’s edition, there is also an op-ed by my colleague John O’Hagan on public sector pay: you can read it here.

The Public Sector Pay Non-Deal

In the absence of reliable information on the details of the proposed deal, an overall evaluation is not feasible.  However, there are several key issues to consider in interpreting the deal that wasn’t.

At one level, it is remarkable that the broad parameters of the required fiscal adjustment seems to have been accepted on all sides,  such that there was a common overall objective. This should not be taken for granted and is a tribute to the social partnership process – it is possible to envisage ‘alternative universes’ in which the union movement adopted a more rigid attitude and failed to take into account the overall macroeconomic and budgetary situation. This also provides hope that a deal may be feasible in the future.

However, there are some fundamental problems with the union position.  The main point of resistance seems to be that the hourly rate of standard pay  (or pay per ‘unit of effort’) should not fall. Under this approach, beyond the savings from proposed changes to normal working hours that should lead to considerable savings in overtime payments, the balance of the required adjustment has to take the form of a reduction in aggregate work hours.  The decline in aggregate work hours can be achieved through some mix of unpaid leave (the focus of the plan for 2010), the continuation of the recruitment embargo and the various other schemes that have provided incentives for individual public sector workers to reduce the level of work hours.

On RTE radio today,  Mr Begg justified the use of ‘short time’ working by citing its prevalence in private sector adjustment in Ireland and elsewhere. However, there are some major differences. First, ‘short time’ working and partial capacity utilisation in the private sector is typically deployed in response to a decline in demand for the output of the industry or firm in question  – it makes no sense to continue a high level of production if there has been a substantial downward shift in demand, since over-supply will just drive down prices and/or reduce profitability.

In contrast, there is no such downward shift in demand for public services in Ireland (indeed, if anything, there is chronic under-supply of public services in many lines of activity). Accordingly, it is not appropriate to deploy ‘short time’ working as a general adjustment measure in the public sector.

Second, the level of public services can be better protected by achieving a decline in the hourly rate of pay – the more can be done in terms of a downwards shift in the pay rate, the more aggregate work hours can be delivered. In this way, in combination with extensive public sector reform, the prospects for transformation of the public sector would be enhanced by a decline in the pay level.

Another argument that has been applied in opposition to a pay cut in the public sector is that pay cuts are not so prevalent in the private sector.  However, many of the real and nominal rigidities that deter pay cuts in the private sector are the result of the highly-decentralised pay process in the private sector, leading to an inefficient response to macroeconomic shocks.  Indeed, that is a core rationale for activist monetary and fiscal policies – the decentralised market outcome leads to excessively high unemployment in response to adverse shocks.

These conditions do not hold in the public sector, especially under coordinated pay bargaining  – the union movement and the government should be able to internalise the overall macroeconomic environment and recognise that a pay cut can be the efficient response to negative macroeconomic developments and offer a superior outcome to the alternative of undesirable reductions in aggregate work hours.

Moreover, the distributional impact of pay cuts is more attractive than the alternative by allowing the maintenance of a higher level of public sector employment, rather than shifting the burden of adjustment onto those public sector workers whose contracts expire and those will be frustrated in their plans to pursue public sector careers by a recruitment embargo.

As I have repeatedly written about,  the necessity of downward wage flexiblity is essential for small member countries of a monetary union.  Negative macroeconomic shocks will often require a real devaluation in order to restore full employment:  inside a low-inflation monetary union, this can be achieved at lowest cost in terms of unemployment through a reduction in wage levels.  The idea that wages can only be adjusted upwards is not sustainable under EMU.

It is also important to appreciate that a resistance to wage cuts during the current crisis will also carry long-term costs for future pay settlements in the public sector.  In particular, a forward-looking government should be very reluctant to grant significant pay increases in the future if there is no ‘escape clause’ by which wage gains can be clawed back in the event of a large-scale negative shock.

Finally, the focus here on public sector pay should not deflect attention from wider policy issues.  In relation to attaining real devaluation,  a deal with the public sector unions that enables improved productivity in the public sector constitutes another source of a decline in the equilibrium real exchange rate.  In addition, the government can do much to foster wage reductions in industries in which it exerts considerable control. Similarly, it can go further in reducing fee levels in those professions that rely heavily on the public sector as a source of demand.  More broadly, tackling monopoly power across sheltered sectors of the economy will further help to engineer widespread reductions in prices and wages.

In relation to fiscal adjustment,  the public sector paybill represents only one dimension of the overall adjustment. Other spending categories face considerable cuts, while the tax/GNP ratio will have to rise considerably in the coming years.

The scale and multi-dimensional nature of the economic and fiscal crisis does call for a collective effort in its resolution.  As such, social partnership still has a lot to offer – however, an insistence on the ‘nominal fetish’ of no reductions in the rate of pay is not helpful.