The Irish Economy

I return to the case for a new fiscal framework in today’s Irish Times: you can read the column here.

The first graph in this post is really quite alarming. (It would of course have been nice if there had been Irish data!)

For an individual country, ‘internal devaluation’ is the optimal strategy in our situation. (Optimal given our constraints that is — it is an incredibly lousy option relative to nominal devaluation, or being able to run a counter-cyclical fiscal policy.) But if everyone is doing the same thing, then it becomes collectively self-defeating.

This is a European problem, and requires European solutions designed to support demand and prevent continent-wide deflation.

Paul Krugman is alarmed here.

Wolfgang Munchau of the FT says no (at least for the euro area): you can read his article here.

Readers of this blog may be interested in an event taking place tomorrow at the Dublin Writers Museum. José Manuel González-Páramo, Member of the Executive Board of the European Central Bank since 2004, will be delivering an address entitled “Globalisation, international financial integration and the financial crisis: The future of European and international financial market regulation and supervision.”

More information can be found here

To register for this event call Shane on 01 874 67 56

A reader has pointed me towards this nice post by Michael Pettis, which strays from his usual Chinese turf to take a look at Europe. It makes the same points as the ones Martin Wolf has been making about the need for the large countries with ‘fiscal room’ in the Eurozone, particularly Germany, to do everything they can to maintain aggregate demand in the Eurozone.

This should be obvious to anyone with an understanding of intermediate macroeconomics, so I won’t comment on it. But Pettis also cites Barry Eichengreen’s classic Golden Fetters, which readers may not be familiar with, and in particular Barry’s views on the implications of democracy for the maintenance of the gold standard. That system required adjustment through deflation for countries suffering negative shocks. This was not necessarily a problem in the 19th century, when wages and prices were flexible, and universal suffrage was rare. By the 20th century, however, rigidities in the economy were such that deflation implied unemployment; and democracy meant that this economic cost translated into a direct political cost for policy makers. The gold standard, inevitably, broke down when confronted with the pressures of the Great Depression.

I don’t think it’s fair to compare the euro to the gold standard, as Pettis does. The ECB has lowered interest rates, not raised them, although not by as much as other central banks; and both the French and the Germans have applied fiscal stimulus to their economies. On the other hand, it is true that adjustment in the PIIGS now implies deflation there (unless, as the FT points out today, inflation in the Eurozone as a whole is increased). This is going to be both economically and politically costly, and will have unpredictable effects, especially if the Eurozone as a whole experiences a double dip recession.

I suspect that Ireland will find these adjustments easier to bear than most, since emigration gives us both an economic and a political safety valve. (That was a positive rather than a normative statement by the way.)

With all the talk about debt crises last weeek, it is easy to forget that there is a real economic crisis afflicting Europe as well. The 4th quarter GDP numbers were disappointing, and the fact that Eurozone industrial output fell 1.7% in December is alarming. Unemployment is still rising, and the real Eurozone economy is not out of the woods yet. A primary focus of economic policy still needs to be the avoidance of a double dip.

The fact that little Ireland is having to cut expenditure and raise taxes at a time like this will further worsen our own economic problems, but is of no broader consequence. How many Irish people have even noticed what is happening in Latvia? The same could be said of Greece. But if the entire periphery found itself having to fight market panic by cutting in an excessive fashion, simultaneously, that could be very dangerous — especially if Spain, or, God forbid, Italy, became involved as well.

Martin Wolf is very good on this, while those of you of a more temperamental disposition may enjoy Simon Johnson’s latest piece, with Peter Boone. The core Eurozone countries don’t just have to ward off self-fulfilling market panics focussed on the PIIGS, but continue to support aggregate demand in the Eurozone. I understand concerns about government debt, but people focussed on that problem should remember three things. First, deficits will continue to rise if the real economy worsens, and a lack of aggregate demand is still a problem for the real economy. Second, the more the ECB does to loosen monetary policy, the less is the burden which fiscal policy has to shoulder. And third, if we experience another year like 2008-2009 any time soon, the probability of a wave of defaults will rise sharply.

You can find this paper (presented to SSISI this evening)  here.

You can find the slides for the talk here.

Martin Wolf’s FT column looks at the macro fundamentals behind the divergence within the euro area: you can read it here.

Courtesy of Eurointelligence, here is a French take on what is happening.

Update: Tony Barber has a blog entry on Thursday’s summit here.

The FT Analysis page is today devoted to the Greek situation: you can read it here.

In addition, there are two opinion pieces  —-

Wolfgang Munchau advocates a eurozone solution here.

Charles Wyplosz cautions against a bailout here.

The Economist carries an extensive article on this subject - you can read it here.

You can read the newly-released documents here.

John Murray Brown writes in today’s FT on the Irish situation - you can read it here.

Nouriel Roubini and Arnab Das write on the Greek situation and the implications for the euro area: you can read it here.

Jean Pisani-Ferry and Andre Sapir (two very influential economists from the Bruegel think tank) recommend the IMF option for Greece:  you can read their article here.

The current crisis is stimulating calls for reform of the overall governance structure for the euro area.  Wolfgang Munchau makes some proposals in his FT column today - you can read it here.

In this new IIIS Discussion Paper, I discuss the potential role of fiscal policy in stabilising the external account.  The main focus is on the management of imbalances within the euro area; I pay particular attention to the Irish situation.

You can download the paper here.

The FT website carries this explanation of the ‘rescue scenario’ if Greece were unable to fund its liabilities.

This article in today’s FT offers yet another adjustment option: you can read it here.

Paul Krugman has a follow-up post to his earlier one where he points out that being pro-European is one thing, but that being pro-EMU in the 1990s was another.

I have one gripe with the piece: it wasn’t only ugly Americans (and eurosceptic Little Englanders) who were €-sceptical. Here is a newspaper article by Peter Neary, for example, written in 1997, and I have already linked to a longer 1997 piece by Neary and Thom, as well as to a 2000 article by Thom and myself that make my own feelings on the subject pretty clear.

More important, however, are PK’s concluding comments:

Was the euro a mistake? There were benefits — but the costs are proving much higher than the optimists claimed. On balance, I still consider it the wrong move, but in a way that’s irrelevant: it happened, it’s not reversible, so Europe now has to find a way to make it work.

I couldn’t agree more. The logical move at this stage (and some cynics thought this was the point of EMU all along) would be a move to fiscal federalism, so as to smooth out asymmetric shocks, but the French and Dutch votes of 2005 make that a pretty implausible scenario. It is the logical move, though.

Martin Wolf writes on the adjustment problems within the euro area: you can read it here.

Landon Thomas has an article on the fragility of EMU in today’s New York Times: you can read the article here.

This FT editorial outlines the challenges facing the euro area.

This is an interesting paper from the ECB on the legal dimensions of these scenarios.

I’d say this little piece by Paul Krugman, and the associated note, will end up on lots of undergraduate syllabi. Liquidity traps are boring to teach, until you find yourself in the middle of one. From an Irish point of view, however, the key section is the following:

if some subset of the work force accepts lower wages, it can gain jobs. If workers in the widget industry take a pay cut, this will lead to lower prices of widgets relative to other things, so people will buy more widgets, hence more employment.

The point is that the Irish are just a subset of the Eurozone workforce, and that our GDP is the equivalent of Krugman’s widgets, whose relative price can be reduced. Krugman makes the same point in a follow-up post here. Of course, devaluation would be preferable to wage (and price) cuts: it would avoid the debt deflation and rising real interest rates which Krugman talks about. But it is not an option.

The Financial Times continues its alliterative series on Ireland by publishing my letter responding to last Friday’s “Debtors in Dublin” editorial.

This article from Spiegel Online is interesting on the Greek situation, including the role of unpaid invoices as a way to understate the level of debt.

One of the things that Philip has been emphasising since the start of the year is that if wages are cut to the point where workers feel confident that they won’t be cut further, they will then start spending again. On the other hand, workers who fear their wages will be cut in the future will, quite rationally, save for the rainy days ahead. The worst of all possible worlds, from the point of maintaining domestic consumption, would be a situation where wages fell, predictably, in slow motion, over a number of years.

So it is a matter of concern to read articles like this.

A further note: public sector wage cuts are required to reduce the possibility of a ’sudden stop’ in lending to the Irish government. Private sector wage and price cuts are required to prevent unemployment from rising further: Ireland is still an unacceptably expensive place in which to live and do business. It is a matter of deep regret that these are not happening in an across the board manner, and that wages in significant sectors of the economy have actually been rising. Allowing the focus to be on public sector wage reductions alone misses this essential point, and represents a serious political failure on the part of the government.

We are seeing just how difficult it is to achieve nominal wage and price reductions in a modern economy, and just how useful it is to have a currency to devalue. But we don’t have one, and can’t leave EMU. Given that wages are proving to be sticky, and that there is no central Eurozone fiscal authority to help maintain demand here, emigration is the most likely margin of adjustment for our economy in the short run. These are the constraints that we signed up for under Maastricht, as Neary and Thom pointed out in the 1990s, and it is too late to start complaining about it now.

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.

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.

This week’s Economics Focus in the Economist takes a look at this issue.