More on that ICTU plan

It seems that the intellectual underpinnings of the ICTU plan for economic recovery are to be found in the Swedish government’s response to their crisis in the 1980s. A Swedish dimension is no great surprise in itself: David Begg has long been an admirer and advocate of the Scandinavian model. He was on RTE’s Q&A on Monday night and in the context of the ICTU plan, referred to the writings of an economist who worked for Goran Persson, the then Swedish finance minister. 

Curiously, more details emerged in this morning’s Irish Times in a discreet article secreted away on p.7 www.irishtimes.com/newspaper/ireland/2009/0218/1224241331376.html. According to the piece “the work of a Swedish economist who advised its government when its banking sector collapsed is being used by ICTU as the basis for its ‘social solidarity pact'”. The article goes on to name the economist concerned – Jens Henrikkson – and refers to a paper he published two years ago under the aegis of Bruegel, the Brussels-based think-tank (of Alan Ahearne fame).

I was intrigued that David Begg would identify a specific paper as the inspiration of the ICTU position and decided to check it out. I suggest that others check it out too. It is called “Ten Lessons About Budget Consolidation” and was published as part of the Bruegel Essay and Lecture Series in 2007. It can be downloaded (after a little bit of search activity) at  http://www.bruegel.org/Public/Section.php?ID=1157

If David Begg is a big fan of this guy and the approach he advocates, there is a light at the end of the tunnel. Henrikkson’s first lesson is: Sound Public Finances are a Prerequisite for Growth; his second: If You Are In Debt, You Are Not Free. He recounts, inter alia, how the Social Democrat government of the day engineered across-the-board cuts in spending, including cuts in welfare benefits.

Henrikkson has quite a few things to say that The Two Brians could usefully take to heart. Some samples: “An ad hoc hodgepodge of measures will only have a limited chance of success” and “It is of great importance that the minister for finance is conservative when it comes to prognosis”.

The downside of all of this is that whatever intellectual debt the ICTU document owes to Henrikkson is not obvious from the document itself. But maybe what Begg is saying is: if you want to know where we really stand, as distinct from the public posture we have to take, you’ve got to read this other stuff too.

Ireland’s borrowing capacity

I didn’t expect to be asking this question again (I thought about it a lot a quarter century ago), but how much Government debt do contributors believe the Irish economy can support? A lot more than it has at present, of course.

But I raise the point now because Morgan seems sure in his latest newspaper article (not as incendiary as the previous one). It’s OK, he says, if the Banks have “bad debt” of only €10-20 billion; not OK if this number goes up to €50-60 billion.

OK, by “bad debt” I presume he means prospective loan losses. And I suppose he also may be ignoring the fact that the banks still have upwards of €20 billion of book equity capital to burn through before the Government starts taking the hit — but let’s ignore such details.

The interesting point is that the difference between his low figure and his high figure is only 22% of forecast GDP for 2009. Can we be so sure that one figure is affordable, and the other not?

Seems to me that the taxation collapse, and the resulting surge in the deficit on normal operations, is at least as big an issue in terms of a sustainable debt path as the prospective banking losses, large though these are.

Foir Teoranta Nua?

A report in this morning’s Sunday Independent flies the kite for a new State Agency to invest equity in private companies. Inevitably, this will remind some of Foir Teoranta, a state agency which was officieally described as a lender-of-last-resort to private companies in the 1970s and 1980s.

Founded in 1972, Foir Teoranta’s stated objective was “to provide reconstruction finance for potentially viable industrial concerns which are unable to raise capital from the normal commercial sources.”

I’m not aware of a systematic analysis of Foir Teo’s effectiveness in that period. Maybe readers can remember more. But my impression is that, on its dissolution in 1991, it was not widely regarded as having been a brilliant success.

So what would make a new company of this type successful? The Indo’s article confirms that it would be well-managed, so that’s all right. But what else? The intended emphasis is said to be on equity, rather than debt (which was Foir’s main instrument). But is that a strength or a weakness in the current climate? How would it complement the European Investment Bank’s EIF, which seems to be in the same territory?

Would it be better to think in terms of a partial credit guarantee scheme instead? After all, if the banks are to receive huge injections of government capital, should one not be thinking of them as a natural source of finance to keep viable firms going? Partial credit guarantee schemes have been the policy instrument of choice for governments wishing to expand credit to small and medium enterprises, and there is an astonishing number of such schemes around the world. However here too there are severe risks; my recent review of these schemes emphasizes the drawbacks and the need for careful scheme design, if damage is to be avoided.

Committing the NPRF

Should the NPRF be used for bank recapitalisation? 

I have always thought the fund a good idea.   It helped increase national saving by reducing measured budget surpluses.   (These surpluses would have been difficult to sustain politically.)  And I believed it would make pension benefits more secure in the face of a rising tax cost as the population ages.  Along with many others, I thought the fund only a good idea if investment decisions were not politicized.   That seems almost quaint. 

I now think it serves another purpose that I simply did not appreciate.   Others were more prescient.   It provides a valuable bulwark against the tail risk of a real “run-on-the-country” kind of crisis (that includes both bank and government debt).   The risk is nicely captured by Larry Summers in his 2000 Richard Ely lecture on international crises.   As he says, in this kind crisis the mode of investment analysis shifts from “economics to hydraulics.”  Fundamentals become irrelevant as everyone tries to get their money out before everybody else.  

The existence of a large and relatively liquid NPRF makes falling into such a bad equilibrium less likely.   I therefore think the Government should be slow to commit a large chunk of the fund to bank recapitalization.  My sense is that it would be better to borrow the funds, notwithstanding the recently increased spread.   Having a substantial liquid sum on the asset side of the government’s balance is valuable insurance in perilous times. 

Irish bond spreads

I was idly looking for patterns in the daily evolution of eurozone government bond spreads (like you do) and thought I would share some findings. The spread of Irish Government bonds over the 10-year German benchmark have of course trended upward during the period since early September 2008 to last week:

If we compute principal components of the spreads of ten euro-currencies we can try to isolate the different factors: separating factors that affect all countries from those that affect Ireland in relative isolation.

Using daily changes in the spreads, the first three principal components explain 80% of the total variation in the ten series.

All ten bonds have roughly equal loadings on the first PC (which alone explains 62%). We can therefore think of PC1 as measuring fluctuations in general aversion to credit risk.

PC2 seems to measure a component which is irrelevant to Ireland — from the loadings this one looks like Club Med vs the North.

But PC3 is an almost Ireland-specific factor, much smaller loadings on the other countries. The big action in PC3 is on just three almost consecutive days in January: the 16th (Anglo nationalization), 19th and 21st.

To me this illustrates just how easily spooked this particular market is. Anglo nationalization was not even demonstrably bad news. When will it settle down to a realistic assessment of Irish risks?

Note:

The linear regression equation explaining changes in the Irish spread in terms of three principal components is (t-stats in parentheses):

ΔIreland = 0.020 + 0.015 PC1 + 0.042 PC3 + 0.024 PC4
(17.7) (32.7) (32.0) (15.6)
RSQ=0.958 DW=2.16

The constant term reflects the general upward trend in Ireland’s spread (which is not explainable by this method).

(Of course there are many methodological tricks one could explore, but it’s getting late and this seems enough for the present. Probably some readers do this stuff for a living!)

Some Progress in Understanding Fiscal Impact of Pension Levy

As reported by today’s Irish Times, the tax offset means that, while the pension levy saves €1.4 billion in gross terms, the tax offset means that the net saving will be €900 million in a full year: the explanatory articles are here and here. However, according to the Irish Times report, the loss in tax revenue as a result of the levy was already factored into the previously-published tax projections of the government. Accordingly, it is the gross €1.4 billion that is relevant in getting to the target of  €2 billion in savings.

More on the Government Plan

The Department of Finance has released an explanatory document on the plan (including a ready-reckoner to work out how much public sector workers will lose at each income level): you can read it here.

It would be useful to see a more extended presentation of the government’s fiscal plans for 2010-2013. Although the cancellation of the scheduled pay increases will achieve €1 billion of the required €4 billion adjustment in 2010, the balance between spending cuts and tax increases remains unclear for each of the years 2010-2013.  While yesterday’s plan is a start, it is important to present the multi-year strategy as soon as possible. Otherwise, economic performance will continue to be affected by an avoidable level of uncertainty regarding tax and spending levels. If the government wishes to secure agreement with the social partners on the non-pay elements, the process needs to re-start sooner rather than later.

Update:  As noticed by Patrick,  Department of Finance now has a new ‘ready reckoner’ that adjusts for the reduction in taxable income: you can find it here.

The Government’s Plan

The statement by the Taoiseach can be read here.

The plan is quite remarkable in specifying substantial expenditure cuts, including the de facto reduction in the take-home pay of public sector workers via the pension levy. It was also welcome to see the extension of a reduction in remuneration levels to those providing professional services to the government.

Accordingly, this plan represents a welcome initial step in fiscal adjustment. As indicated in the Taoiseach’s speech, the fact that the unions could not agree to the plan does not mean that the social partnership approach has failed (the negotiation process delivered a ‘near endorsement’ of the plan and achieved a common consensus regarding the scale of the problem). Indeed, now that the pay element has been dealt with, it is plausible that social partnership talks could resume quite quickly regarding other elements in the overall strategy.

Internationally, this plan should help to dampen concerns about the state of the public finances.

Winds of change

The Guardian has an article today on a topic which we will be hearing a lot more about in the months to come, the ways in which many corporations exploit the possibilities afforded them by globalization to minimise their tax burden. It followed a short piece in yesterday’s Tribune on reports that Ireland is on a list of tax havens currently doing the rounds in Washington. According to the paper,

The Department of Finance told the Sunday Tribune the list had been rejected by the previous Bush administration, which said it oversimplified the issue. It said that it shared the Bush administration’s assessment of the list.

So that’s alright then.

The View from ICTU

Paul Sweeney is today’s contributor to the Irish Times series: you can read his article here.

There is much in his article that would be commonly accepted across the economics profession. However, I discuss below a few points of potential disagreement.

His article seems to suggest that those who advocate cuts in public sector pay are necessarily against the elimination of tax breaks for businesses, farmers, property development etc .   Rather, I would think most of those who have written on public sector pay  would also agree with the elimination of most of these subsidies (see, for example, my own paper.)

He also argues that our low-ish international ranking in earnings means that labour costs are not a major problem. However, it is important to make a distinction between ‘movements along the labour demand curve’  and ‘shifts in the labour demand curve’.    If we can boost productivity, we can raise wages and employment at the same time through an outward shift in labour demand.   Everyone is in favour of this, of course.  However, boosting productivity growth is complex and is really a medium-term process (few instantly effective policies).

However, at the current level of productivity, we can still raise employment by accepting a wage cut (a movement along the labour demand curve).  At a time of sharply rising unemployment, this seems like a sensible approach.

The article suggests that the economic model must “shift rapidly from Boston to Berlin: from the Anglo “shareholder value” system, to the European “stakeholder” model“.  It is certainly true that the crisis should lead to a deep and critical re-assessment of how we should regulate the banking sector and, more generally, the appropriate extent of government regulation across the economy. However, the recession is now getting to be as deep in Europe as in the United States, even if  the origin was American-made. The appropriate analytical framework also needs to be wider than ‘US v Europe’ in view of the rising share of world output that is generated by the emerging markets.

Finally, the article refers to ‘conservative economists’.  I am not sure exactly what he means by that term, but I doubt that the political preferences of academic economists can be easily inferred from their views on topics such as public sector pay.   It is possible to analytically conclude that public sector pay cuts would be a good idea for the overall economy, while holding a very diverse range of views concerning the appropriate level of redistribution in society and other dimensions that differentiate ‘conservatives’ from others.

In similar vein, the article suggests that a neoclassical approach to economics requires a belief in ‘efficient markets’.  This is at odds with the evolution of the profession, with much of the last two decades devoted to using neoclassical economics to analyse market failures (very long list of contributors).

How to Increase the Tax Take

I am interested in the readership’s opinions on how to increase the tax take in ways that respect the advice of Jean Baptiste Colbert (1619-83), finance minister to Louis XIV: “The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.”

Ireland can learn much from the new Mirrlees Report in the UK that commissioned studies from the world’s leading tax experts. See the material here.

It is also interesting / entertaining to read about some novel taxation strategies: taxes that vary with age, gender and height at least do not suffer from moral hazard, since it is quite difficult to change these personal attributes!

Alberto Alesina’s propsal to condition tax rates on gender is explained here.

The logic of conditioning tax rates on age is explained in this post by Greg Mankiw.

His proposal to condition tax rates on height is explained here.

The Curse of Fiscal Procyclicality

Rossa White is today’s contributor to the Irish Times series: “The Time to Take Hard Decisions on Public Pay is Now“.

He concludes by advocating a new system that will avoid fiscal procyclicality in the future, through a ‘golden rule’ policy, plus the establishment of a rainy-day fund.

Institutional reform along these lines is highly important. Indeed, I post a link below to a 1998 article  I presented at Kenmare and published in the now-defunct Irish Banking Review, in which I advocate a similar approach.  However, I wonder about the political incentives to establish such institutional restraints on the conduct of fiscal policy. Again, the current crisis may provide the right environment for undertaking such reforms.

Philip R. Lane, “Irish Fiscal Policy under EMU,”  Irish Banking Review,  1998.

Taxes and Incentives

The media reports suggest that ICTU has proposed a new top income tax rate of 48 percent. If various levies are added to that, the effective marginal income tax rate for high-ish earners could exceed 50 percent.

I am interested in the views of this blog’s readership on the extent to which a top tax rate in this range might adversely affect economic performance, in the specific context of the Irish economy and the Irish labour market.   For myself, I think it is important that the top tax rate in Ireland does not deviate too much from the UK top rate, which is due to be raised to 45 percent after the next election, in view of the high labour mobility between Ireland and the UK.

A not-so-modest proposal

With the massive hole in the public finances, it seems unavoidable that the tax take will rise sharply.   On the positive side, Ireland at least has more tax room than other countries.   On the negative side, near-term, large-scale increases in taxes will further harm demand leading to a further turn in the vicious cycle.   Indeed, the expectation of lower after-tax income must already be curbing household spending.    Moreover, higher taxes will undermine the incentives-based model that has underpinned Irish growth. 

What to do?  

I have previously thought Ireland was fortunate to have avoided an unfunded earnings-related state pension system.   But it is time for some new thinking in what is now a full-blown economic emergency.   Weighing the benefits against the costs, I think a “notional defined contribution” unfunded system would be a large net positive.   Under this system, benefits are rigidly linked to earlier contributions.   For a given contribution rate, contributions receive a “notional” rate of return equal to the growth rate of the wage bill.   But the system is unfunded, so that the revenues are made available to the government today.   There is effectively a “free” period where the government receives revenues but does not have to pay out benefits. 

Why is this a good idea?

First, and most immediately, it would allow for a sizable inflow of funds to the exchequer.   With a contribution rate of 6 percent and a base equal to the entire wage bill, the government would raise roughly 4 percent of GNP (assuming a labor income share of GNP of two thirds—hopefully someone can fill in the correct labor share).    This would largely meet the massive correction penciled in for 2010 and 2011 (though it might make sense to phase it in more gradually).  

Second, the disincentive effects of higher marginal tax rates would be greatly diminished by the strong link from contributions to benefits.   Indeed, it is reasonable not to refer to the contribution rate as a tax rate at all.   The alternative of dramatically higher income tax rates is likely to be a huge drag investment and enterprise going forward. 

Third, the adverse effect of the fiscal correction on expected lifetime income would be minimized as today’s contributions lead to higher future benefits   This is critical in an environment where household confidence in their future after-tax income has collapsed. 

Fourth, the decimation of many private-sector defined-benefit schemes has left many workers dangerously exposed.   At least for those earlier in their careers, this scheme could help build pension “wealth.”

One way to view the policy is as a form of long-term borrowing from current workers.   It is a response to the fact that traditional borrowing through the debt markets is, many believe, reaching its limits.   In return for their contributions, workers under this policy receive a special form of asset–a promise of future benefits that is tightly linked to their contributions.   While there is a risk that the government will renege on its benefit promise.  The recent experience with losses on financial wealth should be borne in mind in assessing the extent of risk in this system.    

A word of caution:  I think it would be critical to avoid turning this into a redistributive scheme.   Lifetime redistribution should continue to take place through the flat rate pension/proportionate PRSI contribution system.   Blurring the link between contributions and pensions would greatly undermine both the incentive and relatively benign income expectation effects of the policy.  

I think it would also be a mistake to demand employer contributions.   Unlike the employee contributions, employer contributions would be a pure labour tax, the last thing that is needed right now.   It would probably also make the policy a political non-starter in the current climate. 

I don’t pretend this is a free lunch—future generations would be stuck with it.   But it may be the closest thing to a free lunch we have.   As a general rule, it is not wise to make long-term policy such as pensions policy to deal with a crisis.   However, it is worth remembering the US Social Security system was introduced during the Great Depression.  

It is far from perfect.  But what are the alternatives?

How to Fix the Economy

Alan Ahearne is today’s contributor to the Irish Times series: “Income Tax Rates Will Need to Rise.” (As usual, headline does not give full flavour of the article.)

The fiscal plan of Fintan O’Toole is also worth reading: “Government Reaction to Crisis Needs to be Credible.” A longer version of this article would have been even more interesting, in which the economic consequences of the pay element of his plan might be explained in more detail.

Issues in The Sovereign Credit Default Swap (CDS) Market: Guest contribution by Dan Donovan

I am pleased that Dan Donovan (a highly-experienced trader in the financial markets) has taken the time to write an explanatory note on some of the most important features of the sovereign CDS market. See his contribution below.
From Dan Donovan:

As the current malaise in the credit markets unfolds one of the rapidly emerging issues has been the markets concern about various sovereign solvency issues, most particularly with regard to the ability or otherwise of countries to be able to pay for the varying forms of bank guarantee’s they have proffered.

Most agents seeking to express views that sovereigns would be unable to meet their commitments and or that the cost of doing so will escalate have been doing so via the Credit Default Swap market; buying “insurance” against the default of the named sovereign. It is note worthy how quickly and dramatically the cost of this insurance has escalated.. Ireland as can be seen below (ex Iceland) has borne the brunt of this position taking.

5y                  10y
Port     134/144       130/150
Ital      177/187       172/182
Gree    260/290       255/285
Spa     148/158       145/160
Irel      260/300       240/290
UK      140/150       137/147
Denk    109/119       108/120
Swe      110/125       115/130
Aust      145/155       145/145
Ger           56/66            56/66
Fran          63/73             64/74
Finl           55/65             57/67
Belg     115/135       113/133
Neth     105/125        105/120
Iceland  925/975          800/1000

Source JP Morgan.

It is tempting to dismiss such moves as merely a thin market overreacting to the current zeitgeist, for instance it now costs roughly 3 times as much to insure against a default of the UK government as it does to insure against the default of Cadburys! There are however some important issues to consider regarding the implications of such moves.

Price Setting: Many participants in the market are able to switch between writing CDS insurance and buying Government bonds. As such the CDS market which is more active than the underlying market can have the effect of defining the cost of borrowing for sovereigns despite the fact that there is very little in the way of transparency regarding who the agents in this market are and what volumes have been traded. Governments could be forced by virtue of this market to pay unnecessarily high (perhaps punitively high) borrowing costs.

Agency Issues:  The existence of the Sovereign CDS market may change, considerably, the motivation of traditional suppliers of credit extension to sovereigns.

Whilst the CDS market is a zero sum game, it is however conceivable that certain groups can accumulate considerable positions in the CDS (buying insurance) of a given Sovereign without holding any underlying positions in the securities referenced by such a CDS. It would then be optimal for such agents to fail to support the issuance programmes of the country in question. The reason being that this will benefit the CDS they own via the spread moving wider or in the extreme technical default of the Sovereign triggering the CDS contract. Under normal circumstances this issue would be so remote as to be irrelevant, but these are far from normal times and as such these issues need consideration.

Possible Solutions: It is certainly arguable that CDS contracts have been far from a force for good in these times and have done more damage than good and should be outlawed. It would be difficult to “put the Genie back in the bottle” however and as is the case in banning short selling may have severe unintended consequences. One simple strategy would be to enforce disclosure of all agents Sovereign CDS positions. Such transparency could be delivered in a very short time frame and would enable Issuers and the market in general to understand and interpret the actions of the varying market constituents more clearly.

Social Harmony and Fiscal Reform

Social solidarity is clearly highly desirable during a period of severe economic and fiscal distress. Accordingly, it is important that the government works out a fiscal adjustment programme that is rigorous but still perceived by the general electorate as distributing the burden as fairly as possible.  Of course, fairness is in the eye of the beholder to some extent but a primary political objective should be to successfully achieve fiscal stabilisation while avoiding social disruption that is now evident in some other European countries. See this article in The Times (London) on the upheaval in Iceland and Greece.

Krugman: Nominal Wage Cuts Necessary but Difficult

Paul Krugman discusses the problem facing those EMU member countries that are currently suffering from a lack of competitiveness (note, by the way, his use of the word competitive!) and accepts that nominal wage reductions are a necessary part of the adjustment: you can read his discussion here.

He also links to a posting by Edward Hugh that probes the difficulties involved in engineering nominal wage reductions: you can read it here.

Where is Ireland’s Tax Burden Heading?

In my discussion at Monday’s conference (slides here), I raised the question of where Ireland’s tax burden was going to settle down once the public finances have been stabilized. The Addendum to the Stability Report published last week by the Department of Finance shows how the Gross Budget Balance can be brought back to a deficit of 2.5% by 2013 through an adjustment process in which the revenue share of GDP stays roughly stable so that almost all of the adjustment occurs on the Revenue side. The document itself does not comment on the composition of the adjustment described in this table, so perhaps this isn’t an actual plan but instead an illustrative example. Still, it’s worth starting with as a baseline for discussing where we are heading.

I noted on Monday that the plan projects a government revenue share of GDP of 34% in 2013 and that this is well below the equivalent share for EU15 countries, which has been stable at about 45% for a number of years. A number of observers at the conference questioned this calculation on the grounds that the calculation should be done relative to GNP. In particular, since GDP has been about 17% higher than GNP in recent years, one might want to adjust the tax share upwards by this amount. Doing so would give a figure for 2013 of about 41.5%. This is still a reasonable amount lower than the EU15 average but not nearly as much as the figures I quoted

However, I do not view this higher GNP-based figure as a useful one, for two reasons.

First, I believe that GDP rather than GNP should be viewed as the correct tax base when making calculations of this sort. GDP represents all the income generated in this country and, technically, all of it is available to be taxed by the Irish government at whatever rate it chooses. Of course, profit income generated by multinational corporations is likely to move elsewhere if we tax it at a sufficiently high rate but this is an issue faced by all governments, not just our own.

Second, if one is going to exclude the substantial factor income repatriated abroad (€28 billion in 2007) from the tax base it is not consistent to then include the taxes earned on this income in the measure of the tax burden. Assuming that the €28 billion figure represents corporate profits repatriated after paying the 12.5% corporate tax rate, one comes up with a figure of €4.1 billion in taxes paid by multinationals on repatriated profits. Excluding tax payments of this magnitude would give a 2013 (adjusted) tax share of GNP of 39%. So, even if one agreed with the idea of GNP as the tax base, an internally-consistent calculation of the Irish tax burden would still leave it well below the European average.

The broader and more important point here is that we need a wider debate about the shape of future fiscal adjustment than the one currently taking place, which focuses almost without exception on the need to reduce public sector pay.

Ten Years of the Euro

We now have a full decade of evidence concerning the impact of European monetary union on Ireland and the other member countries. While my view is that the euro has been beneficial in many ways, the next year or two will be highly revealing about the capacity of member countries to undertake economic adjustment while operating within the constraints of a common currency area.

The Economist has a nicely balanced article in its most recent edition: “Demonstrably Durable“, while John Hurley had an op-ed giving the local central bank view in the Irish Times on December 30th.

I gave my own view on the impact of the euro on Ireland in an article for the Sunday Business Post back in May: you can read it here.

I have also recently written a couple of academic survey papers on different dimensions of the euro:

EMU and Financial Integration,” IIIS Discussion Paper No. 272, December 2008. Prepared for the 5th Central Banking Conference of the European Central Bank.

The Macroeconomics of Financial Integration: A European Perspective,” IIIS Discussion Paper No. 265, October 2008. Prepared for the 5th Annual Research Conference of DG-ECFIN (European Commission).

Designing a Fiscal Response for the Crisis: The IMF View

The IMF has released a detailed study about the optimal design of fiscal policy to combat the crisis. A key feature of this report is that it accepts that the appropriate fiscal response varies across countries. In particular, this extract from an online interview with two of the report’s authors (Olivier Blanchard and Carlo Cottarelli) is relevant to the Irish situation:

Cottarelli: That said, it is critical that this fiscal stimulus isn’t seen by markets as undermining medium-term fiscal sustainability. That would be counterproductive, including in its effects on demand today. Indeed, we’ve said that not all countries can afford a fiscal expansion.

How the stimulus package is designed is also key: fiscal measures should be reversible, and governments may want to precommit to unwinding some of the policies. Also, any stimulus should be formulated within a robust medium-term fiscal framework, which could be made more credible by strengthening independent oversight of fiscal policy.

Tax increases are inevitable: discuss

Garrett had an article in the Irish Times on Saturday which I thought made an important point: the scale of the deficit is so large, that to claim it can be fixed by expenditure cuts alone is inherently implausible. (Although a pay cut for people like us would certainly help.) Presumably (?) the government understands this, and doesn’t really mean it when it claims there will be no more tax rises.

So: what tax increases will do the least damage to the economy? Like expenditure cuts, all tax hikes will obviously drive the economy further into recession, but given that we have no choice here, the question as to what is the least-worst strategy seems worth posing.

Free riding

Nice article in the Irish Times today by Jim O’Leary. I particularly liked the following unusually honest section:

The case for borrowing more to fund an attempted stimulus package would be more difficult to rebut if there was a high probability of it being successful, but fiscal stimulus is notoriously difficult to effect in a very open economy like Ireland. The reason is that a high proportion of any increase in demand leaks out through imports.

From our point of view, the best sort of stimulus package are those put in place by our trading partners since these boost demand for our exports without costing us anything. And here, the good news is that most of our main trading partners have announced reflationary fiscal measures of one sort or another in recent weeks/months. What we need to do is ensure that we are well-positioned to avail of the opportunities that will flow from these and what that means, first and foremost, is reducing our production costs to competitive levels.

It is hard to disagree with the logic. If the amazingly profligate government we have had over the past decade had listened to people like JOL on issues like benchmarking, then we might have tried to pull our weight as part of a Europe-wide reflationary package, but as things stand, we are going to have try to free ride. Not very glorious (and rebalancing the books will obviously make a bad recession worse) but there you are.

But let’s hope that too many others don’t also take a similar view! The thing about free riding is that what is individually rational can be collectively disastrous. Dani Rodrik is gloomy here.