Category: Fiscal Policy

Puzzling Budgetary Reporting

I’m having trouble making sense of most of the reporting of the budgetary discussions.

Two issues are particularly puzzling. The first is the consistent referencing of the idea that the higher requirement for budgetary adjustment is due to a relatively recent worsening in the forecasts for the Irish economy. (Indeed, a number of government politicians have also made reference to the idea that this worsening stems from a recent downgrading of the outlook for the international economy.)

The second is the dismissal of the €7 billion figure for budgetary adjustment mentioned by Michael Noonan and the lack of reference to the 10% deficit target that had been set for 2011.

Continue reading “Puzzling Budgetary Reporting”

How Big (Small?) are Fiscal Multipliers?

Ethan Ilzetzki, Enrique G. Mendoza and Carlos A. Végh provide new empirical evidence (using a different method to the recent IMF study). The paper is here and the abstract is below.

Abstract: We contribute to the intense debate on the real effects of fiscal stimuli by showing that the impact of government expenditure shocks depends crucially on key country characteristics, such as the level of development, exchange rate regime, openness to trade, and public indebtedness. Based on a novel quarterly dataset of government expenditure in 44 countries, we find that (i) the output effect of an increase in government consumption is larger in industrial than in developing countries, (ii) the fiscal multiplier is relatively large in economies operating under predetermined exchange rate but zero in economies operating under flexible exchange rates; (iii) fiscal multipliers in open economies are lower than in closed economies and (iv) fiscal multipliers in high-debt countries are also zero.


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. 

Sticking to 2011 Deficit Goal of 10% Requires €7 Billion Adjustment

Despite all the focus in the past few days on 2014 and European Commission, the key issue facing us right now is the how to convince sovereign bond markets that we are back on a stable fiscal path. Without access to the bond markets, you can be sure that the EU will be imposing the 3% target on us whether we like it or not.

Last December, the government told the EU that our general government deficit would be 11.6% in GDP in 2010 and 10.0% in 2011. So the questions we should now be asking are whether we should still aim to achieve the 10% target and, if not, what are the consequences of missing this target.

Michael Noonan appears to have said yesterday that the Department of Finance briefings called for €7 billion in adjustments. The department is now saying that “Given the current working macroeconomic forecast, indicative deficits were set out for consolidation packages of the order of €3bn, €4.5bn and €7bn.”

Fair enough, they could have set out a no-billion in cuts scenario for all it matters. However, as far as I can see, only the €7 billion scenario sees us meeting the 10% target and this likely explains why Noonan emphasised the €7 billion figure.

This isn’t rocket science. There are four elements to this calculation, none of which are complex or require access to secret figures:

1. Lower GDP: Last year, the government projected that €3 billion in adjustments would get the deficit to 10% of GDP. However, they were projecting GDP in 2011 to be €170 billion. Now, both the Central Bank and the ESRI are projecting GDP in 2011 to be closer to €160 billion. So, hitting the 10% target now requires a deficit of €16 billion rather than €17 billion. Hence, an additional €1 billion in adjustment, bringing the total required adjustment to €4 billion.

2. Promissory Note Interest: The 2009 budget figures did not include the interest on the promissory notes, which appears to be 5% on average. This adds €1.5 billion to next year’s deficit, bringing the total required adjustment to €5.5 billion.

3. Lower Tax Revenues: Tax revenues for 2010 are on target. However, last year’s budget projected a €9 billion increase in nominal GDP in 2011. The Central Bank are currently projecting a €5 billion increase in nominal GDP next year while the ESRI are projecting an increase of only €3.6 billion. Undoubtedly, any credible projection for next year will feature lower tax revenues. In my ongoing calculations (updated here to also include the ESRI’s GDP forecast) I’ve subtracted €1 billion from tax revenues next year. This brings the cumulative adjustment required up to €6.5 billion.

4. GDP Effects of Larger Adjustment: Unfortunately, if additional adjustment of this magnitude is required, then the GDP baseline in the ESRI and CB forecasts are probably too high. Hitting the 10% target will probably require about €7 billion in adjustment.

I’m happy to be corrected about any of these above points but, particularly when one factors in Noonan’s comments, I think it’s reasonable to assume that €7 billion is required to meet the original 10% target.

Is meeting the 10% target really necessary? Might an adjustment of €4 billion to €4.5 billion—perhaps getting us to somewhere between 11.5% and 12% of GDP—be ok if it was accompanied by an impressive-looking four year plan?

It might be but then again it might not. I’d be inclined to recommend assuming the latter. The current EU-agreed plan is already our second plan (there was a previous one in which we reached 3% in 2013). Ripping up this one, so we can start again with a third plan where, after years of cutting, we’ve still only got as far as a 12% deficit next year, doesn’t sound to me like the kind of plan that’s going to work.

So, that’s the debate that needs to be had. Wishful thinking involving only €4 billion in adjustments and still hitting the 10% target just isn’t helpful.

A side-issue in all of this is what exactly the government is (and has been) up to in relation to the budget figures. In relation to point one above, as Philip has pointed out, most of this downward revision in GDP stemmed from the CSO’s annual revision released this summer. Indeed, the Central Bank were projecting nominal GDP in 2011 of €163.7 in July, already over €6 billion short of the original budget projection.  So the government has presumably known the 2011 adjustment requirement was drifting outwards due to this factor for a number of months.

On the second point above, since the government started issuing the magic promissory notes early this year, they will have known about the effect of this on the budget figures for some time.

It seems clear, then, that the government were clinging publicly to a figure of €3 billion in adjustments long after they must have known that this figure wasn’t tenable (e.g. as late as the mid-September Fianna Fail think-in the €3 billion figure was being held to).

Equally, it could be argued that yesterday’s dismissal of Noonan’s comments from, among others, the Taoiseach, also served just to obscure the full scale of the fiscal problem that we face.

Update: I’m not sure if this story pre- or post-dates what I wrote above. It says that “Government sources have firmly ruled out a €7 billion adjustment for 2011.” If so, it looks like they have ruled out meeting their previous target for next year of a deficit of 10% of GDP, though it may be some time before they admit this.

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.