In my presentation to the DEW workshop yesterday and in several previous papers over the last two years  (my recent work on the Irish fiscal situation is gathered here, while you can look up my earlier list of papers here), I have tried to explain the reasons why the current Irish situation requires a fiscal response that is subtly different from the standard Keynesian prescription.  In general, my global view on fiscal policy would be very much in line with the IMF’s view during the current crisis (as explained here):  fiscal expansion should be pursued where it makes sense but “one size does not fit all” and some conditions call for a different fiscal approach.

Here are some of the key issues (but please read my actual papers if you want the more detailed versions of these arguments):

  • The current recession in Ireland is not just a demand slump.  The pre-crisis economy was highly distorted due to the construction boom and the debt-financed consumption boom.  The economy needs to be re-orientated towards the tradables sector and that requires real devaluation.
  • Outside the monetary union,  other countries are undertaking currency depreciation to achieve real devaluation.  The equivalent for Ireland is to reduce domestic wages and prices.  Since aggregate inflation is low in the euro area, a reduction in Ireland’s relative wage and price level requires nominal reductions.  While this is uncharted territory, real devaluation by this method should parallel the gains obtained by those countries that achieve the same outcome through nominal depreciation outside the currency union
  • Part of the distortion during the bubble was that pay rates in the public sector grew rapidly.  While this is understandable to some degree due to the very tight labour market at the time, the change in the labour market since then calls for a reduction in public sector pay rates. This is an important component of the overall real devaluation process.
  • If the government had run sufficiently large surpluses during the boom, the very large swing in the fiscal position in the last two years could have been tolerated without much corrective action.  I have repeatedly pointed to the example of countries such as Chile that successfully ran large enough surpluses during the boom.  I have been highlighting since my 1998 paper in the Economic and Social Review the dangers of such pro-cyclicality in fiscal policy.
  • A large proportion of the deficit is structural in nature:  the resumption of GDP growth in itself will not lead to a return to a sustainable fiscal position.  A combination of tax increases and spending cuts is needed to put the structural deficit on a course back towards balance.
  • Due to the ageing of the population,   public spending is set to increase sharply in the coming decades:  excessive accumulation of debt is not appropriate, given future spending needs.
  • Funding risk remains non-trivial for Ireland.  The sovereign debt spread remains substantial and it is an open question what would happen to the spread if the market’s re-assessed Ireland’s commitment to fiscal stabilisation.  The situation of the US and UK is quite different since the sovereigns in these countries ultimately control the currencies in which government debt is funded.

For such reasons,  I consider that those who advocate an ‘off the shelf’ Keynesian prescription (as advocated by Danny Blanchflower yesterday) do not have a correct diagnosis of Ireland’s current economic and fiscal situation.  The standard Keynesian prescription is appropriate if an economy on a sustainable growth path and with sustainable public finances has been temporarily knocked off course by a demand slump. For the reasons given above, this is not the situation in Ireland.

That said, I would not exaggerate the differences too much:  according to the ESRI’s latest projections,  Ireland is set for a general government deficit of 12.9 percent of GDP in 2009, which corresponds to 15.2 percent of GNP.  A fiscal package of €4 billion in 2010 would still leave the deficit at 12.8 percent of GDP in 2010  – it is not the case that the current strategy is seeking to ‘balance the books’ in the short term.