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Spending and cutting, no, spending, no, cutting, no taxing. Ah… no taxing. October 19, 2010

Posted by WorldbyStorm in Economy, Irish Politics.
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Consider this…

Fine Gael said last night it would back the Government’s four year economic strategy to reduce the deficit, but insisted it favoured cutting spending rather than raising taxes.
The party’s communications spokesman Leo Varadkar told the Dublin Economics Workshop in Kenmare last night that his party is committed to reducing Ireland’s deficit to 3 per cent of GDP by 2014.

And…

“Savings in public spending do less damage to the economic growth and employment than tax increases,” he said. “Increasing taxes is the easy political option but it is not the right one.

However…

“Cuts, tax increases and retrenchment alone will not resolve Ireland’s economic crisis. Indeed, they could push Ireland deeper into recession,” he said. “That’s why we need a four year growth plan as well as a four year budget deficit plan.”

Whereas if we consider the IMF research (which you can most conveniently download from here) linked to a piece in the Sunday Independent mentioned by Garibaldy and first referenced in the Irish Independent by Brendan Keenan on Thursday last we learn something slightly different. As the original piece by Keenan notes:

The research suggests that members of the eurozone suffer a bigger than average impact from fiscal correction. This could be because the ECB is not able to respond in the way a national central bank could, by cutting interest rates.

Well, that’s not good.

It gets worse.

A €4bn adjustment in next year’s Budget would probably knock €2bn off economic growth, (the IMF research) suggests.

And even worse again…

Although the research does not deal specifically with Ireland, it found a consistent pattern across 170 historical episodes that a 1pc of GDP adjustment produced a 0.5pc fall in growth.
The example of Ireland in 1987 — and Denmark in 1983 — where budget correction was followed by growth, appear to be exceptions. They may even be the only two of their kind.

So, we’re set on a course that out of 170 historical examples worked 1% or so of the time.

And the Irish example may have been in 1987, as seems likely on consideration, to be linked to events to our direct East.

“We don’t really know the reason,” Daniel Leigh, one of the IMF researchers said yesterday.
“There are suggestions Ireland was helped by the ‘Lawson boom’ policies of Chancellor Nigel Lawson and by a devaluation of the Irish pound.”

The relevant chapter in the IMF research entitled ‘Will it Hurt’ notes that:

Based on a historical analysis of fiscal consolidation in advanced economies, and on simulations of the IMF’s Global Integrated Monetary and Fiscal Model (GIMF), it finds that fiscal consolidation typically reduces output and raises unemployment in the short term. At the same time, interest rate cuts, a fall in the value of the currency, and a rise in net exports usually soften the contractionary impact.

Except as noted above, interest rates can effectively fall no further. Nor can the value of the currency assist us. We instead face a situation almost entirely the opposite.

And what of the issue of spending cuts over tax increases?

Keenan argues that:

The second [piece of conventional wisdom] is that, in terms of economic damage, it is better to cut public spending than to raise taxes. The IMF research seems to challenge both bits of conventional wisdom — albeit with different degrees of certainty.

The evidence is stronger on the first: that the famous “expansionary fiscal correction” is a myth.

First up the IMF discovers that:

Spending-based adjustments are less contractionary than tax-based adjustments. In the case of tax-based programs, the effect of a fiscal consolidation of 1 percent of GDP on GDP is –1.3 percent after two years (Figure 3.5). In the case of spending-based programs, the effect is –0.3 percent after two years, and is not statistically significant.24 Similarly, while deficit cuts that rely on tax hikes raise the unemployment rate by about 0.6 percentage point, spending-based deficit cuts raise the unemployment rate only by about 0.2 percentage point (see Figure 3.5).
However, as will be shown below, a key reason the costs of spending-based deficit cuts are relatively small is that they typically benefit from a large dose of monetary stimulus, as well as an expansion in exports.
•• Domestic demand contracts for both types of fiscal consolidation, but by more in the case of tax-based packages. In particular, in the case of spending-based measures, domestic demand falls by about 0.9 percent after two years, whereas the decline exceeds 1.8 percent in the case of taxbased packages (see Figure 3.5).
•• A rise in net exports mitigates the impact of the consolidation on GDP in both cases. However, there is a considerably larger improvement in exports associated with spending-based measures than with tax-based measures, whereas imports fall more for tax-based adjustments (see Figure 3.5).

But wait, that means that spending cuts are more optimal than tax increases? Not necessarily:

Much of the difference is due to the response of monetary conditions to fiscal consolidation: interest rates and the value of the currency tend to fall more following spending-based consolidation

Which as we know we cannot do.

Thus, it appears that the difference in monetary policy responses accounts for much, though probably not all, of the difference in output performance.

And sentiment, such a player in all this, appears again:

These findings are in line with the notion that central banks view spending-based deficit cuts more favorably, possibly because they interpret them as a signal of a stronger commitment to fiscal discipline, and are therefore more willing to provide monetary stimulus following spending-based adjustments. It is also plausible that an increase in taxes, if it involves indirect tax hikes (sales and excise taxes, VAT), raises inflation on impact, making interest rate cuts

And there’s more. The report considers that:

spending-based adjustments have relatively benign effects if they involve cuts to politically sensitive items, such as transfer programs, or government consumption, such as the public sector wage bill.

One must stand in awe of the masterful use of the term ‘relatively benign’.

Now note the following:

The key idea is that cutting politically sensitive items may signal a credible commitment to long-term deficit reduction and that, in these cases, positive “non-Keynesian” confidence effects offset the negative “Keynesian” impact on aggregate demand. On the other hand, cuts to less politically sensitive items, such as government investment, might have weaker confidence effects.

So, once more, it’s not about the reality of whether these cuts are – in objective terms, or at least as objective as one can find – effective, and the report continues:

…these results should be interpreted with caution. In particular, even for the cases of consolidation based on transfer cuts, there is no strong evidence of expansionary effects, as the results are statistically indistinguishable from zero.

If that is correct then the social effects of such a course are such that one would hope that any government would think long and hard about prioritising them over tax increases. Indeed, and Keenan makes this point, given that we can’t do the ‘damage’ through increasing interest rates (since as he says the ECB has little interest in Irish inflation) if tax rates increase and prices consequently increase, the effects of one or the other would appear in fiscal terms to be near-identical.

But to add further troubles and woes the report notes that fiscal retrenchment far from triggering faster growth and lower unemployment actually appears to lead to the opposite. And more… in situations where interest rates are close to zero…

…the output cost of fiscal consolidation doubles to about 1 percent after two years (see Figure 3.11). Here, the simulation assumes that the zero lower bound holds for two years.37 During this time, the central bank is powerless to offset the slump in aggregate demand and inflation induced by the cut in government spending. The resulting fall in inflation raises the real interest rate, which in turn exacerbates the decline in aggregate demand, amplifying the short-term contractionary effect of fiscal consolidation.

All this is interesting, because at the very least it throws some doubt on the certainty that tax increases are ‘worse’ than spending cuts (even if one factors out social costs of the latter), and it points to basic problems with the position we find ourselves in and the policies being pursued. However, as always with the IMF it’s in the throw away remarks that one finds the most intriguing aspects. Consider the final paragraph:

Finally, as discussed in Chapter 1, a number of policy actions could enhance the credibility of fiscal adjustment programs, thereby mitigating the adverse effects of fiscal consolidation in the short term. Such actions could include strengthening fiscal institutions and reforming pension entitlements and public health care systems. To the extent that such measures improve household and business confidence and raise expectations about future income, they could help support activity during the process of fiscal adjustment.

Precisely what sort of reforms are these that are mooted? And to whose benefit? It would be interesting to know.

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Comments»

1. Michael Taft - October 19, 2010

A great post that should be read widely. Some comments (aspiring to be brief):

1. The IMF simulations get worse. 1% fiscal consolidation in one country only with zero interest rate floor produced a fall of 1% in GDP. However, when accompanied by other countries pursuing fiscal consolidation, GDP falls by 2%. 1% cut equals 2% deflation.

That’s where interest rates can’t fall. Ireland is suffering retail interest rate increases, with the German economy driving potential ECB rate rises later next year. Current policy may be pushing us into a deflationary cascade.

2. The ESRI has produced two papers in the last 18 months. They find that tax increases are better than spending cuts. They measured the impact of €1 billion adjustments on GNP in the first year:

Income tax: -0.2%
Property tax: -0.3%
Carbon tax: 0.1% (impacts negatively on GDP)
Public wage: -0.4%
Non-wage Government consumption: -1.0% (current spending excluding wages / social transfers).

3. ‘Take the pain up front': said by people who believe economic policy is like going to the dentist. Deflationary affects accelerate over the years. Non-wage Government consumption cuts deflates GNP by -1.0% in first year, deteriorating to -1.3 in the third year, before settling down to -1.1% in fifth year. Pain up front and down back.

4. Spending cuts are internally contradictory. Cutting €1 billion non-wage Government consumption deflates GDP by €1.4 billion and reduces the deficit by €320 million. We cut economic income by more than 4 times the savings achieved. This drives up the debt by half-a-percent. Yes, drives up. Because the reduction in the deficit is outstripped by the reduction in GDP.

Don’t try any of the above at home – you’ll be broke in months. Just like the Irish economy.

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ejh - October 19, 2010

I think the last point is probably not a good one, since half the problem in getting people to grasp the argument is that cutting drastically is precisely what you do do at home when your’re confronted with big financial problems. Indeed and obviously, many many Irish people will currently be doing precisely this. So why, they’ll think, doesn’t government do the same? The fact that a nation’s economy doesn’t really function in the same way as a household economy is a difficult one for many people to get their heads around.

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2. Worldbystorm - October 19, 2010

Thanks Michael. The silence over the current outcome of policy is rather striking, isn’t it? The pain conversation is highly effective in clouding that not so small issue.

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EWI - October 19, 2010

The pain conversation is highly effective in clouding that not so small issue.

I’m open to correction here, but doesn’t the whole “pain” meme derive from usage by toryboy financial types?

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WorldbyStorm - October 19, 2010

Really? Interesting if accurate… I hadn’t heard that to be honest.

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Pope Epopt - October 19, 2010

Ah well, they learn that kind of thing at prep. school, or probably over the nanny’s knee.

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3. Michael Taft - October 19, 2010

ejh – you’ve hit on an extremely important point. When a housheold reduces their spending, they don’t affect their income (if I quit cigarettes that doesn’t affect my wage). However, when a government cuts spending, it also cuts its own income. Getting people to grasp that point is difficult. It’s the flipside of the Keynes’ paradox of thrift. That the economists calling for cuts, cuts, cuts know this, makes their contribution to the debate all the more shameful. We have to find a way of getting this simple equation across, referencing everyday experience. Otherwise, people will understandably go along with something that is profoundly irrational and self-defeating.

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ejh - October 19, 2010

That the economists calling for cuts, cuts, cuts know this, makes their contribution to the debate all the more shameful

Well, quite. But then again, some of them are operating on an ethical model A which says that if you fail, it’s your fault anyway, so who cares if it’s made much easier to fail. And others are operating on the economic model B which uses “market confidence” as magic words, a model which says that if cuts are made then confidence will return (which belief is boosted by the fact that business and financial institutions will nearly always call for cuts) and so never mind if it means a temporary shrinking of the economy, the ol’ voodoo will bring it all back sooner rather than later.

It’s mostly B, but it has a tendency to turn into A under pressure, I think.

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Pope Epopt - October 19, 2010

I’ve tried and failed to get this across to the man or woman in the street and failed, partly for lack of an appropriate metaphor.

(It’s worse in Germany where the budget is known as Haushalt – perhaps if explains their fear of deficits.)

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4. Tim Johnston - October 19, 2010

Slightly reduced growth is still growth, right? Some might consider it a fair trade.

I also don’t the ‘confidence’ thing applies to potential spending cuts in Ireland; Cuts won’t convince people taxes won’t be raised, as I’d say both are inevitable at this stage.

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WorldbyStorm - October 19, 2010

It’s a prioritisation issue though, isn’t it? If social costs can be kept low (and none of this by the way is to suggest for a second that there shouldn’t be a serious consideration of the public sector in terms of efficiency of delivery, etc) isn’t it arguably better to go for increased taxation? Not least because the social strains on the society are going to be enormous as funding is withdrawn from various areas, health, communities, welfare, etc.

The private sector in this state is in no position and has no appetite to take up that slack. I would have serious concerns as to what those pressures could result in.

That would be my sense. And to link to what alastair said elsewhere, that might mean some trade-offs, for example, not increasing corporation tax at least not for a set time period. Or whatever.

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Niall - October 19, 2010

In addition, it should be noted that public spending cuts lead to further problems down the line. The cost of a public spending cut is often difficult to calculate.

Say the numbers of special needs assitants are cut. The cost here may manifest in ten years time when the clients reach the age of 18 and have to be institutionalised. The cost of institutionalisation is massive, and would far exceed the cost that would have had to have been spent to pay for an SNA for that child when providing such a resource would have icreased the probability of independent or assisted living.

Another example would be in the area of carers. An eldery individual who has a paid carer, or a carer who receives support from the state, is likely to be healthier than a similar individual who does not. If carer support is cut, then more elderly people become ill and tax payer ends up paying out more (or if we’re lucky the OAP dies first) for hospital costs.

When community development projects are ended, it may appear that there is no cost to the tax payer. However, amongst other things, these projects sometimes have the effect of “catching” youths before they end up engaging in harmful and/or illegal activities. The cost to tax payer in this case comes in the form of paying for imprisonment, drug rehabilitation and stretching our policing resources.

There are dozens of other examples we could use from classroom sizes, to medical card provision, to the numbers of nursing staff, to prison overcrowding and social workers. It’s easy to fall into the trap of thinking that these kinds of cuts are cost free. They aren’t. They’re just another expensive form of credit. And that’s before you take into consideration the loss of taxes from those made jobless, and the cost of the dole and redundancy payouts. I’d be the first to demand that economists provide us with solid figures in support of a suggested policy, but just because you can’t provide a solid figure for a cost, doesn’t mean you should pretend it doesn’t exist. That’s what seems to happen.

Now, having framed that argument in terms of costs and savings, I’d just like to point out that even if these cuts were cost-neutral in the medium term, I would still not find them acceptable because they would involve denying people their rights under the constitution and under the various human rights agreements we’ve signed up to.

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Tim Johnston - October 19, 2010

Yes it is arguably better to increase taxation, because people would rather pay more tax than see others do without hospitals etc.
There is supposed to be a symbiotic relationship between the private and the public sectors, but the media has been trying to set them at each other’s throats of late.
It’s a truism to say that when the private sector is back on its feet, service cuts will be unnecessary, but I’ve seen very little, if any, commentary suggesting we need to produce more stuff and export more. Or have I missed something?
Tourism was strangled by pure greed on the part of the hospitality industry in recent years, but that sector is one that can grow.
and it’s clear that we could get away with an increase in corporation tax and still undercut other countries by a long shot.

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5. CL - October 19, 2010

As Skidelsky pointed out the other night at the ICTU debate the Irish state is already running a massive fiscal stimulus/deficit equal to about 10/12 per cent of GNP, and the markets are charging us 4 per cent more than what it costs Germany to borrow money. So ‘borrow till you drop’ in this environment is not an option.

The IMF is certainly aware of the deflationary effects of cutting deficits. (Its merely the obverse of the fact that the deficit is an addition to aggregate demand) Yet the IMF and most Irish orthodox economists are advocating austerity for the Irish economy. Because they recognize that standard Keynesian remedies are not available they again invoke the neo-classical ideology of ‘equilibration’ through wage cuts and austerity as their fall-back default position. Economist Philip Lane, on the irisheconomy website advocated that Irish workers should internalize this model and meekly accept wage-cuts.
Its clear that neither Keynesianism nor neo-classicism is the solution to the Irish economic crisis. But what is the cause of the problem cannot be the solution.
Skidlesky the other night supported a European-wide Keynesian stimulus when austerity fails as he predicted that it surely will. This is of little help in the current Irish dilemma.
The left should demand that there be no privatizations, that there be no cuts for people of low and moderate income, that corporate profit tax should be increased, that a property tax be introduced and rendered progressive by taking into account the income of the householder, that a wealth levy of say 10 per cent be applied, that the forthcoming budget measures be such as to redistribute income from higher earners to lower,(thus boosting demand), that govt. capital spending be focused on projects that are most labour-intensive, and that this capital spending be boosted by funds from the pension fund.
The Labour party should be pressured to support these modest proposals. Instead they seem intent on backing the neo-liberal orthodox solution. Labour should play a longer, more strategic game and force F.G. and Fianna Fail to coalesce and deal with the catastrophe their obsolete ideology has caused.

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Tomboktu - October 19, 2010

As an aside, what was the man in the audience, at 1:19:50 to 1:20:00 in the video talking about when he said 1750 is “the only period that I can trace in a historical context to address not only from the economics of what’s happening but from the social disintegration of what’s happening in this period”?

I asked two history geeks who were at the lecture and neither of them knew (and wikipedia doesn’t enlighten me further — I doubt he’s referring to the fires in Istanbul).

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Tim Johnston - October 19, 2010

It’s really annoying that he doesn’t explain it. Is he talking about in Ireland? Did he mean the 1650s?

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Tim Johnston - October 20, 2010

Maybe the Industrial Revolution.

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6. sonofstan - October 20, 2010

I dunno, it puzzled me at the time – my best guess was the beginning of the break up of traditional patterns of agriculture and the enclosure of the commons as a precursor to the Industrial revolution in England, the increasing pauperisation of the French peasantry through taxation in support of an increasingly absolutist monarchy, the small scale famines throughout Europe in the period, the highland clearances….in other words, a general,and cumulatively drastic, break up of the way in which people had sustained themselves on the land.

I suppose the shock of ’89 that was felt everywhere in Europe had its roots then? Just a guess though.

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8. Michael Taft - October 20, 2010

Let us not lose sight of the driving force behind the recession; namely, that falling investment has made up nearly 120 percent of the decline in GDP. According to the Central Bank, investment will still be in decline next year – that’s four years of an investment recession. Investment levels next year will return to 1998 levels. A sustained programme of public sector led investment (involving the Exchequer, public enterprise and private sector but leveraged into projects led by the state) will free up the fiscal options. Public sector efficienes can then be reinvested into domestic demand, thus boosting growth further, tax increases become less onerous and deflationary as they take place in the context of rising employment and wages. If we allow the debate to take place on spending cuts vs. tax increases we lose regardless of the ultimately balance between the two because it will take place within a deflationary framework which, by very definition, can’t succeed in repairing public finances. We must argue the toss within a new framework – an investment-led framework.

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