Tuesday, 10 March 2009

Who’s for some expansionary fiscal contraction?

Peter Connell: The mini-budget that we can look forward to in three weeks time will, I’m sure we’ll be told, ‘constitute a necessary first step on the road to economic recovery’. It will ‘position the economy to take advantage of the global upturn when it happens’. Apparently, the budget will ‘give us a renewed confidence in our ability to see out the recession’ and encourage us to go out and spend for Ireland. But wait, isn’t it also supposed to extract €4 billion out of the economy in the form of taxes rises and public expenditure cuts? And this is on top of the €2 billion in cuts already in place. So how will this piece of magic work? You take €6 billion out of people’s pockets but, somehow, they’ll feel more confident about the future and start spending their money.

The answer is – it’s all down to expansionary fiscal contraction. The theory is that cuts in public spending will lead citizens to believe that taxes will also fall and, on that basis, private spending will increase. In the current Irish context, given that there is a commitment to raise taxes, the most we can say is that consumers will belief that taxes will rise less than they might otherwise do if public spending were not cut. Some economists argue that expansionary fiscal contraction helps to explain the turn around in the Irish economy after 1987 when net government borrowing fell as a percentage of GDP from 10.4% in 1983-86 to 4.2% in 1987-90. Average GDP growth rose from 1.9% in the first period to 5.7% in 1987-90. QED. Well, maybe not. It’s now generally accepted the post 1987 recovery had a lot to do with external factors including falling international interest rates and an upturn in the global economy.

The point is that we need to be as clear as possible about the impact of a combined €6 billion cut in public expenditure and rise in taxation. Has anyone done the sums yet on the impact on government revenue? On how many businesses will be forced to close that otherwise might survive? On the damage that will be inflicted on the productive capacity of the economy? To what extent will the provisions of the mini budget deepen the real crisis which is in the real economy? The government appears to have made an absolute commitment to keep the deficit in 2009 below 10% of GDP, hence the mini budget. Across much of the media the need to stick to this figure is accepted without question. Given the likely impact of that budget in three weeks time on all our futures the public discourse needs to move to another level.

2 comments:

Michael Taft said...

There's a lot of myth-making about what made things right in the 1980s. The current orthodoxy would, as Peter points out, attribute it to expansionary fiscal contraction. This ignores the impact of emigration - between 1985 and 1990 net migration was 179,000, with the biggest flows recorded in 1988 and 1989. This figure was equivalent to over 13% of the labour force in 1990. I suppose if we could convince a similar percentage of our citizens today to leave - over 280,000 - it could do wonders for social welfare costs, general government expenditure and the labour market.

Another aspect is to examine what was cut. In nominal terms, current expenditure (excluding debt servicing) remained static. What the Government of the day was hack capital expenditure - slashing it by 25% between 1987 and 1989. So disastrous was this policy - political and economically - that the first budget after the PDs entered government saw capital expenditure increase by nearly 20% in one year, while between 1990 and 1992, current expenditure rose by nearly 30% in three budgets; quite a little spending spree.

And, of course, we were subsidised by another set of taxpayers - the EU taxpayers. Between 1987 and 1992 we received over €2.5 billion in Social and Regional Development Funds. To put that in perspective - that amounted to more than twice the capital budget and over 7% of GNP in 1992.

So, if we could get people to leave, get the EU to throw wads of money at us, and get a spend-thrift party into Government, we might just get ourselves out of this mess. So much for expansionary fiscal contraction.

James said...

My understanding was that the idea of expansionary fiscal contraction also depended crucially on the idea that high public borrowing was crowding out the private sector by driving up interest rates. But that was when private sector borrowers were competing with the goverment for scare punts, so Eurozone membership presumably weakens the case for an EFC. (I recall Ronnie O'Toole writing a persuasive piece about this in the Sunday Times business section some months ago).