Tuesday, 12 May 2009

Current policies set to exacerbate economic crisis

Jim Stewart: The Government's main stated current economic policies (Budget April, 2009) are (1) to stabilise the public finances and (2) provide finance to banks in order that they will resume lending. Both policies will exacerbate the economic crisis rather than solve it. This is because raising taxes and cutting government expenditure will result in further reductions in demand and incomes, increase unemployment and reduce taxes. The private sector has experienced an enormous fall in wealth (€150 billion according to National Irish Bank, 2009). This fall in wealth has been accompanied by an increase in private sector saving. What is needed is a fiscal stimulus to increase demand. Fiscal stabilisation policies are not enough. Some possible measures to stimulate spending could be vouchers which must be spent within a limited time period, or vouchers which can only be spent in hotels/guesthouses (accredited by Bord Failte). This latter policy has the advantage of minimising leakage, and most likely stimulating spending of a multiple of the value of the voucher.

The second main policy objective is also unlikely to succeed in ensuring “credit flows to businesses and consumers”. Policy should focus on the real economy, not the banking sector. The overall policy emphasis on ensuring the banking sector is commercially viable will not result in credit flows to the real economy. Rather, it damages the real economy because so much of Government borrowing and future tax revenues is used in support of the banking sector. There is a danger that the banking sector will survive but many firms in the real economy will fail. In my next post I will describe what banks should do, why current policy will fail, and what can be done to correct the situation.


James Conran said...

2 points:

Clearly, recapitalising the banking system won't restore the economy's health, or even revive credit flows greatly (given that bad credit risks proliferate in a bedridden economy like ours) - but surely a functioning banking system is a precondition of economic recovery?

Secondly, the argument for fiscal stimulus is incontrovertible for sure. But are we not stuck between the rock of deficient aggregate demand (need for stimulus) and the hard place of the risk of sovereign insolvency (the danger of capital markets shutting us out)? This seemed to be the thrust of Krugman's famous "Erin Go Broke" article.

I look forward to your next post to see what you have to offer us on these points!

Michael Taft said...

Just to deal with your second point, James (I, too, look forward to Jim's next post), there is certainly a risk of the market going cold on Irish Government bonds - or even be squeezed out by British and German demand. However, the risk would seem to be higher if the economy is heading towards double-digit inflation, a fiscal deficit of over 15% (as the EU Commission projects for next year) and unemployment / underemployment climbing towards 20%. The challenge is to pursue a policy that turns high borrowing into concrete stimulus programmes that slow down the rate of economic contraction, unemployment and the rising fiscal deficit, in order to bottom out the recession quicker and move towards a recovery scenario quicker. As it is, with the Government's own projection (as well as the EU Commission) of a contraction next year of nearly 3%, we may not experience a bottoming out until late next year or early 2011. And with high unemployment and a hollowing out of our enterprise base, what chance for recovery in the short-term - never mind bringing the fiscal deficit into EU-compliance levels?

SlĂ­ Eile said...

Lets say that we caught between a hard rock known as deflationary spiral and a hard place known as reflationary stimulus with a lot of uncertainty. A stimulus grown here may not work. Worse still it might be badly managed and targetted (not hard going by recent experience of public governance). However, the point that has to be faced is that 'there is no other game in town' right now other these two. I'd rather gamble on a stimulus package well targetted and complemented by medium-term measures to reform politics, democratise the workplace and strengthen local government. The alternative for Ireland - which is facing the worst decline in national output of any OECD member country in decades - is one of severe depression lasting well into the next decade. We owe our children better than that.