Monday, 6 July 2009

Cuts and economic activity

Michael Taft: While we await the publication (or, at least, the drawn-out leaking) of the An Bord Snip Nua report, it is well to be reminded of the considerable limitations that public expenditure reductions will have on our fiscal deficit and, so, our borrowing requirement. The ESRI has worked through a number of policy proposals to assess their impact on economic activity. Let’s take three calculations. They assess the following three proposals:

• 5% reduction in public sector wages
• 10% cut in health and education employment
• €1 billion in public investment

Together, these would reduce public expenditure by €3 billion. This is more than the Government hopes to cut next year, and about 66 percent of Bord Snip’s total cuts, as reported in the media. No doubt these are the type and extent of cuts that many commentators have been calling for, claiming that it will considerably improve the Exchequer’s fiscal position. However, the ESRI’s conclusions suggest caution regarding the fiscal effect.

Taking these three policy initiatives together, we find that the domestic economy (GNP) would decline by -1.5 percent, consumption would fall by -1.3 percent, while unemployment would climb by 1 percent. Of course, this doesn’t take into account the impact on the quality– in the case of cutting employment – of our educational and health infrastructure.

So: further economic decline and higher unemployment resulting from these three measures. What would be the impact on the Exchequer fiscal position? Minimal. The ESRI calculates that, taken together, these measures would reduce the Exchequer borrowing requirement by 0.9 percent. To put this in perspective, the ESRI projects the borrowing requirement to be -15.6 per cent this year and -14.7 percent next year.

If taken together, the cumulative impact would be even more severe than their individual effect, as reduction of GNP is piled on reduction. The economy will be in a weaker position to confront ever higher debt. And, while accepting that the ESRI doesn’t do black humour, its warning that ‘if the external environment were to continue to be very difficult such a level of emigration might not materialise resulting in higher unemployment in the medium term’ suggests that the small reduction in the borrowing requirement might be limited even further, arising from higher social welfare costs.

Hopefully, more careful analysis of the economic impact of deflationary measures will enter the public debate. For it is becoming clearer (if it isn’t clear already) that deflating an economy through budget reductions is like running in quicksand. The more you cut, the more you sink – with little to show for in terms of controlling the fiscal deficit.


Pavement Trauma said...

Are there any comparative figures for how much economic activity will reduce as a result of a €3 billion increase in taxes?

Michael Taft said...

Yes. The ESRI looked at a range of tax increase measures - incrasing income tax by €1 billion, carbon tax, property tax, etc. By and large, while still deflationary - they had less impact on GNP and unemployment (though the impact on consumption was higher). It also reduced the fiscal deficit by more than public spending cuts - though the difference is minimal. If you hit the link in the post, you can run through the excellent tables the ESRI has produced to assess the effect of a range of measures. These, of course, are not the last word but they should form part of the debate over fiscal and economic policy.

Pavement Trauma said...

Ah yes, reading the referenced article would indeed help.

I thought it was interesting that the projected effect from a 5% decrease in nominal wages, would be to increase numbers employed by 2% within two years, decreasing the unemployment rate by 2.4%. It is initially painful but provides significant benefits pretty quickly.

Does this rather not support the head of the IDA's comment on the need for pay cuts (and attacked by Paul Sweeney here yesterday)?

Michael Taft said...

Pavement Trauma - yes, the ESRI is very optimistic about the effects of cutting general wage levels. Unfortunately, they have yet to bring forward (a) data that shows that wages/labour costs are disproportionately high vis-a-vis our peer group in the EU/OECD; (b) data that provides insight into the comparative non-wage costs; or (c) show at firm and sectoral level that redutions in wages will reverse our growing uncompetitiveness. If they were to do so, we might be in a better position to analyse this particular calculation.

And, yes, the ESRI's calcualtion does support the head of the IDA's comment re: wage cuts. But, again, we might be witnessing a blind-leading-the-blind phenomenon. I note that there is a bit of back-tracking on the position in today's Sunday Business Post. All I would say that, again, it would be nice to be shown the actual numbers and sectors upon which these arguments are based. Why are real devaluationists so shy about giving us the data when they are so quick to call for wage cuts?

Pavement Trauma said...

All of their figures comes from the same HERMES model, which presumably has all sorts of interdependent variables, relationships and assumptions going on.

I have no insight into how good or useful a model this is but it is plainly inconsistent to approvingly quote the model when one agrees with its outcomes but dismiss it when it doesn't.

Sauce for the goose...

Michael Taft said...

Pavement Trauma – I didn’t mean to quote or approve selectively. Personally, I would be cautious about crediting the Hermes programme with too much prescience or accuracy (after all, only weeks before we hit the recession, the ESRI’s Mid-term Review predicted smooth sailing ahead for years). As always, output is equated with input. I only highlighted their discussion of tax increases and spending cuts since it hasn’t permeated the economic debate but what they say is common sensical enough – tax increases and spending cuts during a contraction are likely to have consequences that will undermine the headline budgetary numbers. Hopefully, these calculations will be taken up by others to ensure we have a more fully informed debate. As to the benefits of generalised wage cutting – it would help if the ESRI and all real devaluationists would produce the data upon which they make their proposal. So far they haven’t.

Pavement Trauma said...

Michael, it may not have been your intention to quote selectively but effectively that is what happened.