…we thought of monetary policy as having one target, inflation, and one instrument, the policy rate. So long as inflation was stable, the output gap was likely to be small and stable and monetary policy did its job. We thought of fiscal policy as playing a secondary role, with political constraints sharply limiting its de facto usefulness. And we thought of financial regulation as mostly outside the macroeconomic policy framework…The single-minded focus on particular problems sounds very familiar, I think, to an Irish audience. Before the current crisis, the role of the Central Bank and the Financial Regulator was passive, facilitating, and entailed non-directive counselling to banks. The model worked, so it was thought, and any lancing of the property bubble would be by way of a soft landing. Essentially, the failure was to ‘join up the dots’. People saw different parallel realities and imagined that any one or two could go pear shape but not the whole lot at the same time and in a way that showed how interconnected everything was in a way not previously realised. People were still working out of the old textbooks from the 1970s and 1980s. A previous blog has discussed this.
Now that the world economic system came crashing down in a matter of months in 2008 economists in general, and macro-economists in particular, have been in a state of shock. The Great Moderation from the mid-1970s gave way to the Great Recession. A partial counter-cyclical response on the part of some big players including USA, UK and Germany (and aided by the boom in demand in China) prevented the world from slipping into a major crash à la 1929.
Now, there are rumblings of the need to cut off the initial fiscal stimulus and to prioritise fiscal balance especially in those jurisdictions where the public sector debt to GDP ratio has risen sharply (notably the UK and the US). Inspiration has been provided, let it be said, by the ‘brave Irish’ who lead the way in fiscal contraction (not having done a stimulus in the first place). However, as in boom times so also in crisis times we should be wary of the advice coming from macro-economy. Blanchard et al. observe that:
….The rejection of discretionary fiscal policy as a countercyclical tool was particularly strong in academia. In practice, as for monetary policy, the rhetoric was stronger than the reality. Discretionary fiscal stimulus measures were generally accepted in the face of severe shocks (such as, for example, during the Japanese crisis of the early 1990s)….They go on to say that:
…As a result, the focus was primarily on debt sustainability and on fiscal rules designed to achieve such sustainability. To the extent that policymakers took a long-term view, the focus in advanced economies was on prepositioning the fiscal accounts for the looming consequences of aging…In summary, many economists and some policy-makers forgot about discretionary fiscal policy instruments along with all the other tools available (exchange rate, interest rates, regulation etc). The point is all the more relevant in a small open economy within the European Monetary Union such as Ireland.
The impact of fiscal contraction since October 2008, in the case of Ireland, opens up an interesting case study. Whatever the future holds, levels of debt – personal, corporate and governmental – will remain very high. It is difficult to see any large reduction in these levels any time soon. The second fact is that unemployment will remain very high and may go higher. Should there be a quick recovery in labour markets (especially in English speaking countries) it is possible that outward migration could assume very large numbers here even as the economy here is technically ‘out of recession’ from later on this year.
The multiplier impacts of fiscal contraction are worrying. All the more worrying is the lack of firm empirical work in this domain beyond what can be gleaned from ESRI working papers (documents emanating from the Department of Finance do not provide the technical detail or modelling to show that the full effect over time of recent spending cuts and tax increases have been taken into account)
Blanchard et al. put in succinctly as follows:
Furthermore, the wide variety of approaches in terms of the measures undertaken has made it clear that there is a lot we do not know about the effects of fiscal policy, about the optimal composition of fiscal packages, about the use of spending increases versus tax decreases, and the factors that underlie the sustainability of public debts, topics that had been less active areas of research before the crisis.However, for the sake of balance it should be pointed out that Blanchard et al. are not calling for the baby to be thrown out with the bathwater (to use their words).
..It is important to start by stating the obvious, namely, that the baby should not be thrown out with the bathwater. Most of the elements of the precrisis consensus, including the major conclusions from macroeconomic theory, still hold...Fiscal sustainability is of the essence, not only for the long term, but also in affecting expectations in the short term’ (P10).Their paper is highly nuanced and should not be cited as fundamentally at odds with orthodoxy. There is nothing in their line of argument to suggest that the Irish Government is being anything but ‘fiscally responsible’. The details of how they are going about it may be questioned from within and outside the country. But, as Enda Kenny recently said ‘we have no problems with an adjustment of €4bn.
Finally, Blanchard et al write: ‘Identifying the flaws of existing policy is (relatively) easy. Defining a new macroeconomic policy framework is much harder.’ I could not agree more especially in regard to those working in the field of economics and related other disciplines who seek a new baby and not just the old minus the bathwater.