Thursday, 30 September 2010

The Governor is wrong

Michael Taft: Patrick Honohan, the Government of the Central Bank, was on News at One today. He stated:

‘€3 billion next year will not do it [move us towards the Maastricht Guidelines by 2014]. The economy has drifted so weak that this will not do it. The balance between moving forward with fiscal correction and allowing the economy to grow is, to some extent, a false dichotomy . . It is not a question of growth versus fiscal correction, its fiscal correction leading to growth.’

This is wrong.

Just as the debate is now, finally, entertaining the common-sense and economically verifiable proposition that austerity measures depress future growth which, in turn, undermines deficit reduction (because they depress tax revenue and maintain high unemployment costs) the Central Bank Governor is trying to pull the debate back. He is wrong.

In a paper widely unread, with analysis largely unreported on, the ESRI put forward two models of growth and the subsequent impact on the deficit.

• In their High-Growth model they projected an annual average growth rate of 4.6 percent between 2011 and 2015. This would result, according to their model, in an annual deficit of -1.8 percent by 2015.

• In their Low-Growth model they projected an annual growth rate of 3.2 percent in that same period. Their projected annual deficit by 2015? - 4.1 percent. We miss the Maastricht target by a significant amount.

See a pattern? Higher growth leads to lower deficits. The ESRI reinforces this in their analysis of the structural deficit:

• Under their High Growth model, the structural deficit is projected to be -1.8 percent.

• Under their Low Growth model, the structural deficit is projected to rise to – 4.1 percent.

Here is the key point that has been made numerous times on this blog: economic growth is, itself, fiscally corrective. It is lower growth that engenders higher deficits.

The Governor wants more fiscal adjustment in the 2011 budget (either spending cuts or tax increases or a combination of both). The ESRI projected that a €3 billion package would knock approximately 1 percent off GDP growth. More fiscal contraction will cut GDP growth further.

If under the ESRI’s Low Growth model we miss the Maastricht target by a wide margin, how does cutting that growth even further assist us towards the goal? It won’t. It will embed more deflation in the economy going forward. This, in turn, will depress growth further. This will result in ever higher levels of debt.

The Governor is simply wrong. But if the Government listens to him (as it appears they are) it is the Irish economy that will suffer – through more spending cuts, higher unemployment, lower incomes and poorer public services.


Paul Hunt said...

The Governor might be looking at the chart here:

Anonymous said...

But how does not cutting EUR 3 B from the budget result in the high growth scenario?

Michael Taft said...

Paul - thanks for the chart. It is one more piece of evidence that the Government's current fiscal strategy has failed, that deepening the fiscal contraction will fail (as the ESRI analysis suggests) and that what we desperately need is a Plan B - one that stops digging and starts investing.

Anonymous - I don't know, but I would certainly be interested in any calculations you might present. This issue is about investment, growth-friendly fiscal consolidation and promoting domestic demand - as I pointed out here:

The issue is not about deflating or not deflating.

Paul Hunt said...

Michael, believe me, if there were a viable and feasible Plan B that Ireland had the unfettered ability to implement that would avoid the imposition of sustained economic pain on all Irish people - and, in particular, on those least able to deal with it - I would be all for it.

Unfortunately, Ireland, by virtue of the dysfunctionality of its factional politics, excessive executive dominance and the unleashing of pure selfish greed, is the meat in the sandwich formed by the international bond market, on one side, and the institutional and political EU, on the other.

No government anywhere, least of all a FF-dominated government, will admit that it has blown national sovereignty. But that, unfortunately, is what Irish people have to grasp. The nation, and its people, are in the grip of forces completely beyond its control. The institutional and political EU cannot, and will not, countenance imposing any of the losses of the Irish banking system - or the provision of any fiscal assistance to Ireland - on its banks or voters in the core EZ economies.

The sooner Irish people wake up to this reality, the sooner we will be able to work our way through this disaster. With the Euro, the institutional and political EU sold their voters a pup - particularly voters in the core EZ countries - and they live in mortal dread of their reaction. Citizens in the southern and western EZ periphery are the partially culpable, but totally defenceless victims of this chicanery.

The Irish models of public representation and legislative enactment and of governance have failed - and failed utterly. But the institutional and political EU has an equally serious democratic deficit at its core. The anger of Irish people should be directed at both, but, in the short-term this will achieve little in the context of the current crisis.

I fear that application for support from the EFSF and effective EC/ECB/IMF administration is the only option. The IMF is a great bogeyman, but it has learned from experience, has had a good crisis and is led by a French socialist, DSK, who is contemplating a run for the French Presidency in 2012.

Protection from the international bond market to allow lower cost sovereign funding and deep-seated fiscal and structural reform that the Irish political classes are unable to deliver are what are required. All else has failed and regrettably this is Ireland's best hope.