Monday, 27 September 2010


Michael Burke: One of the key ways in which fiscal stimulus package have worked in the Euro Area- and the reason why the Irish government's policy has failed so disastrously- is the existence of fiscal multipliers. The measure of that success is that Spain has halved its budget deficit this year on foot of the largest investment package in the EU. By contrast, the deficit here has doubled following the 'austerity' measures.

For some reason the very existence of multipliers is contentious in Ireland, as if either of the economies operating here are subject to a separate set of economic laws. However, a glance at the Input-Output tables will show how all the outputs of the public sector draw on the inputs of the private sector. The detail for all the private and public sector multipliers are set out by the CSO here (see Table 5, the 'Leontief Inverse').

So, every €1bn spent on public administration, defence and social security, causes an additional €3mn of output in the agriculture sector, €1mn in mining, €4mn in food and beverages, and so on. The two biggest impacts are on business services and construction, where an additional €96mn, and a further €66mn is required. Altogether the multiplier for this category is 1:1.508. That is every €1bn of final output in this sector requires inputs of €508mn, overwhelmingly form the private sector. The multipliers for sewage, refuse and disposal activities is 2.172, and for health and social work 1.36 and education 1.302. On the face of it, these latter two seem to be severe underestimates, for a number of reasons. But they confirm the general principle, that the entire output of any economy requires the inputs of other sectors of the economy, and this is also true of the public sector.

It is therefore inevitable that cuts to public sector spending produce a depressing effect on private sector output. And the reverse would be true, increasing public sector output would require increase activity from the private sector too. This would create employment and generate increased taxes (as well as reducing welfare payments as employment rises).

But how to fund the increased government spending? This table below (click to enlarge) is reproduced from the European Commission's QUEST model of the European economies.

In the two columns shown there are revenue and expenditure multipliers for selected European countries. The first column shows what happens if a weighted average of tax cuts were made to labour, profits' and VAT taxes equivalent to 1% of GDP. The second column shows what happens when government spending is increased by 1% of GDP. It is important to stress that in both cases the measures are off-set by increases in taxes after 3 years so that the deficit an debt levels are otherwise unchanged.

I terms of the effects of these different measures, the assessment of the tax reductions is underwhelming. There is not much of a response. But the response from increased government spending is significant, an increase in Ireland's case of 0.4% of GDP.

This is despite the fact that the QUEST model includes 'crowdng out' effects, where increased government spending is supposed to push up borrowing costs and canny consumers, 'knowing' that the the boost to government spending will be followed by higher taxes will educe their own spending in advance of that. Frankly this nonsense should just be ignored. On the first, Irish real yields have soared as spending was cut, while those that stimulated their economies in 2009 have seen real yields fall dramatically. On the second issue of consumer behaviour, spending has had precisely the opposite pattern. When taxes were cut and spending increased during the boom, consumers increased their own spending and then cut it when their incomes and jobs were cut, oddly enough. Finally, the issue of corporate behaviour is not at all addressed by the model, but they entirely misdirected investment during the boom towards speculative activity and have been on an investment strike during the slump. Increased government spending would oblige that investment strike to be broken.

Even so, despite all these shortcomings which understate the real position, the model highlights an important fact. It is is possible to have a revenue-neutral increase in government spending, which will boost activity in other sectors, and create jobs, thereby raising tax revenues and lowering welfare outlays.


Donagh said...

And its depressing to see that the only area that the government chooses to invest in order to create jobs is in a sector that is already doing well, not that that success has very little to do with the real economy, which as Michael Taft has pointed out the Dept of Finance realise will not be tax-rich and which provides only marginal employment in the first place.

Brendan Quinn said...

Can I post this thought on the stimulus economists. We have a stimulus in place. We are borrowing €20 billion or more to sustain it. The real economic level of government tax intake is €30-€35 billion. Anything above €40billion is stimulus money. It just so happens that the government is spending that stimulus money on social welfare, health, education current spending, debt servicing and not on capital expenditure. The two major infrastructural elements required are water, energy and broadband. Everything else is much lower priority.
With the IMF in by end of October, it will be SW or debt but not both. Really Michael where is the extra borrowing to come from to act as further stimulus? The government is crowding out investment. It is not giving confidence to private investment. A new government with new mandate to cut 10-15% out of government expenditure, not raise taxes would immediately boost confidence and private investment. Obama's stimulus didn't work and it won't work in old republic of Ireland.(RIP)

Michael Burke said...


The deficit does not equal stimulus. It is measure of how far taxes have been driven lower.

You seem unaware that your prescription of 10% to 15% off spending has aready been tried- and failed. Spending cuts totalling €8.9bn have already been made, equivalent to 22% of government spending in 2009 (not counting PS pay cuts). As predicted here the deficit widened rather than narrowed. In fact it doubled.

Since you advocate repeating this failed policy, is there any evidence, from any reputable source, evaluating the impact of these cuts? (In 380-odd pages the McCarthy Report- not one sentence on the economic or Budgetary effects of the cuts)

If you would point me to one, I would be extremely grateful.

Otherwise, the conclusion I must draw is that the government, and supporters of the policy remain content to wreck the economy without ever once questioning whether this was the right course, or even explaining how it is supposed to work.

If they had there might at least be a basis for rational discussion, rather than the saloon-bar blather that routinely passes for economic discourse.

And they have 'reassured financial markets' so much that the Irish bond market is collapsing.

Brendan Quinn said...

I'm certainly not going to argue that we need to decrease AD. I agree that we have to increase AD and the multiplier effect works. That's a given. However, I don't agree and this is debateable that government spending is necessarily the best approach to increase AD. I know your graph says otherwise but I don't automatically accept data as gospel without empirical evidence. It's a model not evidence based? Firstly what kind of government spending? Where is the best place in government to spend money for good ROI without wastage?
Have you ever read this book about the Agentina experience?
Bascially, borrowed money is as bad for soverigns as it is for people. If things start to go wrong they can go really wrong. Yes, the cuts decreased AD and made the recession worse. However, what choice did they have? They relied on the capital markets for current spending. It went pear shape. The same will happen here. If we keep accepting debt then we will envitably will have to restructure. The IMF etc is not a cure for our problems. They will probably make things worse. The problem is the government is on an unsustainable course. If we weren't in euro maybe we could devalue. If in 2007 there could have been an opportunity for stimulus, we are pass that now. Unless the government restructures now, we are doomed, real absolute poverty not relative poverty. We are into voodoo economics now because economics does not take into account, political economy, corruption, educational and class divisions, etc. Maybe cheap credit could promote economic growth, but where would it come from now and how sustainable would it be?

Robert Sweeney said...

Brendan Quinn

I think the effect of a state's indebtedness on its capacity to borrow is probably overstated. It's its ability to repay which matters, and that's distinct from its level of debt. Japan, for example, has a debt-to-GDP ratio of over 200% (much of it held by its central bank admittedly) but spends only about 2% of its GDP on interest payments. Businesses will invest if they believe they can sell their products. The austerity measures diminish people's capacity to by things and therefore business confidence.

Michael Burke said...


You say you accept the existence of multipliers. Good.

But their existence means that government spending cuts depress economic activity, which in turn depresses tax revenues and increases welfare outlays. The cuts have led to deficit widening.

Conversely, increased government spending is 'multiplied' as private sector activity also increases. The consequent increase in taxation revenues and lowering of welfare outlays leads to deficit reduction.

No progressive is interested in handing over € billions to faceless bond investors. That's why they favour actual deficit reduction through investment, not verbal declarations of deficit-reduction via cuts, which actually lead to the opposite.

Paul Hunt said...

let's see if I'm getting this right. There is potential to increase taxes on higher earners and wealth-holders to close the structural element of the fiscal deficit while leaving the level of current government expenditure unchanged. All Anglo and INBS bondholders would be offered the choice of a debt-equity conversion (wiping them out over time) or an immediate wipe-out. There would be some limited reform of the public sector and equally limited structural reform of the semi-state sector (the detailed specification of both being studiously avoided). The international bond market would be perfectly happy to advance financing of a significant increase in public capital expenditure confident that the remaining current fiscal deficit is purely cyclical and these wonderful multipliers would kick-in big-time.

Now tell me you don't see any flaws in this?

Michael Burke said...


I know its contrary to advance policies like this when things are going so well.

And there are those that yearn for the smack of firm government from the IMF/EFSF to put manners on the 'vested interests' (organised labour and the poor).

But if your question is meant to imply that the other bogeyman, the bond market, would prevent government investment- then bond yields tell a different story.

Yields on 10yr Irish government debt yesterday closed a 6.74%. Given deflation, real yields are considerably higher. 10yr Spanish government debt closed at 4.13%.

Precisely 2 years ago, these yields were efffectively the same, Spain then at 4.62% and Ireland at 4.69%.

So Spain, which adopted the biggest investment package in the EU has seen its yields fall by about 0.5% (as its taxes have recovered), while Irish yields rose by about 2%. Whether NTMA can return to the market at all, given the depressing effects of further 'austerity' measures remains to be seen.

You say, the fiscal multipliers are wonderful. But only if you get them to work positively.