Sunday, 10 October 2010

Just how much is enough?

Slí Eile: Just how much deflation and for how long must it be applied to (i) secure market confidence 'going forward' and (ii) reduce the fiscal deficit to 3% of GDP and (iii) restore consumer and investor confidence? Any clues from the past or the present? Empirical evidence welcome.
If €50bn in bank recapitalisation is less of a problem than an annual fiscal deficit of €22bn per annum (not that there would be any connection between the two don't you know) than is it any wonder that those who think and believe this have wantonly exposed Ireland to a level of debt transfer from private accounts to public accounts which threatens credit into the future.


Rory O'Farrell said...

The 'once-off' bank recapitalisation is not much of an argument. Why not then have a 'once-off' school building programme. At 5.6% a year €50 billion is equivalent to €2.8bn in interest payments, eating up almost all the originally intended 'adjustment'.

To be honest I think the whole consumer 'confidence' notion is overplayed, and linked into the banking strategy. If we get consumers spending again, while ignoring the fundamental problems, then there is less money for bank deposits, so more state money needs to be used to recapitalise the banks.

I think bond investor confidence can be restored by the following.
1) Recognise that it is current taxation and spending that must be brought into balance (my emphasis being on the taxation side). This point is totally lost on the government as they take a short term approach of slashing capital expenditure.
2) Create a medium term (4 to 5 year) plan of how to achieve a current surplus.
3) Give the citizens a chance to vote on it (through a general election).
If investors see that the electorate have bought into a plan and plan and consented to it, they will be more likely to see its implementation as feasible.

So if we have a good plan to fix the current side of things, we will have more leeway to offset the deflationary effects with expansionary capital spending.

Also, I think property prices and rents still have some way to go, so the sooner they reach bottom the better. I consider this to be a fundamental reason why investors (direct investors, rather than financial investors) don't have 'confidence'. Its not confidence itself, but a realistic appraisal that property prices and rents have further to fall. Why buy office space now if it will be a lot cheaper next year?

Similarly consumers are just being realistic in not showing 'confidence'. If we get non-wage costs down so that people can start new businesses and jobs are created then people will be more willing to spend (rents, professional fees etc). Also with a medium term plan consumers can plan better when to spend their money.

History shows that deflation itself does not lead to increased confidence, we just need to look at the US and the Great Depression.

Slí Eile said...

@Rory very good points. Nobody is denying that the current austerity policy is deflationary. Colm McCarthy said, in today's Irish Times, that 'it is unarguable that the tax increases and expenditure cuts since July 2008 have had a contractionary effect'
But, for him the markets are what counts. He writes: 'The higher the growth rate, the easier it will be to close the budget gap. The trouble with this line of argument is that the rate of economic growth is not a policy instrument and cannot be greatly influenced by policy in the short timeframe that matters in today’s bond market.' In other words, the markets are what matter. The markets.
He takes issue with Ray Kinsella ( who argues for a growth policy and one that draws on EU funding for technology. An interesting feature of Kinsella's article is that it shows how an 'anti-contraction' consensus (surely a minority one among economists) can embrace political diversity. Kinsella endorses 'a much smaller, less intrusive and costly state than that which has encouraged a culture of dependency' I would not disagree with the idea of less intrusion and less dependency. But, our problem is that the size of public spending is too low - not too high.