This post follows on from a previous contribution.
Michael Taft: In the previous post, we saw how billions of fiscal contraction has led to little deficit reduction. After that post was written the IMF published their latest projections. They estimate the deficit this year to be -10.8 percent this year. Between 2009 and 2011, we have experienced a fiscal contraction of €10 billion - or over 6 percent of GDP. Nominal GDP will fall by €4 billion. The deficit is expected to fall by less than 1 percent. Does the Government get this connection?
In this post we will examine why the notion that cuts equals savings is one of the more pernicious that has come to dominate the debate; why there is a fundamental flaw at the heart of the methodology employed by the Special Group report. With Government ministers threatening more cuts, this is certainly topical.
The Special Group Report used the word ‘saving’ or ‘savings’ 1,096 times. It neatly equated ‘savings’ and ‘spending cuts’ when no such relationship necessarily exists. Fortunately, we have a simulation of the effects of one of the ‘savings’ that the Special Group highlighted: cutting public sector employment.
Flawed Methodology: The ESRI Stress Test
The Special Group recommended that public sector employment be cut by 17,000. According the ESRI model, reducing public sector employment by 17,000 would mean a reduction of €1 billion in public spending – or 0.6 percent of GDP. What would happen?
• GDP would fall by 0.8 percent. So, for every €1 billion cut, the GDP falls by nearly €1.3 billion.
• More worryingly, GNP would fall by 1 percent. That represents an even more deflationary impact.
• Consumer demand would fall 0.5 percent in the first year, rising to 1 percent in the second year. That’s nearly €1 billion cut from consumer spending – putting considerable pressure on domestic businesses.
• Employment would fall by 1.1 percent. In 2009, that would mean a loss of over 20,000 jobs. Unemployment would rise by almost the same amount.
These are all the factors that must be included before we can assess the ‘savings’ to the Exchequer. So what did the ESRI conclude?
• The deficit would fall by 0.2 percent in the first year and 0.1 percent in the second year.
According to the ESRI, the ‘net saving’ to the Exchequer would be 25 percent of the cut, falling to less than 15 percent in the second year. This is because when you factor in the:
• Loss of tax revenue from reduced spending
• Increase in public sector spending arising from unemployment costs
• Decline in GDP/GNP
The gain to the Exchequer diminishes greatly. This simulation – along with measurements for other spending cuts and tax increases – was available to the Special Group report. It was, and remains, the best estimate of the impact of cutting public sector employment. They didn’t utilise it or even refer to it.
The Special Group could have commissioned, through the Department of Finance, other stress-tests regarding social transfers (nearly 40 percent of the ‘savings’ in the Report was due cuts in direct and in-kind social transfers) and Government purchases of private goods and services, which make up approximately a third of spending on public services They didn’t. They have yet to explain why. But that it would have undermined their basic premise – that cuts equals savings – is fairly certain. For its methodology adopted a crude ‘arithmetic’ approach to spending cuts, not an economic one.
When Government ministers proclaim progress on public sector employment reduction, they are, without realising, actually proclaiming very little progress on deficit reduction but significant progress on deflating the economy, driving up unemployment and cutting domestic demand.
But when this realisation hits home – falling growth, continued high deficits – these same Ministers demand more of the same, again not realising that more of the same is likely to produce the same results which produces more demands for cuts until the economy gives out.
It is a vicious circle, legitimated by the false methodology at the heart of the Special Group report. Cuts do not equal savings. But common sense should tell us this – without resort to models and projections. During a jobs crisis, does it make sense to cut employment levels from the largest employer? Why should we be surprised when the result is so dismal?
We are facing into another round of cuts. Employees are now being threatened - with job losses and pay cuts; in the public and private sector. Why? Because past Government ministers either could not or would not subject their policies to economic stress-tests (any comparison with the banking crisis is not co-incidental). They assumed propositions that had little empirical justification. They suffered from ‘escalation of commitment’ – having committed to a particular strategy, they could not extricate themselves when it became clear the strategy was failing.
It is still not too late for this Government to take a step back from the brink. There is still good will towards it. They could adopt a set of transparent and public measurements whereby fiscal options are assessed on the best data available. And on the basis of such informed analysis, adopt the policies that flow from that.
The last thing the Government should do is merely continue failed Fianna Fail policies with only the most cursory of makeovers. If they do, then people will have the right to ask – what was the election for?