Fiscal Policy

1. Fiscal Policy Some Theory and the Practice in Ireland

2. Learning Objectives • FP as Stabilization Policy for AD & AS Shocks • The Problem of Lags • The Multiplier • The Automatic Stabilizer and Full employment Balance • Debt Sustainability • Deficit control • Policy Rules • What is to be done?

3. 1. FP as Stabilisation Policy • We have already seen that changes in the AS/AD curves cause actual real GNP to swing around natural real GNP. • That is, the business cycles tends to move from recession to boom and back again. • these booms/recessions can persist for long periods of time. • Many Economists advocate an active fiscal policy (changes in government expenditure and/or taxes) to try to stabilise the business cycle. • Others say practical problems render this dangerous • Note ideology: big government vs small government

4. LRAS p SRAS(pe) A B C AD0 AD1 Y* Y

5. Stabilisation policy % change Boom Inflation gap Actual growth rate 3 – 6% Growth rate of potential GDP Recession Unemployment gap Time  Leddin and Walsh Macroeconomy of the Eurozone, 2003

6. FP & Supply Shocks • The government is counter-acting shifts in either the AS or AD curves using only fiscal policy. • However, this is not an effective response to dealing with an adverse supply-side shock. • It may solve unemployment problem but it makes inflation worse. • This happened throughout the western world in 1970s when countries reacted to an oil shock by expanding deficits • Ireland was no different

7. The oil shock increases the real cost of producing everything this shifts the LRAS to the left • Starting at A, the economy moves to B • Output is lower, Unemployment is higher and inflation is higher • “stagflation” • This is a stable long run equilibrium • FP (or MP) shifts AD to right • Even higher inflation and no extra output in long run

8. LRAS0 LRAS1 p SRAS(pe) C B A AD1 AD0 Y1* Y0* Y

9. Be sure you understand why FP doesn’t make things better in this case • This experience made politicians in Ireland and elsewhere suspicious of using FP to • Stabilize the economy • But that is not the correct inference • The problem was one of misdiagnosis

10. Comment on Ireland • We can examine Irish FP from the point of view of Stabilisation • No Stabilisation policy until 1972 • Government didn’t deliberately run CBD • Borrowing for capital was allowed (EBR>CBD) • 1972-77: Oil crisis, recession. Government reacts with expansionary policy Misdiagnosis of supply shock as demand shock • Large increase in deficit

11. 2. Policy Lags • Recognition lag:a delay in realising the economy has gone into boom or recession. Data is out-of-date. • Decision lag: a delay in deciding how to spend, cut expenditure or change tax rates. • Implementation lag: for instance, tenders for projects delay expenditure. • Outside lags: the time policy takes to impact on the economy. • Milton Friedman: “Long and Variable lags” • Government policy could be out-dated by the time it is implemented and could end up destabilising, rather than stabilising, the business cycle • Many Economists agree MP better e.g. aftermath of WTC and current crisis.

12. How a stabilisation policy de-stabilises the business cycle % Economy hit by “shock” goes into recession change Boom Actual growth rate 5 – 6% Natural growth rate Expansionary fiscal policy implemented at this point Business cycle automatically rights itself Time

13. Comment on Irish FP • Lags long in Ireland. • Often leads to mis-timing of policy • As economy improves FP expansion continues leading to inflation • This happened a number of times in Ireland • After the 1970s oil shock • The 2001 WTC attacks • The 2008 financial shock • Partly influenced by “political cycle”

14. 3. The Multiplier • A key detail ails of stabilization policy are key • What is the multiplier? • The effect of any G on Y • Theory suggests low in SOE • Difficult to measure in any case especially so in crisis times • Philip Lane (TCD) • Multiplier of 2 or less • Small multiplier argues against traditional stabilization policy

15. Size of Multiplier • Initial change in government expenditure: DG • Implies a change in income for some group: DY1= DG • This leads to a increase in their consumption DC1= bDY1= bDG • This in turn leads to a further increase in Y representing income for some other group DY2= DC1= bDG

16. This leads to another increase in consumption • DC2= bDY2= b(bDG)=b2DG • This leads to another round of income increase • The process continues for an infinite number of rounds • Total change in income • DY= DY1 +DY2 +…+ DYn +… • DYn=bn-1DG • DY= DG*[1+b+b2+…+bn-1+…] • DY= DG*[1/(1-b)]

17. Negative Multiplier • Some would argue that the multiplier is not only low, it is negative • “Expansionary Fiscal Contraction” • Multiplier negative in times of crisis • Failure to deal with debt causes people to cut back consumption • AD shift to left • Very controversial idea • Some evidence for it including Ireland in 1987 • Something for nothing: expand economy & reduce debt

18. 4. The Automatic Stabilizer • A recession automatically worsens the budget deficit. Tax revenues fall and social welfare spending rises. • Boom period, the deficit falls. • Define: Budget surplus = T – [G + SW] • Defining net taxes (NT) as: • NT = T – SW • NT is the proportion of government tax revenue and spending that varies with fluctuations in nominal GNP. • Positive relationship between NT and GNP. • Current spending (G) is assumed to be constant.

19. Diagram shows how the budget balance varies as GNP changes. (Diagram 1) • Recession: Budget deficit. • Boom: Budget surplus. • Note distinction between automatic and discretionary changes in the budget balance. (Diagram 2) • Discretionary change occurs when the government deliberately changes G, T or SW shifting the lines • The result is a balanced budget at different levels of GNP.

22. Full Employment Budget • At what level of GNP should the government attempt to balance the budget? • It is argued that the relevant budget balance is the “natural GNP budget” or “full employment budget” • That is, the government should choose a combination of taxes and expenditure that balances the budget if the economy were at natural real GNP. • This entails tolerating a deficit in times of recession and a surplus when the economy is over-heating. • The problem is that it is not easy to calculate the natural GNP budget.

23. Calculating Full Employment Budget • AKA “structural” deficit • Represents “discretionary” policy • The concept is straightforward but calculation is more difficult • See irisheconomy.ie for some debate on the issue • OECD adopts the following formula • Actual Def= struct def -0.4*(g-g*) • Where g* is long term growth rate • Note calculation is done in terms of g* not Y* • “-0.4” represents the automatic stabiliser • Take g* to be 3%

25. Comments on Ireland • This is quite conservative approach to the structural deficit because assume that only anything over 3% is bubble • But bubble displaced other parts of the economy • Shows lower surplus throughout decade • EU commissions criticism or Ireland in 2001 seems more reasonable in this context • Automatic stabiliser is huge issue now because recession so severe

26. US Case • US gap between structural and actual deficit is small • Recession much less significant in US • Automatic stabliser smaller • Large discretionary deficit: Stimulus • Debt rising fast • Far from unsustainable • In $: so can always use infaltion

28. Differences between US and Ireland • Or between any large country and a small open economy • US issues debt in its own currency • Can use inflation if necessary • FP policy likely more effective (see later) • US can depreciate its currency • Could expand economy by depreciation • Control deficit by cutting G, raising T • US can reduce interest rates

29. FP during Bubble • Look at bubble in detail later but it is clear that we can say the following • Temporary increases in revenue • Permanent increases in expenditure • An underlying deficit once you strip away temporary revenue • When bubble burst the deficit came to the fore • Possibility of a dynamically unstable debt • Burden of €40,000 per worker • Includes banks (see later)

30. 5. Debt Sustainability • Problem with Fiscal policy in recession • Debt grows exponentially as economy declines and we borrow merely to pay interest on the stock of debt • Problem in 1980s • Could be problem again • Key variable is d=D/Y • Debt-GDP ratio • “debt burden”

31. d evolves according to the following equation • Where • r is the interest rate • g is the growth rate • p is the “primary balance”: G-T excl. interest • Difference equation with impulse and potentially explosive growth • Intuitive • Maths online

34. Comment on Irish Experience • The badly timed FP of the 1970s lead to a rapid increase in debt • Dynamically unstable by 1982 • Got worse during 1982-1987 • Ireland’s failed stabilization attracted international attention • Only disappeared with the Celtic Tiger • Reappeard with the bank debt • Difficult to get debt down in the future as rapid growth of Celtic will not be repeated

35. 6. Deficit Control • “Austerity” big issue in Eurozone, UK & US • If the multiplier is positive cutting deficit now will make recession worse • If multiplier is negative there is no conflict • So why do it now as distinct from postponing to the future? • Dynamically unstable debt now • 13% of GDP is unsustainable • End up borrowing to pay interest • Lenders might refuse loan

36. If we decide to control deficit there are two questions • How much how soon? • By taxes or expenditure? • Time • Do not have to close all the gap immediately • Governments plan is to bring within 3% of GDP within 4 years • That is actually quite quickly • Automatic stabiliser will close some as the economy improves • So plan should concentrate on the structural deficit • Note recent concerns expressed by IMF that adjustment should be slowed down because growth is lower

37. Tax or Expenditure? • The Big question today is whether we choose to close the gap by increasing taxes or cutting expenditure or in what combination • All these actions have multipliers • Probably all positive (assuming no EFC) • Some bigger than others • Lane suggests inv > wages • Government seems to favour expenditure cuts. Why? • Philosophy: ideology supplants evidence • Multipliers: unlikely • Laffer Curve

38. Laffer Curve Average tax rate 100% A T 1 Z * T T B 2 0 % R R 1 2 Tax revenue

39. Laffer Curve • Suppose wanted to close entire Irish structural deficit gap using income taxes • 8% GDP or €13bn • Last year total tax rev was about €40bn • Require one third increase in taxes • Top rate from 50% to 66% • Tax increases of that size likely to have incentive effects • Fail to raise the revenue • Empirical matter whether Laffer curve effects are strong • Diamond and Saez who conclude incentive effects are small and suggest opt higher rate of 73% • Obviously hugely controversial • Ideology usually supplants evidence

40. International Evidence • Empirical matter whether tax based or exp based budget is better • Policy makers remember Ireland’s experience of 1980s and 1990s • But that is just one observation • There is a large literature looking at deficit control worldwide • Conclusion is that expenditure based more likely succeed • Evidence is not overwhelming

41. Comments on Irish Experience • 1982 Economy in recession and budget deficit at an all-time high • Note the effect of the automatic stabiliser • Attempt to cut the deficit largely failed • Why? • Automatic stabiliser • Partners in recession (Volker disinflation) • 1982-86: Laffer curve type effects. Recession and doubling of national debt. • Example of austerity that failed

42. 1987:Another deflationary fiscal policy • This time the focus on expenditure cuts. • The economy roared in fact this is the beginning of the Celtic Tiger • Many are tempted to conclude • Austerity caused the Celtic Tiger • Expenditure based austerity is better than tax based

43. As we will see the first is not true • The second might be but it is only one observation. But it is probably the case that the Irish tax system was so extreme that we did have Laffer curve effects

44. 7. Fiscal Policy Rules • Monetary policy has been taken over by independent central banks, out of the reach of politicians. • Should fiscal policy be removed from the political arena by subscribing to a fiscal rule? • Attractive given Ireland’s experience • Surprisingly common • Superficially attractive given the mess but two questions • what rule? • How enforced?

45. Maastricht Criteria • Two fiscal requirements for Euro membership • Government deficit: must be less 3% of GDP • Debt less 60% to GDP at the end of the preceding fiscal year • Note that countries fiddle the statistics (are were let) Greece clearly lied • Also criteria makes no distinction between current spending and investment • Also not expressed in terms of the structural budget

46. The Stability & Growth Pact • The Stability and Growth Pact (SGP) was framed at the Dublin summit, December 1996, and ratified at the Amsterdam Summit, June 1997 • Designed to prevent backsliding by countries that had met the Maastricht criteria for EMU • Obviously didn’t work: Greece lied and everyone knew

47. Formalised the “Excessive Budget Deficits” procedure • Fiscal deficits should average at most 1% of GDP over the business cycle (“Structural Budget”) • Deficits in excess of 3% of GDP will attract penalties unless they were due to “exceptional” and/or “temporary” • Could imply pro-cyclical transfers from countries to the centre. • Fiscal federalism in reverse

48. SGP: Rise, Fall and Rise Again • Ireland was reprimanded in 2001 because the Council felt that Budget 2001 was too expansionary • In retrospect correct • But the stagnation of the Eurozone economy during 2002 has lessened the appetite for enforcing the SGP • Portugal, Germany, Italy, and France at or above the 3% ceiling • Rule was scrapped • Current Fiscal Compact is similar. • What happens when France or Germany break it

49. The Golden Rule • Economists favourite rule • Was followed by UK • Over the business cycle the government should borrow only to invest and not to fund current spending • No current deficits, but • Future generations should contribute to the costs of infrastructure from which they benefit • Like SGP focus on structural deficit • Unlike SG explicitly GR envisages borrowing for investment • We adhered roughly to this rule in Ireland until the 1970s

50. Problems with The Golden Rule • The threshold between current and capital spending is not hard-and-fast • Education? Health? Etc • Is government capital formation efficient? • Until the crisis government capital formation accounted for borrowing equal to about 4.5% of GDP • What happens if break it? Precedent of SGP