Lessons from abroad

Michael Burke20/09/2010

Michael Burke: There is an imminent danger with regard to government finances. The government and its supporters have repeatedly argued that their policy would have the following effects:- revive growth, correct government finances, bring down borrowing costs and prevent a disaster such as being excluded from financial markets like Greece/the IMF being called in.

In turn, each of the negative consequences they have warned of has come to pass, as a consequences of their policies. GNP growth (the bit that policy, not world trade, directly influences) continues to contract. Government finances continue to deteriorate. Borrowing costs continue to soar, so much that there is genuine concern about NTMA's forthcoming bond auction.

In a previous post, Michael Taft used the analogy of the Titanic heading for the iceberg http://www.progressive-economy.ie/2010/09/debating-on-titanic.html . The government can see the iceberg, like the rest of us and its response? Full steam ahead....stoke the boilers with another €3bn. Mr Honohan says it should be more, as if concerned the iceberg should slip out of our course before we reach it.

What would be the result if the engines were thrown into reverse: instead of cuts there was increased spending? How would the economy, government finances and international markets look then? European experience might be useful.

One thing economies do have in common with large ships is that that they take time to respond to changes in direction. In particular, on the whole taxation revenues are a lagging indicator of activity- they are paid after the event, sometimes a long time afterwards. But we know that in Europe, or more accurately the Euro Area most governments increased their spending in response to the recession (many also increased their minimum wage too, just like the older textbooks said they should). The fruits of that policy can be seen in the 2nd half of last year and this.

Take the case of Spain. It had a sizeable fiscal stimulus in 2009 equivalent to 2.3% of GDP. This ECB publication details the bailouts in the EU. This was before it was strong-armed by the EU, the financial markets, the ratings agencies and the banking interests these both represent into cutting public spending. A very modest improvement in the economy has since taken place, but this contrasts with Ireland's continued contraction in GNP. Spain's central government deficit has almost halved in the first 7 months of this year as tax revenues have rebounded sharply. Because of this improvement, bond yields are falling in Spain even while they are rising here. 10yr yields in Spain are now more than 2% low than Irish yields having been the same earlier in the year, half that change having taken place in the last 4 weeks. Bond investors respond to those tax and deficit data.

Or France, where the stimulus was equivalent to 1% of GDP and the growth rebound has been more robust (partly because the measures have not yet been undone, as they have in Spain). The budget deficit is ¤100bn lower in the first 7 months of this year than last, a decline of 22.8%. And of course, yields are less than half of Irish yields.

Germany is the same, a fiscal stimulus of 1.4% of GDP and record growth in Q2. The Federal structure means that the time la for the improvement in government finances will be greater- both the spending was delayed as much of it devolved to regional Laender and the tax revenues will also be delayed. In any event the deficit is on course to widen to just 3.5% of GDP this year.

The same pattern is true all across those Euro Area economies where government spending was increased (as well as being the case in the US and Britain; the deficit is lower as a result of increased spending).

Now, whenever there is an attempt to draw lessons from international experience, the cry goes up that 'N is not Ireland'. Well of, course. Every concrete situation is a unique combination of general circumstances. Not two phenomenon are exactly alike- otherwise they would not be separate phenomenon. The objection usually boils down to two points. First is the issue of 'leakage', this economy's propensity to import. This has already been dealt with elsewhere, and 90% of Ireland's imports are inputs for production, and the value created from that is what accounts for its wealth-creation, including overwhelmingly its exports. The other objection as that Ireland's position in the markets is a function of its uniquely large bank bailout.

But this does not explain its unique status as remaining in (domestic) recession nor the fact that tax revenues continues to contract. The fact is, the bank bailout, which is a millstone, is not much correlated to yields either, since Greece had no bank bailout to speak of and Belgium- which had the next biggest bank bailout- has not come under any market pressure at all. Instead, it is the disastrous impact of fiscal policy on the economy and the effect that this has had on government finances which is the driving force behind the ongoing risis in Ireland.

It is indeed time to reverse course.

Posted in: EconomicsFiscal policyFiscal policy

Tagged with: deficitstimulusgovernment bonds



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