Fiscal Policy

Some Theory and the Practice in Ireland

Learning Objectives

1. FP as Stabilization Policy for AD & AS Shocks2. The Problem of Lags3. The Multiplier4. The Automatic Stabilizer and Full employment

Balance5. Debt Sustainability6. Deficit control7. Policy Rules8. What is to be done?

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

YY*

LRAS

AD0

AD1

SRAS(e)

A

CB

Growth rate ofpotential GDP

Actual growth rateInflation gap

Unemployment gap

Time

%change

Stabilisation policy

3 – 6%

Boom

Recession

Leddin and Walsh Macroeconomy of the Eurozone, 2003

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

• 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

YY0*

LRAS0

AD1

AD0

SRAS(e)

LRAS1

Y1*

A

C

B

• 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

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

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.

Natural growth rate

Actual growth rate

Economy hit by “shock” goes into recession

Expansionary fiscal policyimplemented at this point

Time

%change

How a stabilisation policy de-stabilises the business cycle

5 – 6%

Boom

Business cycleautomatically rights itself

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”

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

– Initial change in government expenditure: G– Implies a change in income for some group:

Y1= G

– This leads to a increase in their consumption C1= bY1= bG

– This in turn leads to a further increase in Y representing income for some other group Y2= C1= bG

Size of Multiplier

– This leads to another increase in consumption

– C2= bY2= b(bG)=b2G

– This leads to another round of income increase

• The process continues for an infinite number of rounds

• Total change in income– Y= Y1 + Y2 +…+ Yn +…

– Yn=bn-1G

– Y= G*[1+bb2+…+bn-1+…]

– Y= G*[1/(1-b)]

• 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

Negative Multiplier

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.

• 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.

Government expenditure (G)

GNP1

AB

GNP2

C

Nominal GNP

NT

GNP

€ billions

Full-employment budget

G, NT

Budget surplus

Budget deficit

*

Natural GNP

Balanced budget

Government expenditure (G)

GNP1

AB

GNP2

C

Nominal GNP

NT

GNP

€ billions

Discretionary changes in taxes and expenditure

G, NT

*

Natural GNP

NT

NT

1

2

3

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.

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%

Structural Deficit

-6

-4

-2

0

2

4

6

8

10

12

14

16

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

EBR

strucural

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

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

US Structural Deficit

-6

-4

-2

0

2

4

6

8

10

12

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Year

%G

DP Primary Deficit

Structural Deficit

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

• 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)

FP during Bubble

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”

• 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

ttttt grdd )(

Primary Balance % GDP

-15

-10

-5

0

5

10

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Year

% G

DP

US Debt/GDP

0

20

40

60

80

100

120

19

70

19

71

19

72

19

73

19

74

19

75

19

76

19

77

19

78

19

79

19

80

19

81

19

82

19

83

19

84

19

85

19

86

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

Year

%G

DP

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

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

• 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

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

Averagetax rate

100%

0 %

T

T

T

1

*

2

R 1 R 2

Tax revenue

A

B

Laffer Curve

Z

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

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

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

• 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

• 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

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?

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

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

• 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

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

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

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

Fiscal Compact• Rules:

–  Overall deficit less than 3% of GDP – Structural deficit must not exceed 0.5% of GDP – If debt exceeds the 60% must reduce it at an

average rate of one twentieth (5%) per year

• Enforcement– The EU court fine a country that does not adopt a

standardised balanced budget rule - with a penalty equivalent to up to 0.1% of GDP.

– Excessive Deficit Procedure: submit plan to the Commission will be monitored by the Commission and the Council.

Comment on FC• Rule does not make distinction between government

investment and other expenditure so not equivalent to Golden rule– Probably afraid rule would be fudged

• Does make a distinction between structural and overall deficit

• But 3% very harsh in recession doesn’t allow much room for automatic stabilizer so would make recession worse

• The fine would also make recession worse• The compact mimics what the Troika does for bailout

countries.– monitoring of plans to combat deficit by EU– access to Euro bailout funds as part of the adjustment

Conclusion On Rules• Present Crisis: There is need for a rule

– but a rigid one is undesirable

– Probably unenforceable

• Projections of GDP, tax revenue, and spending are uncertain

• Rule should force the present generation to pay for the level of spending on (current) public services it desires

• The Fiscal Compact is probably too rigid and probably unenforceable.

8. What is to be done?

• For any SOE conflict between two basic issues– Stabilisation policy– Deficit control– Empirical question as to size, speed and nature of adjustment

• Stabilization policy– Ideally we would want to increase the deficit in a recession– Shift AD to right and restore full employment– Some of deficit is the automatic stabiliser but could do more

• Deficit control– Irish deficit this year heading towards €30bn = 13%GDP– 13% not sustainable forever – Most Irish economists argue need cuts now

Conclusions1. FP as Stabilization Policy:

– can work for AD shocks but makes things worse when shocks are from the supply side.

2. The Problem of Lags– There are long and variable lags

3. The Multiplier– Likely to be low and even lower in SOE– Unlikely to be negative: austerity hurts

4. The Automatic Stabilizer and Full employment Balance– Recession will make deficit worse leading to demands

for austerity and problems with debt sustainability if there is an underlying deficit i.e. even in full employment

5. Debt Dynamics – Without austerity debt could get out of control

6. Deficit control– Tax vs expenditure unclear

7. Policy Rules– Golden Rule good idea but not likely to be

enforceable

8. What is to be done?– Optimal Speed and nature of adjustment is unclear

– Current plan is probably reasonable

-8

-6

-4

-2

0

2

4

6

8

% o

f G

NP

1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Current budget deficit1972 - 2002

-4

-2

0

2

4

6

8

10

12

14

16

% o

f GN

P

1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Exchequer borrowing requirement1972 - 2002

Leddin and Walsh Macroeconomy of the Eurozone, 2003

CBD/GNP & EBR/GNP1996-2010

-10

-5

0

5

10

15

20

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

CBD

EBR

0

20

40

60

80

100

120

140

1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

National debt1972 - 2000

Leddin and Walsh Macroeconomy of the Eurozone, 2003

Debt/GDP(1996-2010)

0

10

20

30

40

50

60

70

80

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010