Fiscal Policy

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Fiscal Policy

• Some Theory and the Practice in Ireland

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Learning Objectives

1. FP as Stabilization Policy for AD AS Shocks
2. The Problem of Lags
3. The Multiplier
4. The Automatic Stabilizer and Full employment
   Balance
5. Debt Sustainability
6. Deficit control
7. Policy Rules
8. What is to be done?

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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

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LRAS
p
SRAS(pe)
A
B
C
AD0
AD1
Y
Y
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Stabilisation policy

change
Boom
Inflation gap
Actual growth rate
Growth rate of
3 6
potential GDP
Recession
Unemployment gap
Time
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
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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

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• 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

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LRAS0
LRAS1
p
SRAS(pe)
C
B
A
AD1
AD0
Y0
Y1
Y
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• Be sure you understand why FP doesnt 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

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Comment on Ireland

• We can examine Irish FP from the point of view of
  Stabilisation
• No Stabilisation policy until 1972
• Government didnt deliberately run CBD
• Borrowing for capital was allowed (EBRgtCBD)
• 1972-77 Oil crisis, recession. Government
  reacts with expansionary policy Misdiagnosis of
  supply shock as demand shock
• Large increase in deficit

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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.

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How a stabilisation policy de-stabilises the
business cycle

Economy hit by shock goes into recession
change
Boom
Actual growth rate
Natural growth rate
5 6
Expansionary fiscal policy implemented at this
point
Business cycle automatically rights itself
Time
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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

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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

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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

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• 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
• DYnbn-1DG
• DY DG1bb2bn-1
• DY DG1/(1-b)

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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

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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.

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• 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.

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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.

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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

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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

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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

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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

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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)

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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 dD/Y
• Debt-GDP ratio
• debt burden

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• 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

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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
• Irelands 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

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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

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• 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

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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 gt wages
• Government seems to favour expenditure cuts. Why?
• Philosophy ideology supplants evidence
• Multipliers unlikely
• Laffer Curve

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Laffer Curve
Average
tax rate
100
A
T
1
Z

T
T
2
B
0
R
R
1
2
Tax revenue
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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

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International Evidence

• Empirical matter whether tax based or exp based
  budget is better
• Policy makers remember Irelands 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

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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

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• 1987Another 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

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• 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

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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 Irelands experience
• Surprisingly common
• Superficially attractive given the mess but two
  questions
• what rule?
• How enforced?

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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

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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 didnt work Greece lied and everyone
  knew

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• 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

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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

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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

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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

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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.

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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 doesnt 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

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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.

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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
  13GDP
• 13 not sustainable forever
• Most Irish economists argue need cuts now

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Conclusions

• FP as Stabilization Policy
• can work for AD shocks but makes things worse
  when shocks are from the supply side.
• The Problem of Lags
• There are long and variable lags
• The Multiplier
• Likely to be low and even lower in SOE
• Unlikely to be negative austerity hurts
• 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

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• Debt Dynamics
• Without austerity debt could get out of control
• Deficit control
• Tax vs expenditure unclear
• Policy Rules
• Golden Rule good idea but not likely to be
  enforceable
• What is to be done?
• Optimal Speed and nature of adjustment is unclear
• Current plan is probably reasonable

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? Leddin and Walsh Macroeconomy of the Eurozone,
2003
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? Leddin and Walsh Macroeconomy of the Eurozone,
2003
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