Fiscal Policy during and after the Bubble

Agenda Review of theory –What should Fiscal policy do? What did it do during the bubble? What were the consequences? What do we do from here?

Review of the Theory Golden Rule: –Over the business cycle the government should borrow only to invest and not to fund current spending –No current deficits on average over the cycle –Future generations should contribute to the costs of infrastructure from which they benefit

The Golden Rule allows stabilisation policy you to borrow to fund current during a recession i.e. to increase AD The flip side of this is that you should run a current budget surplus during booms Contracting AD when it is above LRAS Was our surplus enough? Some stabilisation will occur automatically Automatic stabiliser During recession tax revenues fall and social welfare spending rises. (Current) Budget should be balanced when GDP is at natural level  Leddin and Walsh Macroeconomy of the Eurozone, 2003 Stabilization Policy

 Leddin and Walsh Macroeconomy of the Eurozone, 2003

Calculating Full Employment Budget AKA “structural” deficit The concept is straightforward but calculation is more difficult –See irisheconomy.ie for some debate on the issue OECD adopts the following formula –Def= struct -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

Structural Deficit in Ireland We need to define what g* is for Ireland We looked at this in the Celtic tiger section –Labour force 1% - 1.5% –Productivity 2% - 2.5% –Total growth 3% - 4% So lets take 3%, plug it into formula

Comments 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

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 €35,000 per worker Summary

What is to be done? Conflict between two basic issues –Stabilisation policy –Deficit control –Empirical question 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 –Blanchflower argued this recently Deficit control –Deficit this year heading towards –€30bn = 13%GDP –13% not sustainable forever –Most Irish economists argue need cuts now

 Y Y*Y* LRAS AD 0 AD 1 SRAS(  e )

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

–Initial change in government expenditure:  G –Implies a change in income for some group:  Y 1 =  G –This leads to a increase in their consumption  C 1 = b  Y 1 = b  G –This in turn leads to a further increase in Y representing income for some other group  Y 2 =  C 1 = b  G Size of Multiplier

–This leads to another increase in consumption –  C 2 = b  Y 2 = b(b  G)=b 2  G –This leads to another round of income increase The process continues for an infinite number of rounds Total change in income –  Y=  Y 1 +  Y 2 +…+  Y n +… –  Y n =b n-1  G –  Y=  G*[1+b  b 2 +…+b n-1 +…] –  Y=  G*[1/(1-b)]

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 Small multiplier argues against traditional stabilization policy –If Neg mult no conflict between the two goals Negative Multiplier

Deficit Control If the multiplier is positive cutting deficit now will make recession worse –If mult is negative there is no conflict So why do it now as distinct from postponing to the future? Dynamically unstable debt –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

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

Average tax rate 100% 0 % T T T 1 * 2 R 1 R 2 Revenue maximizing tax rate Tax revenue £m A B Laffer Curve Z  Leddin and Walsh Macroeconomy of the Eurozone, 2003

Laffer Curve Suppose wanted to close entire 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 –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