Pain, but no gain

Michael Burke: In a recent piece in The Guardian, Dean Baker argues that politicians are ignoring Keynes "at their peril".

Arguing that it would be reasonable if deficit-reduction easures produced positive results, but they do not, Baker says, this is a case of "pain, but no gain."

"Ostensibly, there will be a lower interest-rate burden in future years, but even this is questionable. First, the contractionary policy being pursued by the deficit hawks will slow growth and lead to lower inflation or possibly even deflation. It is entirely possible that the debt-to-GDP ratio may actually end up higher by following their policies than by pursuing more expansionary policy."

This is exactly what has happened. The Fianna Fail-led government has had a fiscal contraction totalling 8.9% of GDP (€14.6bn in fiscal tightening compared to 2009 GDP of €163.5bn).

This is the profile of Ireland's general government borrowing as a proportion of GDP, according to the EU Commission's data and forecasts (click to enlarge). Those for the Euro Area are shown alongside (Euro Area Report, Spring 2010, Table 37)

By contrast, the Euro Area had an average fiscal stimulus of 4.4% of GDP, according to the EU Commission, European Economic Forecast, Autumn 2009, although since that was written both Germany and France announced further significant stimulus at end-2009, pushing the average over 6%.

If we take 2009 as the major year of fiscal stimulus in the Euro Area and of fiscal contraction by the Dublin government, then we have a startling conclusion. It seems that the EU average GGB deficit is barely more than the fiscal stimulus itself, at approximately 6% of GDP. Yet at the same time government policy has saved Irish taxpayers from a far worse fate. If it hadn't been for 'tough decisisons to reassure the markets', by taking 8.9% out of the economy, the deficit would be 21% of GDP in 2011 (8.9% + 12.1%, not including Anglo).

Advocates of fiscal stimulus are accused of believing in the tooth fairy. But this is a tale out of the Brothers Grimm.

The advocates of slash&burn can neither explain the semi-magical way in which the Euro Area's deficit is no greater than the stimulus measures, and is now falling. And they invite us to believe in a horror story, where a gargantuan deficit, unique to Ireland has been averted, leaving just a monstrously-sized one in its stead, which is forecast to rise again in 2011.

But there is another explanation, one which would incorporate the hugely divergent trends in Euro Area government finances. It can be summarised as follows: Stimulus works. Slash-and-burn doesn't.