Trapped in an analytical prison

Michael Taft: Seamus Coffey has written a provocative post over at Irish Economy on the recent Exchequer statement, showing that Government borrowing is not falling even after the €20 billion fiscal contraction over the last few budgets. Some of the commentators on the post find this surprising but it shouldn’t be. The TASC open letter signed by a number economists and analysts predicted this would happen. Contributors on this blog have gone through the numbers to show why this would happen. Nonetheless, the failure to reduce Government borrowing will no doubt spark renewed demands for more contraction; this may explain the Finance Minister’s warning that cuts will be even deeper than anticipated in the Programme for Government.

The problem, however, goes much deeper than argument over numbers. It goes to the heart of how we debate the economy – a debate that currently inhibits a proper understanding of fiscal contraction, public finances and economic growth. In short, we are trapped in an analytical prison.

The current debate over fiscal policy is based on a fundamental confusion – that the finances of a government are analogous to household finances. When spending in the household, exceeds income, goes the argument, the household must reduce its expenditure. People go out less, buy less, take less holidays, postpone major purchases, etc. The key point here is that if I cut my spending, this doesn’t reduce my wage or income. My wage is unaffected by me buying less books. Therefore, spending reductions are a net gain. It is a rational act at household level.

However, governments are not households. When a government cuts its spending, it cuts its revenue as well – because it cuts the economy’s revenue. This is fairly straight-forward and the ESRI has published two studies on this subject. For example, it found that cutting public sector employment equivalent to reducing spending by 0.6 percent of GDP, actually drives down the domestic economy (GNP – where our tax base lies) by over twice that amount in the short-term: -1.1 percent. Therefore, after the fall in demand and business output, and the rise in unemployment (which they measure) the actual ‘savings’ to the Government in the form of deficit reduction is minimal: 0.2 percent. We get little bang for our contraction buck, but we have weakened the economy’s ability to generate revenue in the future by the resulting deflation.

That is why, when using the ESRI measurements, we find that the Government policy of cutting over 20,000 jobs from the public sector will make almost no contribution to fiscal reduction. But it will drive more businesses out of business and more people on to the dole queues or the emigration planes.

Again, this shouldn’t be surprising. If you cut social welfare, people will spend less thus cutting domestic demand which impacts negatively on businesses reliant on that demand. Tax revenue falls, unemployment costs rise; the ‘savings’ turns out to be no such thing.

If you cut contracts to the private sector (which account for one-third of spending on public services), domestic business activity contracts. So don’t be surprised when tax revenue falls and, again, unemployment costs increase.

This is what happens in normal times (and the ESRI simulations were based on a growth base-line). But to do this at the same time as private sector output is contracting is a recipe for accelerating the recession (which is what happened) and embed low-growth into the economy going forward (which is what is happening).

All this because the current debate is based on a false analogy.

A related problem is that the debate confuses means and ends. The goal is to reduce the deficit. However, the debate obsesses over spending cuts and tax increases and measures success in the amount of (downward) fiscal adjustments we can come up with. This is known at the ‘arithmetic’ approach and we see this popping up everywhere. If we cut x, then we save x – but as we know, cuts do not equal savings. We do not debate fiscal effectiveness; we debate different numbers on the revenue and spending balance sheet and delude ourselves that we are discussing fiscal stability. As Seamus has shown, however, this is not happening.

Most crucially, we don’t even acknowledge that the nation’s balance sheet is made up of three elements – revenue, spending and investment. The latter is rarely referred to even though it has been the driving force in the Irish recession. Investment is a tool of fiscal consolidation – a down-payment on future income; an activity that drives up demand in the short-term and continues to contribute to economic growth and revenue raising in the long-term through its supply input.

We are left with a wholly inadequate framework with which to understand, never mind debate, the continuing economic and fiscal crisis. All we get, with every fresh round of bad economic and fiscal news, is call to ‘tighten’ our belt even more, take ‘tough’ decisions, and make ‘sacrifices’. It is depressing that those calls are part of the problem, not part of the solution.

What we need is a new analytical framework – a new fiscal framework if you will. One that can explain why we are still mired in this mess. One that can help explain how an economy – households and businesses – interact with fiscal and investment measures. On that can provide a platform for sustainable pathways back to economic recovery and fiscal stability.

Otherwise, we will continue to sink. And all we will get is ‘solutions’ that will sink us even further.