Multipliers then and now

Michael Burke: There is further evidence that fiscal stimulus works. Kevin O'Rourke has (re)posted here a very interesting piece by Barry Eichengreen et al here - on the parallels between the period of the Great Depression and the current 'Great Credit Crisis'. Taking into account the global economy (not just the US) then and now, the authors find close and very disturbing parallels; that global industrial production has fallen as fast now as then, that global stock markets have fallen more now and that the collapse in world trade is even graver now.

The authors also examine the effectiveness of monetary policy then and now, focusing on short-term interest rates. They also examine the effectiveness of fiscal policy changes.

Their key conclusion is also the most interesting and relevant one;

“[Scepticism suggested that] monetary policy is ineffective when the banking sector is in distress. Fiscal policy is ineffective when the need is to reduce the level of indebtedness and when much previous output in the declining sectors is unsustainable; it simply cannot be replaced by replacing demand.

“Our results push back against this scepticism. They suggest that fiscal stimulus made little difference in the 1930s because it was not deployed on the requisite scale, not because it was ineffective” (p.25).

The authors go on to add that their mathematical estimates for the government spending fiscal multipliers were 2.5 in year 1 and 1.2 thereafter.

Now, we are repeatedly told that Ireland is a small very open economy, where the fiscal multipliers would not work in the same way; that government expenditure would leak abroad in the form of increased import demand. Yet many of the leading economies discussed in the Eichengreen paper were large very open economies in that they were centres of vast established political and economic empires, or putative ones. Furthermore, the colonial possessions were the destinations for huge capital outflows and the source of ultra-cheap labour and imports. Therefore, it would be reasonable to assume that the 'leakage' overseas of any fiscal stimulus would be fairly high, certainly no lower than 21st century Ireland.

But we do not have to rely on supposition in that regard. Bang up to date, the government's Pre-Budget Outlook (PBO) tells us what some of the multipliers are for the output that has been lost to date in the Irish recession and their effects on government finances.

The PBO states that, in the past, the official expectation was that a 1% change in nominal growth would lead to a 1.1% change in tax revenues (strangely low by intenational standards, but perhaps reflecting Ireland's very narrow tax base). But in the last 2 years, tax revenues have declined by 32% while the value of GDP has declined 13% (p.20.). That is, a revenue multiplier of approximately 2.5 over 2 years.

Now, no doubt, there will be those that argue that this is previous taxation data based on the housing bubble, as if that was an argument for maintaining the current narrow tax base. But the decline in Ireland's tax revenue is not wholly attributable to housing as there has also been a commensurate decline in other areas of investment, notably machinery and office equipment, which had a peak-to-trough decline of over two-thirds. In any event, it is entirely possible to adjust the tax base to reflect any areas the government chose to target for reflationary measures.

But that's only one part of government finances. The other side is expenditure. Here, the PBO states that there will be a rise of €4.5bn between 2008 and 2010, "predominantly the rising cost of social expenditures due to an increase in unemployment." This represents a rise in spending of approximately 8.5% in response to a decline in GDP of 13%. Even this total significantly understates the effects on spending given the large number of cuts already enacted.

Based on the PBO's current spending total of €56bn in 2009 and tax receipts of €32bn and the effects on government finances to date, a 1% rise in GDP could yield increased taxes of €790mn and lower spending by €350mn to give a total saving of €1.14bn over two years.

The alternative, attempting to cut your way to a balanced budget has already been tried and has already failed, as the PBO inadvertently admits. The increase in unemployment noted above, and the increasing costs associated with it, predictably, "have more than offset the expenditure economies already announced."