5/10/2014: Why the News of Budget 2014 'Easing' Is a Daft Idea

The reports are out about the IMF 'agreeing' to Government taking shallower adjustment in Budget 2014 are so far not based on IMF statements of record. In its latest review, published yesterday and amended to reflect the latest data, IMF clearly states that we still need a full EUR5.1bn adjustment to be taken over 2014-2015.

Irish Times reports undisclosed sources claiming that the IMF is now not opposing a shallower adjustment in 2014 in exchange for steeper adjustment in 2015. http://www.irishtimes.com/business/sectors/financial-services/imf-agrees-to-easing-of-3-1bn-target-1.1550925 This might be so. But there are several things you should consider before taking this as some unambiguous positive for Budget 2014.

Firstly, if true, this means that Ireland 'easing on austerity' in Budget 2014 to accelerate into 2015 adjustment will be equivalent to a household taking a 1 year mortgage relief in the form of reduced principal repayment relief (sort of a 'interest plus partial principal payment') that has to be recovered in full comes the following year. Even Irish Central Bank would not suggest this would be a meaningful relief to the borrower. In a sense, Irish Government will be taking a gamble if it reduces the EUR3.1 billion adjustment target - if growth undershoots the Budget 2014 projects or revenues slack or unexpected expenditure increases take place or any other possible risks arise, we will face more austerity in 2015 and possibly into 2016. All for a short-term small 'relief'?

Secondly, there are more reasons for being sceptical about the latest Government 'breakthrough':

1. Relief to be gained from such a transaction is not worth much - at most EUR300-400 million 'savings' to be immediately swallowed up by the 'black hole' of Government 'investment' - I wrote about this in my Sunday Times column on September 22nd. 
2. Much of this is unlikely to impact directly in 2014 due to time lags.
3. Much of the 'investment' will go to funding building activities in politicised constituencies. Remember primary care centres locations selection fiasco? The modus operandi that produced them is still here with us. 
4. The 'savings' will be terminated in 2015 as EUR5.1bn required total adjustment will have to erase fully the 'savings' generated in reduced adjustment for 2014. In short - we will get more waste, more future pain; and
5. Relief comes at a price of increased uncertainty into the Budget 2015 just at the time when we are heading into even more uncertainty of having to fund ourselves in the markets (keep in mind - our 2014 borrowing requirements are largely already covered by NTMA pre-borrowing, so real uncertainty over funding will coincide with the need for larger fiscal adjustment in 2015). This uncertainty is likely to result in Troika monitoring extending into 2016 and beyond, instead of Ireland gaining any meaningful clearance from Troika cover with 2015 fiscal adjustment. I covered this in the said Sunday Times article as well.

Oh, and one more little point: there is absolutely nothing new in the IMF taking such a position on Irish budget. IMF operates on the basis of longer-term targets and greater flexibility in adjustment than our EU 'partners'. IMF has signalled on a number of other occasions the same. 

So what exactly does the IMF 'support' for Budget 2014? Not much at all so far. And the risks from it, as noted above, are almost codified.

"The review had preliminary discussions on fiscal consolidation in Budget 2014. The Irish authorities are firmly committed to meeting the 5.1 percent of GDP ceiling on the deficit in 2014. They note some room to meet this ceiling with a smaller consolidation effort than the €3.1 billion (1.8 percent of GDP) set out previously, but have deferred a decision on the amount of adjustment in 2014 until closer to Budget 2014. [IMF] ...staff stressed the importance of delivering the planned cumulative consolidation in 2014–15 of €5.1 billion (2.9 percent of GDP). Under the revised macroeconomic projections, this amount of cumulative consolidation is also consistent with reaching a deficit within the EDP target of less than 3 percent of GDP by 2015." 

Note any statement about a 'relief'? I don't see one... But: "In this context, it was agreed that the authorities will publish Budget 2014 on October 15 with fiscal targets until 2016 fully in line with the 2010 Council Recommendation under the EDP, including the required fiscal consolidation effort until 2015, and national fiscal rules (proposed structural benchmark, MEFP)." Meanwhile, "the specific consolidation effort for 2014 will be discussed with the EC, ECB and IMF staff taking into account budgetary outturns in the first three quarters of 2013 and further information on growth developments and prospects." 

The IMF reiterates the same position of serious ambiguity on Budget 2014 and strict clarity on 2014-2015 adjustments targets throughout the entire Review. The Fund also clearly states where the thrust of 'savings' should be delivered: "An expenditure-led consolidation remains appropriate, including improved targeting of social supports and subsidies while protecting core public services and the most vulnerable."

18/3/2012: Fiscal Stimulus Multipliers - US data and some Irish considerations

In a recent paper, “Fiscal Stimulus and Distortionary Taxation”, Thorsten Drautzburg and Harald Uhlig (published Becker Friedman Institute for Research in Economics Working Paper No. 2011-005 ) estimate the fiscal policy multipliers from the federal spending programmes under the American Recovery and Reinvestment Act (ARRA) of 2009.

Fiscal multiplier is the ratio of output changes to the total stimulus policy-driven change in Government spending and transfers. So positive large multiplier means greater response in economic output per unit of spending, negative multiplier means a fall in the economic output for a unit of spending.

In addition to the traditional literature, the authors include a number of coincident effects:

• Fiscal expansion takes place in the environment of recession, which is also coincident with the Federal Reserve carrying out a monetary easing – referenced as the zero lower bound interest rates policy (ZLB). When the fiscal policy stimulus creates positive impact, this translates into incentives for the Fed to exit ZLB earlier, which in turn reduces economic activity rate of growth. The effect is compounded in the case when wages are sticky (for example, if negotiated via collective bargaining) and/or prices are sticky (for example, if set by regulatory authorities).
• In addition, the authors recognize that implementing / deploying fiscal stimulus in practice takes time in practice.
• Third, government expenditures on stimulus are financed, eventually, with distortionary taxes, creating costly disincentive effects in the future.
• Fourth, welfare transfers matter “to the degree to which they are given to credit-constrained households”.
• Fifth, the authors use Bayesian estimation techniques as well as sensitivity analysis to quantify the uncertain nature of the estimated coefficients in the New Keynesian model.

The study distinguishes between short-run and long-run multipliers in a benchmark model, finding:

• “Modestly positive short-run multipliers” that average 0.51, and
• “Modestly negative long-run multipliers” averaging around -0.42.
• The multiplier is particularly sensitive to the fraction of transfers given to [credit constrained] consumers, is sensitive to the anticipated length of the zero lower bound [the expected period of monetary policy easing], is sensitive to the capital share [in overall stimulus – i.e. the share of stimulus spending directed to capital formation as opposed to consumption] and is nonlinear in the degree of price and wage stickiness.
• Crucially, “reasonable specifications are consistent with substantially negative short-run multipliers within a short time frame” meaning that under reasonably realistic assumptions on price/wage stickiness and model parameterization fiscal stimulus can result in a negative effect on economic growth even in a short-run.
• In the US, the stimulus results in negative welfare effects for agents not constrained by debt. The debt-constrained agents gain, if they discount the future substantially.

Now, the above results are quite interesting in the context of the US economy, but they are even more interesting in the context of Ireland, as a small open economy with fixed interest rates. This is so for a number of reasons:

1. Ireland’s domestic demand is closely linked to imports, which means that unlike in the US, Ireland’s short-run multipliers can be expected to be smaller in magnitude due to losses of economic activity to imports. Note – imports enter GDP and GNP determination as a negative component, so any stimulus funds expended on imported consumption (public and private) will have a dual effect on overall economic activity: in the short run, they will reduce economic activity via imports increases (effects not present in the US economy), and they will reduce, in the longer term economic activity via same pathways as those revealed in the paper.
2. Ireland’s public expenditure is heavily leaned in the direction of consumption supports / income transfers. These provide support for both credit ‘unconstrained’ (non-indebted) poor households (who do not have mortgages and are not subject to the adverse effects of debt overhang) and for households of the unemployed who are constrained by debt overhang (hence significant rise in mortgage supplements payments). Those households, constrained by debt (such as mortgage holders still in employment) and the ones unconstrained by debt and not in welfare net (for example older households with no debt overhang) are therefore direct losers in the short run and in the long run. This, per findings above means that increasing social welfare transfers during the current crisis can lead to reduced economic activity even in the short run, while increasing negative effects of the stimulus in the long run.
3. Our monetary policies are determined outside Ireland and hence we can add higher uncertainty and shorter periods of ZLB duration to the Ireland-specific assumptions (remember, the ECB did hike interest rates into the Irish recession and then repeated the same again). This means that any fiscal stimulus in Ireland will be subject to stronger monetary policy headwinds, further reducing the multipliers in the short run and amplifying long-term costs of such a stimulus.
4. Ireland’s tax system became even more distortionary during the crisis and this process is ongoing. Once again, this amplifies the adverse finding from the US data and interacts negatively with point (2) above.

The study also incorporates consideration of the time-varying differentials between the central bank-set interest rates, government borrowing costs (bond rates) and returns to private capital (cost of private sector credit). The paper shows that “these wedges are indeed the key to understanding the recession of 2007 to 2009.” Although the study does not explicitly quantify these drivers effects, one can suspect that in the case of Ireland, dramatic increases in the cost of Government borrowing, alongside the rise in retail-level interest rates due to banks bust would have much more adverse impact on fiscal stimulus effectiveness. Whether or not these effects are enough to swing the stimulus short-run multiplier to the negative territory we do not know. But it is pretty safe to assume that they will make long-term costs of the stimulus more severe.

The use of New Keynesian model specification allows authors to conclude that “the model here is heavily tilted towards a model in which fiscal stimulus is often thought to work well: we therefore believe that the negative long-run effects of fiscal stimulus should give pause to arguments in its favor. Even at the short horizon, the benchmark multiplier is just around 0.5.”

Another interesting result is that consumption taxes, rather than income taxes are a better way to offset the costs of stimulus in the longer term. This is intuitive and consistent with other evidence. However, the paper finds that “adjusting [raising] consumption taxes only yields a slightly higher multiplier than adjusting labor tax rates.”

Please keep in mind that the Irish stimulus theory supporters have ardently argued that fiscal stimulus must be financed via income tax increases, not consumption tax hikes and have opposed even a modest Budget 2012 shift of tax burden on VAT.

08/07/2011: Effects of the spending stimulus on unemployment

An interesting study on the effectiveness of fiscal spending on unemployment was recently published in the CESifo working paper series. The full study can accessed here: Steinar Holden and Victoria Sparrman, "Do Government Purchases Affect Unemployment?" CESifo Working Paper No 3482, May 2011.

The study presents estimated effects of 1% increase in Government purchasing of goods and services on unemployment in 20 OECD countries for the period 1960-2007, controlling for a number of factors, including the size and the openness of the economy, the exchange rate regime and the economy position in the business cycle.

To summarize relevant results (found in Table 7) in the case of small open economies within the currency union, the effect of 1% increase in government purchases of goods and services translates into 0.37 decrease in unemployment rate. The effect can be as high as 0.47% decrease. Year after there is no net effect of jobs creation from the purchasing.

So what does this mean in the case of Ireland? Per latest QNA, Irish GDP in current market prices was €155,992 million in 2010. 1% of that spent on new purchases of goods and services amounts to €1,559,920,000. Q1 2011 unemployment, per QNHS, amounted to 295,700 and the unemployment rate stood at 14.1%. These are our inputs into the estimate.

Now, let's make an assumption concerning jobs created - suppose these pay €35,000 per annum in wages. Suppose that they pay €7,067 in income-related taxes (inclusive of USC etc), as consistent with single tax filer with no deductions. Suppose the social welfare benefits savings amount to €350 per week (note these are taken on purpose to be larger to account for other benefits that might be foregone) to the annual total of €18,200. Suppose that additional 30% is collected on income tax contributions due to higher consumption taxes contributions in employment - generating savings of additional €2,120 per annum.

So total savings per person moved off welfare into employment are roughly speaking €27,287. In other words, we assume that for each €35,000 job created, the Government get back almost €28,000 through various tax returns and savings.

Now on to the estimated impact of 1% increase in Government purchases of goods and services:

1. Case 1: maximum effect of 0.47% reduction in unemployment rate will result in 9,857 jobs created with the total cost of €158,260 per job created. Net of Government returns and savings, this means net cost per each job created of €130,873. Total impact is to generate a loss of 0.84% of GDP due to 'stimulus'. If we are to assume that all of the jobs created remain for ever after the 'stimulus' (a very tall assumption, but let's be generous), while the Government finances the stimulus at a constant interest rate of 6%, it will take almost 7 years for the economy to recover the costs of the 'stimulus' (if the rate of borrowing is zero - e.g. by using NPRF or some other 'free' funding, the period to recovery shrinks to 5.8 years).
2. Case 2: most likely effect of 0.37% reduction in unemployment rate will result in 7,760 jobs created with the total cost of €201,033 per job created. Net of Government returns and savings, this means net cost per each job created of €173,646. Total impact is to generate a loss of 0.88% of GDP due to 'stimulus'. If we are to assume that all of the jobs created remain for ever after the 'stimulus', while the Government finances the stimulus at a constant interest rate of 6%, it will take over 9 years for the economy to recover the costs of the 'stimulus' (if the rate of borrowing is zero, the period to recovery shrinks to 7.3 years).