Transcript Fiscal Policy during and after the Bubble

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
CBD/GNP & EBR/GNP
1996-2010
20
15
10
5
0
1996
-5
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
CBD
EBR
-10
2010
Stabilization Policy
•
•
•
•
•
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
Full-employment budget
G, NT
Natural GNP
NT
€ billions
Budget surplus
B
A
C
Budget deficit
GNP
Government
expenditure (G)
Balanced budget
1
GNP *
GNP 2
Nominal GNP
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Discretionary changes in taxes and expenditure
NT2
Natural GNP
G, NT
NT
1
NT
3
€ billions
B
GNP 1
A
C
GNP *
GNP 2
Government
expenditure (G)
Nominal GNP
 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
Structural Deficit
16
14
12
10
8
6
EBR
strucural
4
2
0
1996
-2
-4
-6
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
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
Summary
• 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
Debt/GDP
(1996-2010)
80
70
60
50
40
30
20
10
0
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
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
LRAS
p
SRAS(pe)
AD0
AD1
Y*
Y
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
Size of Multiplier
– Initial change in government expenditure:
DG
– Implies a change in income for some
group: DY1= DG
– This leads to a increase in their
consumption DC1= bDY1= bDG
– This in turn leads to a further increase in Y
representing income for some other group
DY2= DC1= bDG
– This leads to another increase in consumption
 DC2= bDY2= b(bDG)=b2DG
– This leads to another round of income increase
• The process continues for an infinite number
of rounds
• Total change in income
– DY= DY1 + DY2 +…+ DYn +…
 DYn=bn-1DG
 DY= DG*[1+b+b2+…+bn-1+…]
 DY= DG*[1/(1-b)]
Negative Multiplier
• 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
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
Laffer Curve
Average
tax rate
100%
A
T1
Z
T*
T2
Revenue
maximizing
tax rate
B
0%
R1
R
2
Tax revenue £m
 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
-5
-10
-15
Year
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
% GDP
Primary Balance % GDP
10
5
0