Fiscal Policy
Some Theory and the Practice in
Ireland
Learning Objectives
1.
2.
3.
4.
5.
6.
7.
8.
FP as Stabilization Policy for AD & AS Shocks
The Problem of Lags
The Multiplier
The Automatic Stabilizer and Full employment
Balance
Debt Sustainability
Deficit control
Policy Rules
What is to be done?
1. FP as Stabilisation Policy
• We have already seen that changes in the AS/AD curves
cause actual real GNP to swing around natural real GNP.
– That is, the business cycles tends to move from recession to boom
and back again.
• these booms/recessions can persist for long periods of
time.
• Many Economists advocate an active fiscal policy
(changes in government expenditure and/or taxes) to try to
stabilise the business cycle.
• Others say practical problems render this dangerous
• Note ideology: big government vs small government
LRAS
p
SRAS(pe)
A
B
C
AD0
AD1
Y*
Y
Stabilisation policy
%
change
Boom
Inflation gap
Actual growth rate
3 – 6%
Growth rate of
potential GDP
Unemployment gap
Recession
Time
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
FP & Supply Shocks
• The government is counter-acting shifts in either
the AS or AD curves using only fiscal policy.
• However, this is not an effective response to
dealing with an adverse supply-side shock.
• It may solve unemployment problem but it makes
inflation worse.
• This happened throughout the western world in
1970s when countries reacted to an oil shock by
expanding deficits
– Ireland was no different
• The oil shock increases the real cost of
producing everything this shifts the LRAS
to the left
• Starting at A, the economy moves to B
– Output is lower, Unemployment is higher and
inflation is higher
– “stagflation”
• This is a stable long run equilibrium
• FP (or MP) shifts AD to right
• Even higher inflation and no extra output in
long run
p
LRAS1
LRAS0
SRAS(pe)
C
B
A
AD1
AD0
Y1*
Y0*
Y
• Be sure you understand why FP doesn’t
make things better in this case
• This experience made politicians in Ireland
and elsewhere suspicious of using FP to
• Stabilize the economy
• But that is not the correct inference
– The problem was one of misdiagnosis
Comment on Ireland
• We can examine Irish FP from the point of
view of Stabilisation
• No Stabilisation policy until 1972
– Government didn’t deliberately run CBD
– Borrowing for capital was allowed (EBR>CBD)
• 1972-77: Oil crisis, recession. Government
reacts with expansionary policy Misdiagnosis
of supply shock as demand shock
• Large increase in deficit
2. Policy Lags
• Recognition lag: a delay in realising the economy has
gone into boom or recession. Data is out-of-date.
• Decision lag: a delay in deciding how to spend, cut
expenditure or change tax rates.
• Implementation lag: for instance, tenders for projects
delay expenditure.
• Outside lags: the time policy takes to impact on the
economy.
• Milton Friedman: “Long and Variable lags”
– Government policy could be out-dated by the time it is
implemented and could end up destabilising, rather than
stabilising, the business cycle
• Many Economists agree MP better e.g. aftermath of WTC
and current crisis.
How a stabilisation
policy de-stabilises
the business cycle
%
change
Economy hit by “shock”
goes into recession
Boom
Actual growth rate
5 – 6%
Natural growth rate
Expansionary fiscal policy
implemented at this point
Business cycle
automatically
rights itself
Time
Comment on Irish FP
• Lags long in Ireland.
– Often leads to mis-timing of policy
– As economy improves FP expansion continues
leading to inflation
• This happened a number of times in Ireland
– After the 1970s oil shock
– The 2001 WTC attacks
– The 2008 financial shock
• Partly influenced by “political cycle”
3. 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
• Small multiplier argues against traditional
stabilization policy
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
• Some would argue that the multiplier is not
only low, it is negative
• “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
• Something for nothing: expand economy &
reduce debt
4. The Automatic Stabilizer
•
•
•
•
•
•
•
•
A recession automatically worsens the budget deficit. Tax
revenues fall and social welfare spending rises.
Boom period, the deficit falls.
Define: Budget surplus = T – [G + SW]
Defining net taxes (NT) as:
NT = T – SW
NT is the proportion of government tax revenue and
spending that varies with fluctuations in nominal GNP.
Positive relationship between NT and GNP.
Current spending (G) is assumed to be constant.
•
•
•
•
•
•
Diagram shows how the budget balance varies as GNP
changes. (Diagram 1)
Recession: Budget deficit.
Boom: Budget surplus.
Note distinction between automatic and discretionary
changes in the budget balance. (Diagram 2)
Discretionary change occurs when the government
deliberately changes G, T or SW shifting the lines
The result is a balanced budget at different levels of GNP.
Full-employment budget
G, NT
Natural GNP
NT
€ billions
Budget surplus
B
A
Government
expenditure (G)
C
Budget deficit
Balanced budget
GNP
1
GNP*
GNP
2
Nominal GNP
Discretionary changes in taxes and expenditure
NT2
Natural GNP
G, NT
NT
1
NT
3
€ billions
B
GNP1
A
C
GNP *
GNP2
Government
expenditure (G)
Nominal GNP
Full Employment Budget
•
•
•
•
•
At what level of GNP should the government attempt to
balance the budget?
It is argued that the relevant budget balance is the “natural
GNP budget” or “full employment budget”
That is, the government should choose a combination of
taxes and expenditure that balances the budget if the
economy were at natural real GNP.
This entails tolerating a deficit in times of recession and a
surplus when the economy is over-heating.
The problem is that it is not easy to calculate the natural
GNP budget.
Calculating Full Employment
Budget
• AKA “structural” deficit
• Represents “discretionary” policy
• The concept is straightforward but calculation is more
difficult
– See irisheconomy.ie for some debate on the issue
• OECD adopts the following formula
–
–
–
–
–
Actual Def= struct def -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
Take g* to be 3%
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 on Ireland
• 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
• Automatic stabiliser is huge issue now because
recession so severe
US Case
• US gap between structural and actual deficit
is small
– Recession much less significant in US
– Automatic stabliser smaller
• Large discretionary deficit: Stimulus
• Debt rising fast
– Far from unsustainable
– In $: so can always use infaltion
US Structural Deficit
12
10
8
%GDP
6
4
Primary Deficit
Structural Deficit
2
0
1997
1998
1999
2000
2001
2002
2003
2004
-2
-4
-6
Year
2005
2006
2007
2008
2009
2010
Differences between US and Ireland
• Or between any large country and a small open
economy
• US issues debt in its own currency
– Can use inflation if necessary
• FP policy likely more effective (see later)
• US can depreciate its currency
– Could expand economy by depreciation
– Control deficit by cutting G, raising T
• US can reduce interest rates
FP during Bubble
• Look at bubble in detail later but it is clear that
we can say the following
– 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 €40,000 per worker
– Includes banks (see later)
5. Debt Sustainability
• Problem with Fiscal policy in recession
• Debt grows exponentially as economy declines
and we borrow merely to pay interest on the
stock of debt
– Problem in 1980s
– Could be problem again
• Key variable is d=D/Y
– Debt-GDP ratio
– “debt burden”
• d evolves according to the following equation
Ddt  dt (rt  gt ) + t
• Where
– r is the interest rate
– g is the growth rate
– p is the “primary balance”: G-T excl. interest
• Difference equation with impulse and potentially
explosive growth
• Intuitive
– Maths online
-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
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
US Debt/GDP
120
100
80
60
40
20
0
Comment on Irish Experience
• The badly timed FP of the 1970s lead to a
rapid increase in debt
• Dynamically unstable by 1982
• Got worse during 1982-1987
– Ireland’s failed stabilization attracted international
attention
• Only disappeared with the Celtic Tiger
• Reappeard with the bank debt
• Difficult to get debt down in the future as rapid
growth of Celtic will not be repeated
6. Deficit Control
• “Austerity” big issue in Eurozone, UK & US
• If the multiplier is positive cutting deficit now
will make recession worse
– If multiplier is negative there is no conflict
• So why do it now as distinct from postponing to
the future?
• Dynamically unstable debt now
– 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
– Note recent concerns expressed by IMF that adjustment
should be slowed down because growth is lower
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
B
0%
R1
R
2
Tax revenue
Laffer Curve
• Suppose wanted to close entire Irish 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
– Diamond and Saez who conclude incentive effects are
small and suggest opt higher rate of 73%
• 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
Comments on Irish Experience
• 1982 Economy in recession and budget deficit
at an all-time high
– Note the effect of the automatic stabiliser
• Attempt to cut the deficit largely failed
• Why?
– Automatic stabiliser
– Partners in recession (Volker disinflation)
• 1982-86: Laffer curve type effects. Recession
and doubling of national debt.
• Example of austerity that failed
• 1987:Another deflationary fiscal policy
– This time the focus on expenditure cuts.
• The economy roared in fact this is the
beginning of the Celtic Tiger
• Many are tempted to conclude
– Austerity caused the Celtic Tiger
– Expenditure based austerity is better than tax
based
• As we will see the first is not true
• The second might be but it is only one
observation. But it is probably the case that
the Irish tax system was so extreme that we
did have Laffer curve effects
7. Fiscal Policy Rules
• Monetary policy has been taken over by
independent central banks, out of the reach of
politicians.
• Should fiscal policy be removed from the
political arena by subscribing to a fiscal rule?
• Attractive given Ireland’s experience
• Surprisingly common
• Superficially attractive given the mess but two
questions
– what rule?
– How enforced?
Maastricht Criteria
• Two fiscal requirements for Euro membership
– Government deficit: must be less 3% of GDP
– Debt less 60% to GDP at the end of the preceding
fiscal year
• Note that countries fiddle the statistics (are
were let) Greece clearly lied
• Also criteria makes no distinction between
current spending and investment
• Also not expressed in terms of the structural
budget
The Stability & Growth Pact
• The Stability and Growth Pact (SGP) was
framed at the Dublin summit, December
1996, and ratified at the Amsterdam
Summit, June 1997
• Designed to prevent backsliding by
countries that had met the Maastricht
criteria for EMU
• Obviously didn’t work: Greece lied and
everyone knew
• Formalised the “Excessive Budget Deficits”
procedure
• Fiscal deficits should average at most 1% of
GDP over the business cycle (“Structural
Budget”)
• Deficits in excess of 3% of GDP will attract
penalties unless they were due to
“exceptional” and/or “temporary”
• Could imply pro-cyclical transfers from
countries to the centre.
– Fiscal federalism in reverse
SGP: Rise, Fall and Rise Again
• Ireland was reprimanded in 2001 because
the Council felt that Budget 2001 was too
expansionary
– In retrospect correct
• But the stagnation of the Eurozone economy
during 2002 has lessened the appetite for
enforcing the SGP
– Portugal, Germany, Italy, and France at or above
the 3% ceiling
• Rule was scrapped
• Current Fiscal Compact is similar.
– What happens when France or Germany break it
The Golden Rule
• Economists favourite rule
– Was followed by UK
• Over the business cycle the government should borrow
only to invest and not to fund current spending
– No current deficits, but
– Future generations should contribute to the costs of infrastructure
from which they benefit
• Like SGP focus on structural deficit
• Unlike SG explicitly GR envisages borrowing for
investment
• We adhered roughly to this rule in Ireland until the 1970s
Problems with The Golden Rule
• The threshold between current and capital
spending is not hard-and-fast
– Education? Health? Etc
• Is government capital formation efficient?
• Until the crisis government capital formation
accounted for borrowing equal to about 4.5% of
GDP
• What happens if break it? Precedent of SGP
Fiscal Compact
• Rules:
– Overall deficit less than 3% of GDP
– Structural deficit must not exceed 0.5% of GDP
– If debt exceeds the 60% must reduce it at an
average rate of one twentieth (5%) per year
• Enforcement
– The EU court fine a country that does not adopt a
standardised balanced budget rule - with a penalty
equivalent to up to 0.1% of GDP.
– Excessive Deficit Procedure: submit plan to the
Commission will be monitored by the Commission
and the Council.
Comment on FC
• Rule does not make distinction between government
investment and other expenditure so not equivalent to
Golden rule
– Probably afraid rule would be fudged
• Does make a distinction between structural and overall
deficit
• But 3% very harsh in recession doesn’t allow much
room for automatic stabilizer so would make recession
worse
• The fine would also make recession worse
• The compact mimics what the Troika does for bailout
countries.
– monitoring of plans to combat deficit by EU
– access to Euro bailout funds as part of the adjustment
Conclusion On Rules
• Present Crisis: There is need for a rule
– but a rigid one is undesirable
– Probably unenforceable
• Projections of GDP, tax revenue, and spending are
uncertain
• Rule should force the present generation to pay for
the level of spending on (current) public services it
desires
• The Fiscal Compact is probably too rigid and
probably unenforceable.
8. What is to be done?
• For any SOE conflict between two basic issues
– Stabilisation policy
– Deficit control
– Empirical question as to size, speed and nature of adjustment
• 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
• Deficit control
– Irish deficit this year heading towards €30bn = 13%GDP
– 13% not sustainable forever
– Most Irish economists argue need cuts now
Conclusions
1. FP as Stabilization Policy:
– can work for AD shocks but makes things worse when
shocks are from the supply side.
2. The Problem of Lags
– There are long and variable lags
3. The Multiplier
– Likely to be low and even lower in SOE
– Unlikely to be negative: austerity hurts
4. The Automatic Stabilizer and Full employment
Balance
– Recession will make deficit worse leading to demands
for austerity and problems with debt sustainability if
there is an underlying deficit i.e. even in full
employment
5. Debt Dynamics
– Without austerity debt could get out of control
6. Deficit control
– Tax vs expenditure unclear
7. Policy Rules
– Golden Rule good idea but not likely to be
enforceable
8. What is to be done?
– Optimal Speed and nature of adjustment is
unclear
– Current plan is probably reasonable
Current budget deficit
1972 - 2002
8
6
4
% of GNP
2
0
-2
-4
-6
-8
1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Exchequer borrowing requirement
1972 - 2002
16
14
12
10
% of GNP
8
6
4
2
0
-2
-4
1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
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
National debt
1972 - 2000
140
120
% of GNP
100
80
60
40
20
0
1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
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