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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