‘Fair distribution of burdens’ vital as part of austerity process

Ireland has to date managed the austerity process better than most other countries, but the continued success of the adjustment process depends on maintaining social cohesion and a sense of fairness, according to the Central Bank’s chief economist, Lars Frisell.

There has been much discussion among academics about the multiplier effect in the event of an economic downturn, he said. This means the effect on an economy of the Government cutting spending or the impact of increasing spending.

However, just as important as the multiplier effect is the way that budgetary cutbacks are implemented.

“Austerity is difficult. Psychological resistance will be greater than pure economic impact would suggest. It is therefore hard to overstate the importance of social cohesion and a fair distribution of burdens when countries embark on fiscal consolidation,” said the Swedish-born economist.

Mr Frisell was speaking at the Paddy Ryan Memorial lecture at the Galway-Mayo Institute of Technology last night. His topic was the economics and psychology of financial crises.

The Central Bank economist did not talk specifically about last week’s budget which imposed €3.5bn of fiscal consolidation.

“Insights from the behavioural sciences may offer more to the debate on austerity. The first I want to mention is known as the endowment effect: The fact that it is much harder to give up something you once possessed than to abstain from getting it in the first place.

“A second psychological force is the human desire for fairness.”

Mr Frisell argued it is very hard to call a bubble, as irrational behaviour becomes the norm in times of excess. He cited the property bubble, the 1990s dotcom frenzy and Dutch tulip bubble of the 17th century.

“In retrospect, it is of course blatantly clear that asset prices in all these episodes were driven far beyond their fundamental value. But is it possible that the valuations made at the time seemed reasonable?”

Thus, central banks and supervisors must have an explicit macro-prudential mandate, “not because we are better at forecasting prices or assessing credit risk than others, but because we can combine information from all strands of the economy, including every lender. Our task is to distill these masses of information to detect potential imbalances, and, if publicising our assessment is not enough to stem the tide, we must take action on the basis of it.”