Is austerity working? YES
Since this is substantially below the 3% of GDP ceiling that is enshrined in EU guidelines, there is now speculation that the Government will slow down the pace of fiscal adjustment in Budget 2014.
However, there are several compelling reasons to stick to the original plan. Most important, the market will the sole funding source for the Government once the troika leaves later this year. The interest rate charged to the Government on its borrowings will depend on the level of confidence of investors in the Government’s willingness to service its debts in the years ahead. The postponement of the agreed fiscal package would add to the amounts that Ireland will need to borrow from market investors and create uncertainty about the Government’s determination to complete the austerity programme. As an example, we have seen the market interest rate on Portugal’s sovereign debt climb rapidly in recent weeks as its political crisis has created new doubts about its willingness to reduce its deficit.
A substantial increase in the market interest rate would be very costly. First, it would require future tax increases or spending cuts to finance higher debt servicing payments — at very high debt levels, the fiscal cost of an increase in the interest rate on sovereign debt would dominate any short-term relief from delayed adjustment. Second, the market interest rate charged on government debt also directly influences the cost of funding to the banking system, so that households and firms would also face higher interest rates. Third, the interaction of a high debt level and an increase in the interest rate could give rise to the type of unstable dynamics that would result in a new funding crisis for the Government. In turn, such a funding crisis would entail the return of the troika and/or force a restructuring of Ireland’s sovereign debt.
So, the deferral of fiscal adjustment would entail a clear downside risk. To put it mildly, inadequate recognition of downside risk has been a recurrent feature in Ireland’s fiscal history, accounting for our vulnerability to reversals in global financial conditions in the early 1980s and again in 2007-2008.
The electoral cycle also matters for the timing of fiscal adjustment packages. This Government has a large majority and its lifetime should encompass the budgets for 2014, 2015, and 2016. All else equal, the postponement of measures in Budget 2014 will mean that more austerity could be required for 2015 or 2016.
As the next general election draws closer, it will be politically more difficult to implement further austerity measures. This is well understood by market investors — if the fiscal measures are postponed in Budget 2014, it will foster doubts about the capacity of the political system to deliver the extra austerity in the run up to the next election. Given these negatives, any positive impact from a loosening of fiscal policy would have to be very strong to justify the postponement of the fiscal austerity and the taking on of these downside risks. However, the high import content in Irish expenditure patterns means that the multiplier effect of stimulus measures is much smaller here than in larger economies or in relation to the impact of a coordinated Europe-wide stimulus programme.
Accordingly, from a macroeconomic perspective, stimulus measures of €1bn (the projected savings from the promissory note deal) would simply be too small to have a noticeable impact on the overall growth performance of the economy; in contrast, securing €1bn in expenditure cuts or revenue increases would be a major achievement in the context of closing the remaining fiscal gap.
From an overall perspective, it is terrible that fiscal austerity is necessary at a time when unemployment is so high and many households are under massive financial strain.
This predicament can be traced back to the boom-bust cycle in the construction sector, the failure to regulate the banking system, insufficient prudence in fiscal policy during the boom years, and mistakes in the design of the bank rescue initiative.
In order to avoid such damaging pro-cyclicality in fiscal policy in the future, it is imperative that the political system guards against downside risk and manages the fiscal position in a prudent manner. Only with the restoration of fiscal stability can citizens be assured that the risk of future crises will be minimised and that the Government will have the fiscal flexibility to better insulate households from future downturns.
