Is austerity working?

YES, says John FitzGerald

THE word austerity has connotations of virtuous hermits leading simple abstemious lives away from the world.

However, when used to characterise fiscal adjustments undertaken by governments, there is nothing virtuous or desirable involved.

The programme of fiscal austerity that Ireland has undertaken over the last five years was a necessary evil. In dramatically reducing demand, it had a substantial negative effect on growth and it also added significantly to unemployment.

However, there was no alternative.

At the beginning of the crisis the then government found itself with a massive hole in the public finances. In the absence of a generous fairy godparent, Ireland has had to borrow huge sums of money abroad to fund a gradual adjustment process.

While the borrowing has been on favourable terms, by 2012 the interest on the debt accounted for almost 5% of gross national product, up from just over 1% in 2007.

This year the Government will still borrow well over €10bn to fund day-today expenditure (about 7% of gross domestic product).

Whatever about the concerns of the countries lending to Ireland, the increasing burden of debt on the Irish people means that it is essential for our future employment and income prospects that the public finances are brought back to balance.

In choosing what needs to be done in the 2014 and 2015 budgets, the major problem is that we do not know for certain what the future holds for the economy.

In a recent publication (available at http://exa.mn/lr), we considered a range of possible outcomes. In the more benign case, a €3.1bn adjustment in next year’s budgets would be enough to eventually restore the public finances to balance.

While in this case the deficit next year could be around 5% of GDP, under this benign scenario future growth would wipe out the rest of the deficit over the following three or four years without further fiscal action.

However, it is quite possible that the EU economy could stagnate for a few more years and the consequences for Ireland would be very low growth beyond 2015.

Under these circumstances, even the €3.1bn adjustment scheduled for 2014, and the additional €2bn planned for 2015, would not be enough to restore Ireland to a sustainable path.

Those who argue for undertaking an adjustment of less than €3.1bn in 2014 are gambling on a favourable economic outcome in 2014 and 2015, with no certainty of success. We could be lucky and it might prove sustainable.

However, if things turned out worse than they expect, then we would have to undertake an adjustment of more than €2bn in 2015, with the prospect of even more to come in an election year, 2016.

The proponents of an early easing have not fully recognised the gamble that they are proposing and the consequences if their optimism proves unfounded.

In a recent paper (available at http://exa.mn/ls) I have considered the past history of some major adjustments in Europe, including the Irish experience in the 1980s.

This analysis provides some useful lessons. In the case of the 1980s, the two toughest budgets were in 1983 and 1984 (tougher than any recent budget).

However, subsequent budgets in 1985 and 1986 failed to complete the job and it was necessary to put the nose to the grindstone again between 1987 and 1989, making further painful cuts.

The delayed fiscal adjustment in the middle years of that decade prolonged the crisis.

With the benefit of hindsight it would have been better to have completed the adjustment in 1985-86.

The second lesson from European experience is that progress in reducing a large government deficit is generally slow.

It is only once the necessary period of austerity is complete that the success becomes fully apparent.

This was true in the case of the UK adjustment in the late 1980s and of the major Finnish adjustment in the 1990s.

Thus talk of fiscal adjustment being “self-defeating” is misplaced.

In our recent medium-term review, we estimated that if no fiscal adjustment had been undertaken, the deficit today would have been over 13% of GDP.

Instead it is likely to be about 7% of GDP.

Up to two thirds of the remaining deficit is due to cyclical factors so that it will disappear with an economic recovery.

Thus talk of a failure of current policy is incorrect as real progress has been made.

As in the case of Finland in the 1990s, the pay-off in terms of a return to growth and falling unemployment awaits a completion of the fiscal adjustment process.

The choice we face now is whether to finish off the adjustment quickly or to risk seeing it being drawn out over another three or four years if Europe continues to stagnate.

John FitzGerald is a research professor with the ESRI