Brendan Keenan: Slaughter of those sacred cows
New research challenges the conventional wisdom on spending cuts and tax hikes but history shows it's not easy to get the balance right
THERE was quite a cull of sacred cows last week, but the slaughter was discreet and you may not have noticed. Some people, especially my friends in the trade unions, did notice, though and were quick to point to the carcasses.
The unlikely occasion of this was a series of briefings by a senior economist from the International Monetary Fund (IMF) on what he and his colleagues found in an analysis of budgetary corrections.
There are two big bits of conventional wisdom about fiscal correction. The first is that the increased confidence that comes from a government getting to grips with budget deficits can inspire more consumer spending, and therefore more growth.
The second is that, in terms of economic damage, it is better to cut public spending than to raise taxes. The IMF research seems to challenge both bits of conventional wisdom -- albeit with different degrees of certainty.
The evidence is stronger on the first: that the famous "expansionary fiscal correction" is a myth. This research used an unusual method, which allowed them to study fiscal adjustments during recessions.
As is the case now, recessions are often when corrections take place, but the standard research technique did not identify such cases.
Using this new method, the IMF analysts looked at more than 170 episodes of fiscal adjustment in OECD countries. They found only two episodes where economies expanded as deficits were cut: Denmark in 1983; and Ireland in 1987.
The fact that there were only two suggests that many may have drawn the wrong conclusions about 1987 -- that the Ray MacSharry cuts persuaded people that taxes would not rise further and so they could save less and spend more.
This argument rages far beyond Ireland. Another visitor to Dublin last week was Prof Robert Skidelsky, who gave a lecture sponsored by Ictu. He is author of the definitive biography of the economist John Maynard Keynes and champion of Keynesian policies. In his view, government borrowing is merely replacing private saving in current circumstances, he says, and cutting it as well can only reduce growth. Siptu president Jack O'Connor could not agree more.
David Leigh, the senior researcher on the IMF paper, had no particular explanation for the 1987 episode. Like several Irish economists, he pointed to external factors -- falling interest rates, a booming UK economy -- and the 1986 devaluation of the Irish pound.
His research finds that the two main mitigating factors in a fiscal correction are a fall in the exchange rate and a reduction in interest rates.
It is, of course, the case that neither is available to a member of the euro area.
And, indeed, the research also concludes that eurozone countries did suffer a bigger reduction in growth from fiscal austerity than those outside the monetary union. On the other hand, the difference was not large. Certainly not large enough to offset the gigantic costs of leaving the euro.
Apart from those striking exceptions of Denmark and Ireland, other conclusions are more tentative. The most robust seems to be that a one per cent cut in government borrowing produces a half-point drop in economic activity. This was the case across nearly all examples studied and, oddly, seemed not to vary whether the cuts were large or small.
We have, of course, never seen anything like the present round of cuts. They amounted to more than two per cent of GDP this year, and it looks like we will get something similar next year. Based on these findings, we can expect growth to be more than two per cent lower than would otherwise be the case.
The best we can hope for is that the 50 cent lost output for each euro of correction gets no worse as Ireland struggles with perhaps the biggest budgetary correction ever attempted. However, Mr Leigh delicately pointed out, the research does not mean that Ireland, with one of the biggest deficits ever seen, has a lot of policy choices.
That still leaves the question of spending cuts versus tax rises. The researchers suggest that the observed difference comes because central banks are more likely to put up interest rates if higher taxes like VAT increase prices -- thereby increasing the economic damage.
Euro membership means this is not a problem for Ireland, since the ECB has little interest in Irish inflation. This will also find favour in some quarters. Blair Horan, general secretary of the Civil Public and Services Union, suggested last week that, while we might not like to return to 1980s levels of taxation, it might be the best option.
Perhaps it is not so much taxes versus spending, but the kind of tax rises and the kind of spending cuts.
Taxes that increase the cost of employment or productive capital are perhaps best avoided. Cuts that maintain services but reduce the cost of providing them should perhaps be favoured. It is not easy to do either.