Fiscal Policy during and after the Bubble. Agenda Review of theory –What should Fiscal policy do?...
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Transcript of Fiscal Policy during and after the Bubble. Agenda Review of theory –What should Fiscal policy do?...
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/GNP1996-2010
-10
-5
0
5
10
15
20
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
CBD
EBR
• 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 levelLeddin and Walsh Macroeconomy of the Eurozone, 2003
Stabilization Policy
Government expenditure (G)
GNP1
AB
GNP2
C
Nominal GNP
NT
GNP
€ billions
Full-employment budget
G, NT
Budget surplus
Budget deficit
*
Natural GNP
Balanced budget
Leddin and Walsh Macroeconomy of the Eurozone, 2003
Government expenditure (G)
GNP1
AB
GNP2
C
Nominal GNP
NT
GNP
€ billions
Discretionary changes in taxes and expenditure
G, NT
*
Natural GNP
NT
NT
1
2
3
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
-6
-4
-2
0
2
4
6
8
10
12
14
16
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
EBR
strucural
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
• 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
Summary
Debt/GDP(1996-2010)
0
10
20
30
40
50
60
70
80
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
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
– Initial change in government expenditure: G
– Implies a change in income for some group: Y1= G
– This leads to a increase in their consumption C1= bY1= bG
– This in turn leads to a further increase in Y representing income for some other group Y2= C1= bG
Size of Multiplier
– This leads to another increase in consumption C2= bY2= b(bG)=b2G
– This leads to another round of income increase
• The process continues for an infinite number of rounds
• Total change in income– Y= Y1 + Y2 +…+ Yn +…
Yn=bn-1G
Y= G*[1+bb2+…+bn-1+…]
Y= G*[1/(1-b)]
• 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
Negative Multiplier
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
Averagetax rate
100%
0 %
T
T
T
1
*
2
R 1 R 2
Revenuemaximizingtax rate
Tax revenue £m
A
B
Laffer Curve
Z
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