Government spending cuts need not be deflationary

 

ECONOMICS:Adjustments that boost competitiveness by reducing pay can have overall expansionary effects

ICTU GENERAL-SECRETARY David Begg’s op-ed article in this newspaper on Wednesday of last week (“Deflationary policies have little chance of succeeding”) generated quite some debate with both the The Irish Times website and irisheconomy.ie registering a large volume of comments.

For the most part, and despite the populist appeal of his position, most of the responses, especially on The Irish Times site, were hostile and in several cases bordered on the offensive. A man of Begg’s stature deserves better than this. There is a way of rebutting the case he makes that is both firm and respectful.

The nub of the Begg position can be summarised in his own words: “we know that pro-cyclical deflationary policies will drive down the domestic demand side of the economy and increase unemployment, but there is no evidence to suggest any immediate boost to exports that would counterbalance this”. He defines “deflationary policies” as those that involve cutting public services, cutting social welfare and cutting the minimum wage and wages generally in the public and private sectors.

The first point to make is that two distinct sets of measures are in the frame here: measures the purpose of which is to reduce the yawning gap between Government spending and receipts (cuts in public services, social welfare and public sector pay), and measures the purpose of which would be to bring about an improvement in competitiveness through real devaluation (cuts in private sector wages and the minimum wage). Of course, the two sets of measures overlap in so far as cuts in social welfare and public sector pay might facilitate reductions in private sector wages and salaries. More on this in a moment.

The first set of measures is designed to achieve an objective that is not discretionary, but an imperative, namely the reduction in the huge budget deficit. There is room for argument about the pace at which this reduction should occur. There is also room for debating the composition of that adjustment as between spending cuts and tax increases.

However, given the enormous scale of the problem, it would be fanciful to suppose that it can be solved without at least some reductions in public spending, and anyone who doubts this cannot really be regarded as a serious participant in the public discourse on the matter. I don’t believe that David Begg is among the doubters in this respect, although his article seems equivocal on the issue. The next question to be addressed is whether a policy designed to cut a Government budget deficit is necessarily deflationary. The standard textbook (or naive Keynesian) answer to this question is yes.

But a more sophisticated answer, embodying insights derived from over two decades of applied research, is that it depends. For one thing, household and business sentiment may be so negatively affected by large budget deficits that decisive government action to reduce them may restore confidence and regenerate private sector spending. In this type of scenario, which is most likely when the initial deterioration in the public finance position is very large and the sense of crisis correspondingly powerful, overall domestic demand may not be much reduced by fiscal consolidation.

The other, and arguably more relevant point, highlighted by the literature is that the effects of fiscal consolidation on the broader economy depend critically on the composition of the corrective measures.

Here the research suggests that adjustments that rely more heavily on spending cuts than tax increases, and where the spending cuts are concentrated on pay and welfare payments rather than capital spending, are not only more likely to be successful in stabilising public finance positions, but may also be expansionary of overall economic activity. The reason for this expansionary effect is that adjustments of this sort enhance the competitiveness of the economy by facilitating the emergence of lower private sector wages. This may not be music to the ears of a trade union leader, but it is the way the world seems to work. Of course, David Begg is absolutely right in one respect.

The positive response of exports will almost certainly not be immediate. But this is not because wage and salary levels are not an important component of competitiveness. They are, and probably the single most eloquent statistic in this regard is the roughly 60 per cent of GDP that aggregate wages and salaries account for. Nor is it because global economic recovery may be slow to get under way.

However slow the global economy may be to start growing again, Ireland can still materially increase its share of world export markets if Irish producers are competitive enough. No, the delayed response of exports will simply reflect the fact that competitiveness improvements take time to come about and to impinge on trade performance.

Essentially the position is this. The Government has no option but to reduce its huge borrowing requirement. Where it has options is in the approach it adopts. Here, it can choose between a strategy that relies heavily on tax increases and cuts in capital spending and one that concentrates more on reducing current spending, in particular pay and transfer payments.

The evidence (from Ireland and overseas) suggests that a strategy along the latter lines is more likely to be successful, more likely to be supportive of overall economic activity and more likely to protect employment.

jim.oleary@nuim.ie