Minimising the pain

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ANALYSIS:Cutting public-sector wages is the fairest, least deflationary way to begin the economy’s return to its underlying growth potential, writes John McHale

IT SHOULD never have come to this. Fiscal austerity in the face of recession means breaking what Nobel Laureate Paul Krugman calls the “Keynesian compact” – the expectation that governments can and will aggressively manage demand to counter severe downturns. A series of policy mistakes – structural deficits during the property boom, a risky reliance on transaction taxes, an overly broad bank guarantee – means Ireland is suddenly facing emerging-market rules.

As the Asian economies found out over a decade ago, immediate pain is the price to restore confidence.

The challenge now is to minimise the pain while quickly returning the economy to its underlying growth potential. To do this we need an integrated short- and medium-term strategy that restores confidence in the management of the economy, carries broad-based social support, and provides maximum immediate room for manoeuvre.

I have reluctantly concluded that discretionary fiscal cuts need to be part of the short-term response. International debt markets are increasingly – many think bizarrely – pricing in the probability of an Irish default despite a continued high debt rating.

The rising uncertainty about fiscal sustainability is also leading to increased precautionary saving and debt reduction by families and businesses. Unfortunately, additional cuts are required for the Government to signal it is in control of the public finances.

The immediate questions are how much and where to cut.

A target cut of €2 billion seems about right if backed by a credible medium-term fiscal consolidation plan.

The most pressing question is where to cut? Although the Government should apply strict cost-benefit tests to its investments, I believe it would be counter-productive to make overall cuts in the capital programme.

Capital spending is both supporting current demand and laying the foundation for future productivity. Other governments are desperately trying to ramp up their infrastructure spending to take advantage of multiplier effects. It would be foolish to scale back or slow down the projects already well advanced in the pipeline.

The burden of the immediate cuts should be borne by the public-sector wage bill for three reasons.

First, fairness requires that the pain of recession not fall only on the private sector. Workers in the private sector are suffering job losses, wage reductions and deep uncertainty about the future. Business owners are struggling to survive. They should not have to bear the burden alone.

More instrumentally, a demonstration of shared sacrifice would bolster the country’s international credibility and help minimise the needed austerity.

Second, wage cuts would help reinforce the falling benchmark for wages in the private sector. This will help price Irish goods back into world markets and retain multinational investment in the economy.

Third, the available evidence shows that cuts in the wage bill do the least damage to aggregate demand. Recent estimates by Philip Lane show a substantially lower fiscal multiplier for wage bill spending compared to other current and capital spending. Critically, cutting the wage bill gives the least-deflationary bang for the euro cut.

How large a cut in public-sector wages is required? Unfortunately, the cut must be substantial to make a dent of any size in the deficit. With a pay and pensions bill of roughly €20 billion, an average cut of 10 per cent would be required to produce the €2 billion in gross savings. Of course, reducing the incomes of public-sector workers will also reduce income and expenditure taxes. With a 41 per cent tax-share of GNP, a conservative calculation puts the net deficit reduction at €1.2 billion.

The suggested cut applies to both wages and pensions. The broader cut is appropriate given the indexation of public-sector pensions to wages; this link should not be a one-way street. The recently mooted pension levy is also less appealing because it concentrates the cuts on current workers.

In deciding how the cut should be distributed across pay grades, the Government faces a difficult task in balancing the need to protect those on lower incomes with evidence that the public-private wage premium is highest at lower pay grades. It is important to have an easy-to-understand formula. There is merit in a simple across-the-board percentage cut so that there are larger nominal cuts at higher pay grades. An alternative is to roll back recent awards, which have favoured those at the upper grades.

How should the Government make the remaining €0.8 billion cut? With the recent rapid growth in expenditure, it should be possible for the new “Bord Snip” to find expenditures of such wastefulness that their elimination would scarcely be missed (even allowing for fiscal multipliers).

Another option is to adjust budgeted increases in current expenditure for the fall in expected inflation. As pointed out by John FitzGerald on Saturday (“How Ireland can stage an economic recovery”, Opinion), the consumer price index is now expected to fall by 3 per cent or more in 2009.

Anticipating positive inflation, the Government increased social welfare payments by 3 per cent in the budget. Freezing social welfare in nominal terms would save roughly €0.6 billion, while still allowing an inflation-adjusted increase of at least 3 per cent.

Having canvassed the admittedly unattractive options for making €2 billion in cuts, it is sobering to see that the January Stability Programme Update has pencilled in a further €4 billion of fiscal adjustment for 2010, followed by €4 billion in 2011, €3.5 billion in 2012, and €3 billion in 2013.

While there is hope that the global economy will have turned around by 2010, the current outlook is bleak. The IMF is forecasting that 2009 will be the first year of negative growth in the advanced economies in the post-war period. In this environment, the Government’s projection of just a 0.9 per cent contraction in GDP in 2010, while taking an additional €4 billion (2.25 per cent of GDP) out of the economy, looks extremely optimistic.

A cut of €4 billion would be unfortunate with the economy still in recession a year from now. It is conceivable that a cut of this magnitude will be necessary in a continuing battle for confidence. But it would leave the Keynesian compact in shreds.

It is interesting that the IMF programme for Iceland imposes no discretionary cuts for 2009 despite an even more severe crisis. (A fiscal adjustment of eight percentage points of GDP begins in 2010.) The IMF appears to have learned a lesson from the Asian crisis, where excessive upfront austerity worked to undermine confidence rather than enhance it.

The overriding requirement for the medium-term element of the fiscal strategy is to put in place a fiscal programme that buys the Government time. Regrettably, it is hard to see how this can be achieved without a credible commitment to raise the tax-share of GDP as the economy recovers.

The Commission on Taxation provides an obvious instrument to make this commitment. However, the original terms of reference for the commission are now an anachronism.

Under commitments made in the programme for government, the commission is tasked with keeping the “overall tax burden low”; it is also to “consider how best the tax system can support economic activity and promote increased employment and prosperity”.

Meeting the latter goal now requires avoiding near-term demand destruction. But that is possible only if international debt markets believe the public finances are on a sustainable path.

The Government should instruct the commission to propose how to raise the tax share of GNP by up to four percentage points. This would bring Ireland towards the European norm. If global conditions improve, there is hope that increases of this magnitude would not be needed.

What is essential now is a credible demonstration that the political system can produce additional tax capacity if needed. The diverse make-up of the commission means that negotiations would be difficult but stand a good chance of producing the necessary social consensus.

The commission is already considering a carbon tax as a means of meeting Ireland’s emission-reduction commitments. The premium on such revenue-raising instruments has now increased considerably. The internationally anomalous absence of a property tax may also be a luxury the country can no longer afford.

The Government is in the unenviable position of having simultaneously to battle a fiscal and a banking crisis. But of course the two are intertwined. It is becoming increasingly clear that the contingent liability of the banking guarantee is having a detrimental effect on the Government’s creditworthiness.

The opacity of bank balance sheets means that markets have a hard time valuing the liability. There is a tendency to assume the worst in the current risk-averse environment. I doubt if we would be looking now at how to make €2 billion in cuts if not for the shadow of the guarantee. Although guarantees and insurance schemes can help unfreeze credit, the Government should be wary of committing itself any further.

All of this sounds unrelentingly dismal. But the failure of the Keynesian compact is disappointing mainly because the fundamentals of the economy are so strong – in large part because of very good policies. Bad luck and some bad policies have pushed the economy below its potential.

The immediate challenge is to restore confidence and get back the ability to use the arsenal of recession-fighting weapons. The longer-term challenge is to restore the competitiveness that underpinned the Celtic Tiger phase of economic growth.

John McHale is associate professor of economics at the school of business, Queen’s University, Canada. He was raised in Co Waterford but has spent the past 19 years in

the US and Canada. In July, he will join NUI Galway as professor of economics.

Later this week, in our “What is to be Done?” series, contributions will be from Alan Ahearne, Paul Sweeney, Richard Tol and Rossa White.

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