Not seen on the newswires from the Federal Reserve retreat in Jackson Hole, Wyoming —
“The world of economics was rocked to its foundations yesterday when European Central Bank President Jean Claude Trichet urged countries to run huge structural budget deficits and massively pro-cyclical fiscal policy while creating huge contingent liabilities in their financial sectors.”
Because that’s not what M. Trichet actually said, or what the media took him to say.Â But did he know that was the apparent implication of what he said?Â Yes, it’s Ireland again, seemingly everyone’s favourite misunderstood episode of boom and bust.Â Â It’s what Paul Krugman might call the Magical Foreigner syndrome.
Here’s the relevant section of the speech —
Given the size of the accumulated public debt, fiscal consolidation will have to be ambitious. In the euro area, to reach the reference value of a debt-to-GDP ratio of 60%, a cumulative drop of almost 30 percentage points will be needed. Such reductions are not uncommon. Beside the post-war UK experience, sizeable debt consolidations have been implemented in Belgium, which over a period of 14 years from 1994 to 2007 reduced its ratio from 134% to 84%; in Ireland, which reduced its debt ratio over a 13-year period starting in 1994 by 69 percentage points; and, starting in the mid-1990s, in Spain, the Netherlands and Finland, which saw their debt-to-GDP ratios drop in the range of 20 to 30 percentage points.Â Â What we can learn from these historical experiences is that large reductions in debt-to-GDP ratios are not uncommon and quite feasible. In all cases, the fiscal adjustments mainly occurred through expenditure cuts, but they were also supported by lower interest payments due to falling interest rates.
The reference supporting these claims is to the May ECB Monthly Bulletin which does indeed lay out (page 46) Ireland achieving that extent of debt reduction during the stated period, with expenditure falling from 44.6% of GDP in 1994 to 34.4% in 2006 and revenue falling from 41.9% to 37.4% over the same period.Â So it all looks good.
The problem is that 1994-2006 is mingling too many different versions of the Celtic Tiger.Â I can’t find a consistent and linkable Eurostat series going back to 1994 for government expenditure, but consider instead the OECD Economic Outlook Annex measure of general government total outlays as % of GDP.Â In 1994, it was 43.9%.Â Â In 1998, it was 34.5 percent.Â Thus a nearly 10 percentage point reduction was done in 4 years.Â Thereafter it briefly bottomed out at 31 percent before spending most of the 2000s in the 34-36% range.
Thus, from the 12 year period picked by the ECB, only the first 4 saw any long-lived reduction in government spending; for the rest the government was doing an impressive job of keeping public spending constant — as a share of GDP.Â And that’s the other crucial aspect.Â Ireland was growing at spectacular rates during this period.Â There were 6 years with growth above 8 percent per year, and 5 percent per year came to be seen as normal.Â This meant that governments could increase cash outlays like confetti and still show reductions as a share of GDP, since the latter was growing so fast.
On the revenue side, we get a more muted picture of what was happening to expenditure — a significant decline in the earlier period and then hovering in the 36 percent range thereafter.Â The story here is instead in the composition — the tax base was becoming ever more dependent on the property boom, so it allowed the government to reduce debt, cut other taxes, and increase spending — and stoke the same boom which was feeding these revenues in the first place.
In fact, IMF estimates (WEO database, general govt structural balance, data extract) now show that the government was running large structural budget deficits during the entire period hailed by M. Trichet — 6% of GDP in the last year of the boom, 2006.Â But with so few explicit warning signs, it’s little wonder that financial sector regulation didn’t seem like a pressing problem, with consequences the country is now living with.Â It’s likely that by sometime next year, all that 1994-2006 progress in debt reduction will be erased.
In short, the Irish example of debt reduction as cited by M. Trichet is dodgy.Â Yes there was debt reduction, but it wasn’t done by spending cuts, it wasn’t sustainable, and its achievement was symptomatic of deeper structural (and political) problems in Ireland.Â And we’ve leave that parenthetical comment for a long in-progress future post on Irish political economy.