Another Irish lesson fail

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.  But did he know that was the apparent implication of what he said?  Yes, it’s Ireland again, seemingly everyone’s favourite misunderstood episode of boom and bust.   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.   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.  So it all looks good.

The problem is that 1994-2006 is mingling too many different versions of the Celtic Tiger.  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.  In 1994, it was 43.9%.   In 1998, it was 34.5 percent.  Thus a nearly 10 percentage point reduction was done in 4 years.  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.  And that’s the other crucial aspect.  Ireland was growing at spectacular rates during this period.  There were 6 years with growth above 8 percent per year, and 5 percent per year came to be seen as normal.  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.  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.  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.  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.  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.  And we’ve leave that parenthetical comment for a long in-progress future post on Irish political economy.

12 thoughts on “Another Irish lesson fail

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  2. There are two points worth noting in deconstructing Trichet’s assertion. First, as you rightly point out, expenditure fell as a % of GDP between 1994 and 1998. However, this wasn’t a matter of ‘cutting public expenditure’. During that period nominal current spending increased by a healthy annual average of 7.1 percent, while overall nominal Government expenditure (excl. redemption of securities) rose an annual average of 7.3 percent. The reason for the contrast is that, while spending rose substantially during this period, growth was higher. This should provide us with some clues regarding our current situation.

    Second, the problem with structural deficit calculations (apart from the fact that there is no universally agreed methodology with some economists even claiming it doesn’t exist) is that they happen to be after-the-fact’, subject to considerable change. For instance, as you point out, the IMF’s latest database shows a continual structural deficit all during the boom years. Yet, the same IMF database (edition: October 2007) showed the Irish economy running a structural surplus all those years (with the exception of 2002) – with 2006 registering a structural surplus of nearly 3 percent. This confusion arises out of the difficulties in measuring the output gap (the EU Commission database still shows Ireland with a healthy surplus in 2006).

    All this to say that we must be cautious when institutions, databases and central bankers put out data; it is always well to do a thorough check.

  3. I agree Michael, which makes it even more surprising that the ECB, with the advantage of hindsight, still chose to highlight such a strained example.

  4. They don’t mention sweden, who did go in the same time frame from ~ 80% debt to ~ 40%. I owdenr why. Perhaps the “In all cases, the fiscal adjustments mainly occurred through expenditure cuts,” doesn’t fit.

  5. IM – the example you highlight is instructive. According to the EU Commission Annex, Sweden turned around its public finances from a negative – 11.2 percent in 1993 to a positive 1.1 percent in 1998. During that same period, Government expenditure fell from 72 percent of GDP to 59 percent while Government revenue remained static at 60 percent. On this surface reading, Trichet might conclude that Sweden succeeded owing to public spending cuts. If he did so, he would be wrong.

    Nominal government spending rose by 8 percent between 1993-1998. Government revenue rose by 30 percent in nominal terms. Fiscal repair was down to growing tax revenue – and this was due to growth. During that period nominal GDP grew by 31 percent (approximately 14 percent in real terms).

    Growth is the key. This is the lesson that our government (and apparently Trichet) has missed. P. O’Neill has opened up a fruitful area for more investigation and discussion.

  6. I think Trichet and governments know this Michael . The problem is that the expansion of the last decade or so was based on construction and rising realty prices crossed with easy debt, hence a fast flow of money. I have not seen anyone offer any solution for the future except to attempt to shore up the exisitng financial structure and gradually work down the level of debt to one which allows consumers to start spending again.

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  8. Thanks Michael, that was what I waved at. And I think rapid debt to gdp reductions are in most cases just the result of high growth.

  9. Br, “to shore up the exisitng financial structure and gradually work down the level of debt to one which allows consumers to start spending again” could be contradictory objetives. The question is: how is it supposed to do that?

  10. Karl

    True. So far the financial world has been supported. In whichever form, this adds up to debt owned by finance not having to be marked to market, not having to be released or sold off, and so supporting the values of the financial institutions , or the equity and debt they hold. This has held prices of property , amongst others, higher than they would have been the last couple of years. So far so ‘good’, as long as you are not looking for a new home maybe, or willing to walk from a property you own that is about underwater with its mortgage etc. . We might even say the fast action of the government and ECB has stopped the system stalling in what is normally an American interbank lending inspired ‘brief’ crisis. That however is not true – the US reached the circumstance it is in due to similar reasons the EU is also in trouble, and that is excess lending (both creating property bubbles and excess personal debt and governmental spending ), and that is what is playing out on the economies now. All this rapidly circulating debt simply fuelled the economy till it could no longer.
    So how to keep finance more or less afloat and debt being repaid and the economy still turning over while consumer spends less ? Firstly austerity or deflation (depending on its source) may help. A lot depends on the eventual destination of repayed debt and the effect any deflation in spending has on other debt. If a local bank then reinvests that money repaid directly back into the local economy into a more efficient or competitive enterprise which then helps generate additional finance for the country great. If it has to simply send it off to the US or China or wherever and not see more than a few % interest which has to go to cover other unpaid loans, not so great, especially if to borrow again it must pay much higher interest, which implies higher earnings..from where? This is part of the crux of the matter, the interelationships of debt and dues worldwide are not transparent. Nor are peoples wishes to invest anywhere lately. Personally I think that there is no plan B to cover the shortfalls (i.e. a working plan that will properly shift the economic source to some other realm ) at the time being and so either there will be restructuring of debt or simply write offs to a degree that relates to the ability of society to repay its debts and the ECB to ensure adequate liquidity … that can be used constructively. Even structural sovereign borrowing by Europe as a whole will reach its limits. Short of printing and deflating the currency to inflate prices, with which even then the ECB watches a CPI that has little to do with housing or debt…. and with rates so low money could not be made much cheaper. So this brings us on to a larger scheme of things whereby existing liabilities have to be ‘reversed’ in a sense , from the consumer all the way to Germany or France, back to the US and then to say China. I have no idea (at all) how that may happen, especially given the scale of existing debt. So the idea may be right, but the possibility of it succeeding ‘nicely’ – close to zero ?

  11. I agree with P O’Neill.

    The ECB is still talking down the Euro. All fiat currencies head to ground, just as they build inflation into the economy: it is politic as it enables the politicians to “offer” people dole of all kinds with the odd circus, to keep the ring in their snout.

    Good blog!

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