Michael Taft: Those Ol’ Pro-Cyclical Blues

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At top. from left: Minister for Finance,Paschal O Donohue , Taoiseach Leo Varadkar and Minister for Communications, Climate Action and the Environment Richard Bruton; Michael Taft

We are now getting crash courses in pro-cyclical and counter-cyclical fiscal strategies. This has the potential to be more mind-numbing than discussion of fiscal space. But at the risk of numbed minds let’s jump into this by first defining these terms.

Pro-cyclical means a fiscal policy that accelerates either the upward or downward trajectory of the economy.

We have two recent examples:

Prior to the crash, Fianna Fail-led governments accelerated the economy and the property market through tax cuts and spending increases that resulted in unsustainable growth. They were feeding an economy to the point of gluttony.

Following the crash, Fianna Fail and Fine Gael-led governments accelerated the decline of the economy through tax increases and spending cuts, taking money out of a cash-starved economy.

Successive governments pursued the same fiscal policy both before and after the crash – a pro-cyclical policy. At their extremes such policies lead to booms and busts which is exactly what Ireland suffered.

The alternative is to pursue a counter-cyclical fiscal strategy. This is intended to smooth out the inevitable ups and downs of a capitalist market economy.

Therefore, when the economy is accelerating, a prudent government would try to slow it down to something approximating normal. This would entail raising taxes and slowing down spending increases.

For instance, had the government removed property tax breaks and introduced a property-tax in 2003/04, this would have taken some of the heat out of a runaway property market.

And if the government had stimulated the economy through investment increases in 2009/10, the economy would not have collapsed to the extent it did.

Now we are getting lectures about the current pro-cyclical policies, how we should have been cutting back when the economy started growing; and how we should be running substantial surpluses (the budget won’t go into surplus until next year and, even then, only marginally).

That, however, is the wrong way to read our current situation.

We are stuck in upside-down fiscal strategies. Yes, the right-side up approach would be to start cutting back (reduce the pace of spending increases, reduce the level of tax cuts) as the economy recovers.

But you only do that if fiscal strategy expanded during the preceding downturn. That didn’t happen here. We cut back during the recession.

So when the economy started growing, the government had to raise spending to make up for the cuts during the austerity years, while at the same time trying to turn the deficit into a surplus.

Public spending only started increasing in 2015, but the deficit was still nearly 2 percent of GDP. It wasn’t possible to do both.

Indeed, the Government struggled to return spending to pre-crash levels.

Factoring in inflation (GDP deflator), public spending per capita – in particular, investment – has not returned to 2008 level. Not only did spending increases struggle, deficit reduction started to lose steam.

Upside-down fiscal strategies cannot be corrected by simply flicking a policy switch. We may be stuck in a pro-cyclical trap that is structurally embedded in our public finances. And, like a finger trap, if we start reducing spending just before an economic slow-down we could end up reinforcing the trap by accelerating the slow-down.

This gives a different perspective to the oft-repeated phrase ‘well, austerity worked’. It didn’t. Austerity was many things, but in this context it was like cramming clothes into a suitcase and then sitting on the cover to close it shut.

It seemed to work for a while but it wasn’t sustainable. Eventually, the cover blows open and the clothes spill out on the floor. This is the pro-cyclical trap we are in.

So how should we proceed? Carefully, eschewing quick-fix solutions. Let’s look at two things that could help inform a more viable and sustainable fiscal policy.

First, strengthen our automatic stabilisers. This usually refers to unemployment benefit. Unemployment benefit replaces the reduced purchasing power of those who have lost jobs.

In other EU countries, unemployment benefit is pay-related which means most of the purchasing power is replaced. This helps maintain consumer spending and domestic demand.

In Ireland, the benefit is low which means only a small amount of purchasing power is replaced.
In the upcoming budget it is imperative to introduce a pay-related component to unemployment benefit (Fine Gael actually advanced this proposal recently).

This should be paid for by a small, incremental increase in employers’ social insurance which is ultra-low by EU standards.

Second: never mind the deficit, focus on the debt. We have considerable savings to help prevent the debt from rising out of control.

We have more than €20 billion in Exchequer savings. Judicious use of these funds (it is unclear if this includes the NAMA surplus of €4 billion or the liquid assets in the Strategic Investment Fund) could help moderate any increases in the debt arising from a hard Brexit.

This will depend on how bad the hit is. The ESRI projects a small hit, with the budget immediately going into deficit but returning to surplus by 2023 with debt falling again.

The Central Bank’s projection is more pessimistic, with the county’s finances still mired in a significant deficit in 2023 with debt still rising.

There are other measures we can take to mitigate the downward impact on public finances (a small example would be the net assets tax outlined here) and using the NAMA surplus for public housing in order to maintain revenue-generating activity (and to house people).

The very last thing we need to do is take fright and start cutting and taxing without regard to economic and fiscal harm – like we did in the last crisis.

If we do go down that route we’ll just be reinforcing the pro-cyclical trap. And picking clothes off the floor for a very long time.

Michael Taft is a researcher for SIPTU and author of the political economy blog, Notes on the Front. His column appears here every Tuesday.

Sam Boal/ Rollingnews

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