The workings of austerity
Posted on November 08, 2014
When, in November 2010, the President of the European Central Bank wrote to the then Irish Minister for Finance, he stated on behalf of the Governing Council of the ECB that the Irish Government undertake four specific actions. The first two included the following commitments: “1) The Irish government shall send a request for financial support to the Eurogroup; 2) The request shall include the commitment to undertake decisive actions in the areas of fiscal consolidation, structural reforms and financial sector restructuring, in agreement with the European Commission, the International Monetary Fund and the ECB.” 'With kind regards etc.'
‘Decisive actions’ in the area of ‘fiscal consolidation’ were well underway since 2008. The huge transfers of capital to the banks in 2009 and especially in 2010 put enormous additional pressure on Irish public finances. €15 billion in spending cuts and revenue increases had been announced between 2008 and 2010 just prior to the arrival of the Troika. The budget of December 2010 added another €6 billion of measures while the incoming Fine Gael/Labour coalition finished the fiscal job by adding another €9 billion in adjustments. Throughout the period from 2008 up to 2013 fiscal consolidation leaned heavily on expenditure cuts. This exacted a severe cost on public services, incomes as well as employment and GDP. While difficult to provide exact estimates it is likely that the entire fiscal consolidation package which added up to €30 billion (or 20% of GDP) reduced GDP by a significant proportion. The fact that GDP grew in 2011 and did not contract significantly in 2011-2012 is due to the positive impact of exports. Domestic demand remained stagnant throughout this period. While incomes and employment fell suddenly in 2008-2009 as a result of a collapse in construction with knock-on effects across the economy fiscal consolidation undoubtedly added to the contraction.
Did fiscal austerity work? It is suggested that the policy of austerity worked for two fundamental reasons: (1) swift and decisive action to cut spending and raise revenue narrowed the deficit and (2) the pursuit of a coherent and convincing plan to restore order to the public finances reassured the markets – over time.
Chart 1 shows the fall in the underlying ‘primary deficit’ from 2009 onwards (excluding and including the impact of bank bailout spending).
Chart 1: Primary deficit/surplus as a percentage of GDP
Yes, fiscal consolidation certainly did help to reduce the deficit over time. However, the empirical evidence reviewed by O’Farrell (2013) suggests that the scale and composition of the fiscal adjustment was unnecessarily blunt and inefficient. A heavy reliance on spending cuts over tax increases and the use of regressive tax measures such as VAT increases in later budgets had an unnecessarily large negative impact on GDP with a limited reduction in the government deficit. The deficit did come down – due in part to the impact of fiscal consolidation but at a rate that could have been faster if the Government had adopted a more growth-friendly fiscal consolidation that did not cut capital spending and used revenue increases (especially those on capital income) over spending cuts.
The fact that the cost of borrowing on Irish government bonds began to fall from 2011 onwards is related to the fact that many investors and speculators figured – by mid-2011 that the Irish Government would not exact debt write-downs (burn the bondholders) inspite of threats or indications prior to the general election earlier that year. It became Frankfurt’s way after all. The prize was the gradual, slow restoration of confidence from about mid-2011 onwards with some large, initial bond purchases. The (positive) threat of outright monetary transactions by the ECB in 2012 further helped. From then on, 10-year bond yields began to fall for all the periphery economies. At the same time bond prices rose (in inverse proportion to bond yield). Some speculators who bought in mid-2011 sold eventually and made a killing.
An alternative fiscal adjustment could have worked if it yielded higher growth and faster reduction in the deficit. Bond markets look for assurance on investments and the capacity of sovereigns to pay back. They also look for long-term yield which reflects risk and short-term capital gain in some cases.
A key consideration is not what might have happened if the fiscal consolidation had not been done, but, if it had been done differently with no cuts to public capital investment, minimal cuts to current spending and significant increases to revenue especially that related to income from capital? Moreover, a carefully planned and strategic investment programme conducted ‘off-the-books’ availing of the limited resources available in the National Pension Reserve Fund would have assisted economic recovery and government revenue buoyancy. It is acknowledged that such measures would have been constrained by the need to maintain a large cash reserve as part of an adjustment to re-entry to the international capital markets. Moreover, borrowing costs for commercial enterprises were very high in the 2010-2011 period. A forthcoming NERI Working paper will explore these issues further.
Whatever the impact of fiscal adjustment on the deficit it should never be forgotten that a heavy price was paid – especially by those who lost jobs, suffered a huge jump in personal indebtedness (whether mortgage related or otherwise) as well as real wage cuts, tax, levy and charge increases of various types and cancellation of various public services or supports in some cases. One way to assess the impact of the recession is to examine trends in material deprivation. Chart 2 [indicator 5.1 in the latest NERI Quarterly Economic Facts ] shows trends up to 2012 using published CSO data. What is striking is the increase in material deprivation.