Abandon the deflationary ship

Michael Taft: The Minister for Finance when announcing his €4 billion spending cuts in the last budget, stated confidently:

‘Further corrections will be needed in the coming years, but none as big as today’s. . . A Cheann Comhairle, the worst is over.’

Well, the worst has gotten worster. We are now told we will need another €4 billion or €5 billion in ‘adjustment’ (read: contraction) on top of the €7.5 billion the Government intends. We are told the reason for this is that growth projections are lower. Nobody has copped it that deflationary policies themselves are suppressing growth, the main reason why we known apparently need . . more deflationary policies. But won’t more deflationary policies produce ever lower growth which in turn will maintain unsustainably high levels of deficit? Silence all around.

Let’s be clear: the issue is not the balance between spending cuts and tax increases. The issue is the deflationary model itself. As long as policy is determined within the parameters of that model, it will fail to repair the public finances.

Using the ESRI fiscal multipliers and their growth rates contained in their Recovery Scenarios Update, let’s see where additional contraction will get us. These figures are provisional insofar as there is some extrapolation and, therefore, are intended to be indicative only. But they show the scale of the failure that is the deflationary model.

The ESRI was the first to signal that the Government’s strategy will fail. The €7.5 billion would not only fail to reach Maastricht compliance by 2014, it would fail to do so by 2020. As a percentage of GDP, (with an additional €1.5 billion added due to increased interest payments and revising growth downwards by a third, which seems to be consensus projection) this is what the deficit would look like:

As can be seen, even with an additional contraction of €4 billion, on top of the current €7.5 billion, public finances cannot be brought into Maastricht compliance by 2020. It would flat-line between -4 and -5 percent. And each additional €1 billion contraction would only lower the deficit by between -0.1 and -0.2 percent.

However, there are problems with even these projections. The ESRI model assumes an interest rate risk premium of 2 percent. We are now double that position. With projections showing that even with additional contraction, we won’t repair public finances we should expect that risk premium to remain high (that is, if we are still in the market).

Nor does the above take account of the probability that growth and deficit-reduction are reacting to the deflationary impact on the GNP (where most tax revenue is generated) – an impact which is 20 percent to 30 percent more negative than on GDP. If we tried to factor that in, we’d flat-lining at above -6 percent or so.

Nor does it include the extra interest payments arising from higher deficits. With additional fiscal contraction we’d still be adding €10 billion to €15 billion on our overall debt by 2105, putting cumulative pressure on the deficit.

And what it doesn’t take into account the spectre of what can be described as a deflationary cascade.

Something darker may be hiding in the Government’s fiscal cupboard. Michael Burke referred to this when highlighting the findings of the IMF. In short, for economies that have hit an interest rate floor and where other countries are pursuing fiscal consolidation, a 1 percent budgetary contraction could produce a decline in the GDP of 2 percent.

To put this in perspective, current policies are closely following the rule of thumb – a 1 percent contraction is producing a fall of 1 percent in GDP (marginally more). However, if we start entering more sustained deflation, we could really be in trouble. Even if the IMF is only half right (I emphasise half right), we could find ourselves in this ugly situation:

The deficit would fall to only –8 to -9 percent of GDP by 2014 and then flat-line for the rest of the decade.

The more we engage in fiscal contraction, the more we would be entrenching high deficits in the economy. The economy would literally be spinning its wheels with all the consequences this would have for unemployment, growth, debt and interest payments.

Additional fiscal contraction will not repair public finances but will drive the debt ever upwards (the ESRI already estimates the debt to be 130 percent of GNP by 2015 on current policies, but that’s not even counting the additional Anglo-Irish/INWB bail-out which will add another €10 billion minimum to that debt pile).

If we accept the fiscal contraction coming down the line and content ourselves to debating the relationship between spending cuts and tax increases, then we will be debating on the Titanic. For the real problem is not how much cuts or taxes, but the Government’s deflationary model itself. It can’t change direction.

And we’re heading for a big iceberg.

Posted in: Economics • Economics

Tagged with: deficit • Deflation