There has been a lot of talk recently abut austerity. The recent UK budget emphasized that the deficit had to reduced. The G20 summit suggested that this approach should be adopted by all countries. There are worries about the size of the US budget deficit. In the last few days, there have been strikes in Greece and France against austerity plans. So it seems timely to put a few posts up on what governmentsshould do in the current situation. Overall there seems a growing consensus that pain is good — it builds character. The world seems to be going S&M.
It is far from clear that it is a good idea. In fact, orthodox economics advises that taxes should be reduced and expenditure increased in a time of recession i.e. deliberately induce a large budget deficit. The idea is that the net government expenditure will replace some of the private sector expenditure that is missing in the recession. This should help boost demand and ease — if not eliminate — the recession. When the good times return, taxes can be increased to pay back the debt accumulated during the recession. Normally this approach works well (although there can be problems persuading people to accept higher taxes in the good times). It is clearly the motivation behind the US stimulus package and the UK’s approach under Gordon Brown.
However, a problem might arise in very extreme situations such as we now face. With the deficit in Ireland, US and UK already expected to be well above 10% there is little scope to increase it further. International investors might be quite reluctant to lend money to a country whose deficit was heading much higher than that. And if they did lend, it would only be at a high interest rate. Nobody wants to be the next Greece.
So if we shouldn’t increase the deficit, The question becomes by how much should we reduce it now? The answer, I think is “not by much”. Probably not much below 9%. Any reduction in the deficit is going to have a negative impact on the economy. At a time when private sector expenditure is falling, we are going to reduce net public sector expenditure. It is like kicking the economy when it is down. However, there is good reason to believe that a moderate reduction in the deficit is not so bad for a small open economy like Ireland. The reason is that the reduction in the expenditure will not fall entirely on the domestic economy. Simply because we import so much in Ireland, any decline in public expenditure will be felt as much by our major trading partners as by us. As a result, a reasonable guess is that the effect of any change in budget deficit on GDP in Ireland is half what it would be in the US. Of course it isn’t zero — we will feel the pain. The UK will probably feel the effects of its austerity more as it has a slightly less open economy than us. In fact, as the UK is still our major trading partner, we will feel some pain as a result of their austerity. In fact, if austerity does become the norm in the US, UK and Eurozone, demand for our exports would probably fall. This will make it more difficult for us to recover from recession.
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