Wednesday, December 29, 2010

The test of time

The American Enterprise Institute has a new working paper by Andrew Biggs, Kevin  Hassett, and Matthew Jensen which looks for patterns in successful budget deficit reductions (associated WSJ op-ed).  Specifically patterns in terms of whether sustainable cuts in the deficit relied on tax increases or spending cuts.  The conclusion is that successful deficit reduction programs relied on spending cuts.  One of the successful cases identified by their approach is Ireland in the year 2000. 

And so the puzzle-solving must begin.  Ireland 2000, with Charlie "When I have it, I spend it" McCreevy as finance minister?  We've collected together the relevant economic indicators based on IMF data, along incidentally with the same indicators for the Netherlands and Sweden.  Why those two?  Because they have boringly effective economic policies without any of the splashy initiatives that draw more media attention, and they're good to have handy when Irish politicians trot out the "it wasn't just us" excuse when things went wrong. 

Anyway, that's incidental to the main point.  Here's the then European Commissioner for economic and monetary affairs Pedro Solbes speaking about the Irish economy in 2000 --

In this regard, the experience of Ireland is a striking case-study. The growth rate in the Irish economy in 1999 was four times the euro-area average, while the inflation rate is currently twice the average. The small weight of Ireland limits the implications of this growth and inflation divergence for the euro-area economy and for the conduct of ECB monetary policy in particular. 

However, it poses a major dilemma at the national level. The Irish economy is clearly overheating as the supply-side of the economy is increasingly constrained. The Government has responded by proceeding with their well-established tax cutting agenda in the hope of easing supply constraints - particularly in the labour market. Whatever the merits of this approach may be in a medium-term perspective, the short-term risks cannot be ignored. Inflation rates are accelerating - especially in the sheltered sectors of the economy, for instance the housing market. The decision to pre-commit tax reductions in the next three years - as a supplement to an already generous wage agreement - risks to exacerbate the short-term problem of overheating by further stoking demand. 

In other words, this was an overheating economy and the obsession with tax cuts was making things worse, not boosting supply side potential.  By the following year, the Commission was sounding the alarm bells about Ireland's tax-cut driven boom.  

So what looks in the statistics like a successful deficit reduction effort was in fact the stoking of the fire.  Unfortunately for the Commission -- and for Ireland -- its prescient warnings about a housing and spending boom were 7 years too early, their credibility undercut as a result.

But we have the benefit of hindsight.  Do we still want to go back and declare Ireland in the year 2000 as an example of good fiscal policy?

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