The macroeconomic effects of fiscal policy have long been understood: when an economy is growing below trend, government should stimulate activity, and when full employment is reached, governments should put on the brakes. That way, governments can smooth activity in the economy, minimising shocks to consumers and business.
However, the optimal economic policy often comes second to political pressures, especially in the run-up to an election. Whatever the state of the economic cycle, a politically astute government may sometimes put the fiscal brakes on early in its term, leaving more room for “generosity” at election time.
The scale of the fiscal injection into the economy in last year’s budget was inappropriate, given full-employment, rapid growth and capacity constraints. It added to inflationary pressures, including in the housing market. Whether it influenced the election outcome is for political scientists to analyse.
In the past there have been some notable examples where governments, rather masochistically and inappropriately, implemented very tough budgets in the run-up to an election, damaging both the economy and their political prospects.
The 1957 budget, implemented by the outgoing interparty coalition government, took about 2 per cent of national income out of the economy. As a consequence, output fell by almost 1 per cent. Coming on top of very low growth in 1955 and 1956, the miserable economic performance in 1957 saw a surge in emigration.
As Patrick Honohan and Cormac O’Gráda have shown, that coalition government had tried to keep interest rates in Ireland below UK rates despite a fixed exchange rate. As a result, there was a major outflow of funds to London as savers sought higher interest rate there. Instead of understanding that the outflow was due to the unwise interest rate policy, the government concluded that the outflow of funds was due to excessive domestic demand. Hence the inappropriately tough budget.
Understandably, this unwise fiscal action saw the outgoing coalition government lose the election later that year. It was 16 years before Fine Gael and Labour returned to office. They did so in 1973, despite the outgoing Fianna Fáil government having pumped a significant sum into the economy in 1972.
The new government was immediately faced with the first major oil crisis. In 1974 and 1975, the government tried to insulate the population from the effects of the dramatic change in the cost of energy and in world economic circumstances by generous budgetary measures. However, in 1976, when the economy was still suffering major damage from the oil crisis, the coalition government unleashed the toughest budget of the last 70 years. The cuts in capital expenditure were particularly savage. Again, not surprisingly, that coalition government suffered a massive defeat in the 1977 election.
The economy was well into recovery mode in 1977, with national income growing by over 6 per cent. However, the incoming victorious Fianna Fáil government implemented in full its wildly ambitious manifesto commitments, providing a massive stimulus at a time when the economy was already recovering. At the time, interest rates on the large borrowings to fund the giveaways were relatively low. However, the chickens came home to roost in 1979 when there was a second oil price shock. Interest rates then rose well above the rate of inflation, posing huge strain on the public finances. The result was a miserable decade of underperformance in the economy as five successive governments tried to undo the mess.
The first real action to tackle the 1980s fiscal crisis was implemented in 1983 and 1984 by the then coalition government. The main instrument used to try to bring order to the public finances was tax increases, with less attention to expenditure cuts. The government took about 2 per cent of national income out of the economy in both 1983 and 1984.
However, that was not enough to restore the economy to a sustainable path, and very limited further action was taken in 1985 and 1986. It was left to the incoming Fianna Fáil government to implement major cuts in expenditure in 1988 and 1989, completing the fiscal adjustment.
A key lesson from the miserable economic performance of the 1980s is that it is vital to act quickly when in a fiscal crisis. Spreading the adjustment out over the course of a decade made things worse rather than easier.
In the financial crisis that began in 2008-09, this lesson was learned. The really painful adjustment was completed between 2010 and 2013, resulting in a rapid and sustained recovery from 2014. While many at the time argued for a slower adjustment, it is likely that would only have prolonged the agony, as in the 1980s.
