ECONOMICS:There is a balancing act between frontloading the correction and spreading it over the right amount of time, writes PAT McARDLE

IN 2008, when the crisis broke, the instinctive reaction of economists, nurtured on Keynesianism, was that the appropriate response was a substantial fiscal stimulus. Stimulus packages were put in place in a range of countries, albeit with notable exceptions in the case of some countries, like Ireland, which are now in EU-IMF programmes.

Nowadays, all but the most obdurate recognise that we have a massive budget deficit (the consequence of past spending and revenue decisions, very little of it reflecting the cost of borrowing to fund bank recapitalisations) which has to be eliminated.

The few remaining proponents of fiscal expansion have several hurdles to overcome.

The first is that it is by no means clear that such programmes work.

Recently, the US Council of Economic Advisers released its seventh report on the economic impact of the American Recovery and Reinvestment Act of 2009, Washington’s massive stimulus programme. The council calculated that the programme had added or saved 2.4 million jobs at a cost of $666 billion (€475 billion). That’s a cost to the taxpayer of almost €200,000 per job, not good value for money.

Moreover, the stimulus has gone into reverse and the number of jobs created had fallen by more than 10 per cent from its peak with further falls in prospect.

The second issue reflects the fact that some countries may simply not have the capacity to stimulate. This is the “when you’re in a hole stop digging” argument, which ultimately won the day in the programme countries.

Frequently, one can’t trust governments, particularly at election time, to recognise this reality. However, in our case, the presence of the troika (EU, ECB and IMF) means policy is dictated from abroad and we have little choice in the matter – the Government did announce a modest package a few months ago.

Frustrated by their inability to prompt further spending, proponents of stimulus increasingly resort to bemoaning the negative impact which spending cutbacks and/or tax increases have on economic activity.

There are also issues such as the optimal speed of adjustment and its sustainability. The balancing act here is between frontloading the adjustment to convince the markets and spreading it over a number of years to minimise the negative impact.

Using IMF data on past fiscal consolidations, Goldman Sachs recently concluded that the probability of sustaining a fiscal adjustment increases with (i) a larger underlying structural deficit, (ii) higher real bond yields, (iii) large previous consolidation efforts, and (iv) a preceding election.

Ireland scored highly on all of these. Despite several years of fiscal correction, we still have a very large structural deficit, our bond yields are second only to Greece, we had a successful correction in the 1980s and the recent election gave the Government a mandate to implement the programme. One could add that there is greater popular acceptance of harsh fiscal measures here than in the other programme countries though this may be captured by the correction of the 1980s factor.

Goldman Sachs concluded that there is a very high probability that fiscal consolidation will be sustained in Greece and Ireland, with somewhat lower probabilities for Portugal and Spain.

The negative impact of fiscal correction is three times larger than average in a fixed exchange-rate regime, such as the euro, because this rules out devaluation. But the degree of openness of the economy provides an important offset as exports can compensate for declining domestic demand.

Also, the impact of fiscal consolidation tends to be lower in countries where yields are high before the adjustment, because there is more “room” for the cost of government and corporate borrowing to ease.

Similarly, a “negative output gap” – ie an underperforming economy with lots of slack and high unemployment – limits the adverse effects of consolidation while a good balance of payments position also helps as it implies that the economy is more competitive.

When Goldman Sachs modelled these factors, it found that, on average, a 1 per cent adjustment in the budget deficit reduces GDP by about half a percentage point after three years. Spain and Portugal were above average with GDP falls around three-quarters of a per cent but Ireland was below; in fact, Ireland had the lowest negative impact – about a quarter of a percentage point or half the average. In other words, a 10 per cent correction in the Irish deficit might leave GDP about 2.5 per cent below what it would otherwise be after three years.

An “optimal” speed of adjustment seeks to balance the need to return the public finances to a sustainable path, with the adverse impact on growth. History indicates that the desired rate of adjustment is between 2 and 3 per cent of GDP per annum. The Irish adjustment is slightly below this range, possibly reflecting our weak starting point and strenuous past efforts, but in Greece and Portugal the consolidation effort is an astonishing five to six percentage points this year with another 2 to 3 per cent to come in 2012.

This leads Goldman Sachs to conclude that the pace of adjustment in these countries is too fast in “normal” circumstances but it quickly adds that current circumstances are far from normal and a significant degree of frontloading may be necessary to signal credibility.

All this gives rise to two conclusions. First, there is probably scope for a modest speeding up of the pace of adjustment as suggested recently by this writer and others. Second, we are fortunate that the negative impact of budget cutbacks appears to be less here.