Pity the economy with an exploding budget deficit and no currency of its own. Ireland is a case in point: its deficit will soon leave 10 per cent of GDP behind. There is a need for immediate fiscal stimulus, and this is what the economy is getting owing to the collapse of revenues. But fiscal consolidation will soon be essential to avert financial catastrophe. And here the absence of a national currency is problematic. Virtually every example we have of a country that has successfully closed a large deficit has done so while at the same time depreciating its currency.
Why is clear enough. Raising taxes and cutting public spending to close the budget gap depresses demand. This raises questions about whether politicians and their constituents are prepared to stay the course. Fiscal consolidation that precipitates a deep and lengthy recession is unlikely to stick. The only countries that have succeeded in closing a large fiscal gap are those that have meanwhile depreciated the currency and exported more, so that export demand replaces domestic demand. This was of course the case of Ireland in the 1980s.
Members of the euro area lack this option. When tax increases and spending cuts come, there will be no Irish punt to depreciate to crowd in exports. The choice will be an extended period of stagnation as cuts are put in place, or failure to follow through with fiscal consolidation which risks a crash. And since the markets look forward, the day of reckoning will come sooner rather than later.
Fortunately, there is one example of an economy with a large budget deficit and no currency of its own that has done a substantial fiscal consolidation. By now you will know where I’m headed: it’s the State of California. One of the biggest housing booms anywhere. Inability to restrain spending during good times. A tax system that is hypersensitive to asset valuations. A projected shortfall of (gulp) $40 billion on a budget of $135 billion, leading to credit-rating downgrades. And, obviously, no currency of its own.
The budget deal finalized last week reduces the deficit by about 2 ½ per cent of state GDP. How was this accomplished? In part through difficult compromise. Unable to finance additional spending, the state began laying off public employees and halted public works projects. Confronting economic catastrophe, Republicans in the state assembly who had said “tax increases over my dead body” agreed to $13 billion in “revenue enhancements.” Democrats committed to “more public service cuts over my dead body” agreed to $15 billion of spending reductions. Not enough to fully close the gap, but a significant step.
So how was the rest of the hole filled? There was some fiscal fiddling (“projected revenues” from selling of future revenues from the state lottery). There was $5 billion of new borrowing. But the key contribution was $8 billion of federal resources from the Economic Stimulus Bill signed by President Obama on February 17th, two days before the budget deal. (Notice the timing.) This limited the pain that both Democrats and Republics in the assembly had to inflict on their constituents. It made compromise feasible. It also limited the compression of demand, which was essential for a credible plan given the absence of a California currency to depreciate.
What are the implications for Ireland? Closing a budget gap in excess of 10 per cent of GDP will require outside help in the absence of a national currency. There is the question of who to ask and who is more likely to respond positively – the EU, the IMF or both. But there is no question that political compromise and the prospects for economic stability will be enhanced by temporary outside help.
California’s budget as a share of GDP is considerably smaller than Ireland’s. On the other hand, Ireland’s corporatist labor market institutions should give it an advantage in wage adjustment (though last weekend’s mass demonstrations in Dublin raise questions about whether what is true in principle is also true in practice). Still, the comparison is suggestive. It points to what European policy makers should be thinking about.
Originally published at Euro Intelligence and reproduced here with the author’s permission.