Economic Lessons from the Tao Te Ching: The Recession Diaries - November 16th

‘The sage does no-thing, but leaves no-thing undone.’

So wrote Lao Tsu in what is now a major religious text. There may be something in this when it comes to fiscal policy.

There are, broadly speaking, three things a Government can do when the recessionary fires break out in the house.

• It can do nothing and wait for the fire to burn itself out. Problem with this is that a lot of possessions and livlihoods get burned up as well. This is neither an economically or politically attractive option.
• It can try to put the fires out – all those spending programmes, tax cuts, job creation / retention measures, printing money. It’s expensive but when the house is burning down you’re probably not interested in book-keeping lessons. You save the house and worry about the cost afterwards.

Or it can follow Fianna Fails unique approach – it can throw fuel on the fire. You cut spending, cut investment, pile on taxes (and, so, cut consumer spending) and sit on your hands and hope emigration will sort out labour market issues. Of course, you won’t have much of a house left but you’ll be secure in the knowledge that you ‘did’ (or think you did) something.

Guess which is the best option?

In all this comes an interesting calculation from the Pre-Budget Outlook published last Thursday (it was written before the EU Commission’s extension of the Maastricht target date to 2014). It produced a projection of what the deficit would look like if there was no fiscal correction - I have added in 2014 for the new target date and based it on the Outlooks’s trend. What’s noteworthy is that:

If the Government did no-thing - neither cut public spending or increased taxation - the deficit would fall anyway (as a percentage of GDP). Increased economic activity would reduce the deficit by nearly 40 percent.

It would still leave the deficit at an unacceptably high level. But if you accept their trend, it would mean that the level of fiscal correction is far less than what either the Government of the EU Commission claims is necessary. If policy worked with the grain of economic growth rather than undermining it through deflationary spending cuts and tax increases. We may only need half of the medicine that the EU Commission is suggesting.

Of course, there’s a problem with the Outlook’s projections: they are, on their admission, ‘static’. This means it doesn’t take account of the economic effect of not implementing deflationary measures.

For instance, the Outlook projects that if the €4 billion correction didn’t go ahead, the deficit would rise to -14 percent next year. How do they calculate this? Since the correction amounts to 2 percent of GDP, they just add that number on to the deficit and move on. That’s the static scenario.

In the dynamic scenario, you assess the impact on the economy of the withdrawal of correction. It will have a slightly reflationary effect. Let’s use the example of cutting public sector pay by 5 percent. Prior to the April budget, the ESRI estimated this measure would reduce government spending by €1 billion in government spending. However, the net savings would be €676 million, with the GDP declining by €335 million. After the April budget An Saoi and I revised the net savings downwards – to €545 million.

In the Government’s static method the €1 billion is just added to public expenditure and, thus, to deficit. But, of course, if the wage cuts don’t proceed, public sector workers will be paying more tax to the Exchequer, so you have to factor that in the revenue.

The point is, on conservative estimates, the decline in the deficit arising from ‘not doing anything’ is less than what the Government is telling us.

In trying to do a full analysis of the €4 billion correction, we have to use proxies because we don’t know the shape of the contraction. Nor do we have multipliers for, say, social welfare cuts (though I suspect these could be quite deflationary since this most of this cut would result in reduced consumer spending). So let’s use the average of both public sector wage and job cuts. This is illustrative only.

As can be seen, when we factor in the economic impact of not proceeding with the fiscal correction, the deficit doesn’t fall to -14 percent but only to slightly more than -13 percent.  When you factor in the impact of not proceeding with fiscal correction through to 2014, the deficit could be slightly slower.

Doing nothing is not a solution for the simple reason that under the Government’s baseline projections public services are getting hammered, capital investment is being cut, there is no support for economic growth. labour market initiatives and productivity – never mind diverting such growth into sustainable areas.

But what this does show is that, by working with the grain of economic growth, we can introduce both a stimulus investment to hasten the end of the cyclical deficit and tax-based fiscal consolidation measures to attack the structural deficit. One the one hand we spur and incentivise economic growth; in the latter we address the outstanding deficit in a non-deflationary, progressive manner.

There is much Lao Tsu can teach us. And don’t think that his ‘no-thing’ is some sort of embryonic ‘efficient market theory’. It is about doing nothing that goes against the way of Nature. He was big into that. In a very progressive way. That’s why he also wrote:

‘The Way of Nature is to take from those who have too much and give to those who do not have enough. Man’s Way is different. He takes from those who don’t have enough and gives to those who have too much.’

I guess back in ancient China, they must have had a Fianna Fail, too.

Comments

[MichaelBurke]

A very valuable post Michael.

Regarding the negative effect on taxation receipts from a deflationary fiscal stance, the Pre-Budget Outlook does have some helpful information regarding the tax take.

The scale of the decline in taxation revenues (the primary source of the rise in the deficit, not increased spending), has been a surprise, even taking into account the severe fall in activity. In the PBO, (p.20), "The usual expectation is that a 1% change in nominal growth would lead to a 1.1% change in tax revenues. But in this recession a 13% decline in GDP has led to a 32% decline in taxation revenues."

While disastrous for public finances, this data is useful in terms of analysis. The PBO states that there is an assumption that the usual 1: 1.1 ratio will reassert itself overtime. But, from this analysis we can assume that a €4bn cut in spending (equivalent to approx 2.5% of GDP, or a higher 2.85% of GNP, for those that insist o that measure) could lead a decrease in taxation revenues of up to 6.15% (based on the recent ratio) or, at least a 2.75% decline in taxaion revenues (the usual, assumed ratio). Or, given that the return to the usual ratio, if it occurs, will be a process, not an event, somewhere in between those two percentages.

The PBO forecast assumes a tax revenue of €32bn in 2009. A 2.75% decline would be a fall of €880mn, while a 6.15% decline would be a fall of €1.968bn. Using GNP (the PBO doesnt state which it is using), these losses rise to €912mn and €2.245bn respectively.

Even this is, as you say, a static assessment, using only the direct effects of a cut in government spending on the tax take, and not including the wider deflationary effect of falling government spending on the wider economy.

Taking this factor into account would multiply the loss to the Exchequer from the cuts in government spending to such an extent that no savings at all would be made well before the 6.15% current ratio is reached.

As a wise man once said; Cuts Are Not The Same As Savings.

[Proposition Joe]

@MichaelB

I suspect the 13:32 ratio of declines in output versus tax is an artifact of the disproportionate hit taken by the construction and property transacting industries. The activity in this sector has an unusually high tax yield (CGT on site sales, plus VAT on the houses built on the sites, plus stamp duty on trader-uppers, plus VAT on all the furnishing & decor, plus income tax on everyone getting a taste of the action).

Its unlikely IMO that a €4bn cut in public spending would have anything like the same impact on tax revenues.

[Pat Donnelly]

Are these scenarios factoring in the need for repayment of a mere 54,000,000,000 and associated debt costs of 5 to 10% in real terms over twenty years?
Nama of course! The Rolls Royce of bank and land bailouts!