Cutting Public Sector Pay and Jobs - the High Cost of Irrelevance. The Recession Diaries - March 11

In a previous post we saw that public sector labour costs are below-average by EU-15 standards. The argument that Irish public sector workers are ‘over-paid’ in relation to their European counterparts holds no water whatsoever. However, that doesn’t answer the charge that, regardless of comparative costs, we just have to cut public sector wages because of the fiscal crisis. No matter how unjust it might seem, public sector workers’ must suffer cuts in living standards so that we can bring the fiscal deficit under control by 2014.

The truth is that cutting the public sector payroll will have almost no effect on the fiscal deficits, while at the same time being economically damaging. Indeed, it might end up actually increasing the deficit burden. How does this work?

A simple, slide-rule approach might suggest that cutting €2 billion will reduce borrowing by €2 billion. This is our experience at the household level. When our spending exceeds income, we cut spending to stop the cash-flow deficit. We stop eating out, turn off lights in unused rooms, buy cheaper wine, take fewer holidays, postpone replacing the car, etc. One thing is certain: when we cut spending at household level we rarely if ever cut our income.

This is not the case at the level of the economy. When the Government cuts spending it cuts its own income: for instance, cutting public sector wages reduces tax/PRSI revenue. But it also cuts other people’s income. This reduces consumer spending, which harms businesses, which in turn can harm employees (wage or hour cuts, even lay-offs); this in turn reduces tax revenue further while driving up unemployment costs. When the Government cuts spending it sets in motion a downward spiral that spreads throughout the economy.

We can measure these reductions – approximately. The ESRI ran two simulations in early 2009 showing how (a) a public sector wage cut and (b) a cut in public sector employment would harm the economy but have little effect on public finances. Both simulations were intended to reduce public spending by €1 billion each. Will this reduce borrowing by €2 billion? No.

According to the ESRI, the impact of the measures in the first year

• Consumer spending falls by over €1 billion (what businesses would support that?)
• Employment falls by approximately 20,000 – this can lead to either higher dole queues or emigration
• GDP falls by €1.5 billion – deepening the economic decline

In short, these measures wreak a terrible toll on the economy and economic activity. So what is the effect on the borrowing requirement? Minimal.

In the first year, the borrowing requirement will fall by 0.5 of GDP (this year our borrowing requirement is expected to be 11.7 percent). After all this economic carnage, this is not much of a fiscal return. But there’s another important twist to this dismal tale.

The impact of these cuts gets worse over the years: consumer spending is cut even further and the downturn in the GDP accelerates. So much for the theory of ‘taking the pain up front’. In fact, the pain gets worse.

As a consequence, the ‘savings’ to the Exchequer gets less. By the fourth year the impact on borrowing is reduced – to 0.3 percent. This impact on borrowing is fractional at best.

And what will be the effect on the overall debt level? None. By 2014, cutting the public sector payroll will reduce the borrowing requirement by €915 million (not the headline €2 billion cut). However, the negative economic impact will reduce the GDP by over twice that amount - €2 billion. The debt burden doesn’t fall and it may even rise.

So let’s summarise: we’ve cut economic growth, cut consumer spending – forcing more enterprises up to the wall, and cut employment; all to reduce borrowing by 0.3 percent and with no effect on the overall debt. I just have one question: who thinks up these proposals?

Needless to say, the numbers are on such a knife-edge that, combined with other deflationary cuts, the impact on the borrowing requirement could actually be negative. Perversely, cutting wages and employment could end up worsening the fiscal crisis. When the economy does return to growth, when it starts to climb out of this recessionary hole - it will do so with a giant anchor tied to its ankles.

So why is the Government proceeding with such cuts when all the evidence shows that they will have almost no impact on the fiscal deficit or the overall debt burden?

It only makes sense when we understand the Government’s real agenda: maintaining the low-tax economy. Only by cutting public sector spending – regardless of the harm to growth, jobs and spending – can they keep tax levels at their historical lows (for discussion of this – see here).

Public sector workers are engaged in industrial action to defend their living standards. But now we can add another purpose to their action – an attempt to reverse an irrational economic policy that is doing such harm; to both private and public sector workers, and to business.

That is what this battle is about. We can only hope that the women and men in the public sector win. If they do, we all win.

Comments

[Proposition Joe]

One thing confuses me about this argument that cutting public sector wages is counter-productive for the economy at large.

Surely the converse would hold that positive economic effects should accrue from raising public sector wages right now (paying the 6% due under T2016) and also driving up headcount (not only doing away with the embargo but even accelerating recruitment).

However since almost no-one is arguing for the latter course, it seems we must conclude that PS pay levels had somehow found an optimum level, prior to the pension levy and recent paycut. Yet that assertion seems to strain credulity to breaking point, given the chaotic and illogical process of public wage determination during the past decade. It would be akin to the proverbial thousand monkeys banging on typewriters somehow typing up the complete works of Shakespeare on their first go. Possible, but highly improbable.

[Mack]

You could just as easily write -

"Increasing taxes - the High Cost of Irrelevance".

Both are the true cost of the banking guarantee...

[blagroll]

Prop Joe, you're psuedo arguments are wearing exceedingly thin. Nobody is suggesting that everyone become a civil servant, if we were to take your logic to its conclusion. There is an arguement, however, based on the premise that cutting wages dampens demand, and this is not a constructive policy to adopt during a recession. As always this policy depends entirely upon the economic-political framework populalarly adopted by the establishment coupled with concrete circumstances leading up to and dependent upon the crisis with which many people now find themselves entangled. In other words, the policy advocated in this blog, if I might be so bold, isn't taken in isolation or in a vacuum. It follows from observation of data and the sequence of causal events both concrete and due to the ideological underpinnings of the ruling govt of the last 12 years.

The establishment of NAMA, which was nothing more than a get out of jail free card for the financial losers of the Celtic Paper Tiger, has foisted massive debt onto the Irish nation in an almost instaneous fashion. This decision alone then requires and sets the groundwork for deflationary policy. The result is that ordinary working people, who may or may not have taken part in the Tigger party, are saddled with the results. Except, of course, for the top eschelons of the cs, who are too important to loose if we cut their wages too severly; among many other "cushioned" sections of the population.

From the outside looking in, I see an Irish govt whose only concern is to make whole those who screwed up but are deemed too important to penalise for some reason whilst not only foisting the losses onto the general worker but also making their situation more onerous by cutting their wages in both the private and public sector.

[Proposition Joe]

I totally agree NAMA is a very bad thing.

I don't agree however that the existence of NAMA is necessarily determining public pay policy. Nor that opposition to NAMA should imply any particular line on pay.

The simple fact is that our economy doesn't generate sufficient tax revenue to keep the state in the style to which it grew accustomed. It'll be a difficult and slow process to adjust our tax raising capacity without damaging a potential recovery.

This process is made doubly difficult by the fact that many voices advocating a higher tax burden are also ideologically wedded to the idea that nearly half the workforce should be absolved from an income tax liability.

[Pidge]

Doesn't that assume that the cost of borrowing remains the same, and isn't influenced by (even perceived) attempts to cut public spending?

[Michael Taft]

Pidge, that's a good point. If borrowing costs rise, we may see that interest payments rise as a % of GDP and the overall debt. We then would have a perverse result - cut public sector wages, little effect on fiscal deficit, no effect on overall debt, but debt servicing rises. And your comment also holds true re: perceptions. Once it becomes evident that the Government is pursuing a policy that is economically damaging and fiscally irrelevant - in pursuit of maintaining low-tax model (as per my linked Progressive-Economy.ie article), it may not go well among investors. The reaction could be similar in the aftermath of the Anglo-Irish nationalisation when bond prices peaked - not so much from the nationalisation but the perception that the Government didn't know what it was doing, as only a couple of weeks previous they announced a recap payment to that same bank.

Proposition Joe - that would certainly be an intersting simulation to run: that increasing public sector wages would provide a sustainable boost to output. I'm a bit dubious but would love to see any data you can supply on that.

[Pidge]

Thanks for replying Michael. My point was more about the perception that Ireland has "taken tough decisions" (or whatever phrase is in vogue) and how that would lower or stymie the growth in costs of borrowing.

In other words, hasn't the perception of public sector paycuts and "strong" government meant that the cost of servicing our debt has gone down from what it otherwise would be?

[Shay Conway]

Any chance of getting Stephen Collins from the Irish Times to read this article. Assuming that he will understand the well explained simple economics involved, it may help temper his regular Saturday rant at low ranking public servants.

[JC Skinner]

It's not a matter of whether Irish civil servants are paid the same as German ones.
Benchmarking underwrote their pay at levels commensurate with the IRISH private sector.
But yet somehow they ended up receiving around 30% MORE than their private sector counterparts, plus the added perks of job security, pensions, flexi-time, etc.
So why aren't they being benchmarked back down?

[bigred]

Well, all has come to pass with this so called agreement in public service.Talk about being led up the garden path! Union members wanted the pay cuts reversed, their so called leaders agreed, and instead came out with no strike clauses, no more pay demands, working for more and for less now,doesn't get much better!! than this.Do us a favour, all those so called Union leaders should resign fortwith and spare us all the spin.

[Proposition Joe]

@bigred

The key point is that union leaders are not delusional, well not as delusional as their membership at least. Full reversal of the cuts was never going to happen and they knew it, but they egged on the membership none-the-less with the "vicious attack" rhetoric in order to march them sufficiently up the hill to gain some leverage in the talks. But no-one ever believed reversal would be the outcome. Now what's on the table is actually an excellent deal for the members compared to the alternative, though of course they don't realize this and probably never will. The net outcome is likely to be deeper social welfare cuts than would otherwise be required, though this nasty side-effect of guaranteeing PS wages til 2014 is unlikely to get much attention.