Philip Lane’s thoughtful article in the Sunday Business Post helps clarify the debate. For while he argues for further fiscal contraction, this should not distract us from the underlying point of difference between those who support (more) austerity, and those who support an expansionist approach. Disputes over fiscal policy can mask more fundamental differences in economic and political outlook. Let’s examine the root issue as Philip defines it, and see where those differences lie.

Philip points out that, notwithstanding the reduction in interest rates which should boost the prospect of hitting the -8.6 percent deficit target next year, problems arise from lower GDP growth. At the time of the EU-IMF deal, the last Government projected nominal GDP growth to be 6.9 percent over 2011 and 2012. Last April the current Government revised that growth downwards to 4.5 percent (and revised the deficit upwards). Recently, the ESRI and the Central Bank have projected nominal growth over this period at 3.3 and 2.5 percent respectively; a long way from the original projections underpinning the EU-IMF deal.

This is important as Philip notes:

‘A lower GDP make it more difficult to hit targets that are expressed as ratios to GDP; lower GDP also means a loss in tax revenues and an increase in welfare payments.’

However, Philip responds to this issue in a far more sophisticated manner than most commentators, making a clear distinction between ‘cyclical’ and ‘structural’ factors:

‘If the lower GDP forecast is classified as a temporary cyclical factor, then it means a widening in the cyclical component of the budget deficit but does not adversely affect the structural component that is the main concern in international policy and investor circles. A cyclical decline in the budget balance of itself does not call for additional austerity measures, since subsequent economic recovery will fix the cyclical component of the deficit.

‘Alternatively, if the lower GDP forecast is classified as a reduction in the long-term potential output level of the economy, then the implication is that the structural budget deficit has deteriorated, since cyclical recovery in the economy will not be enough to restore budget balance. If that is the case, then the government will need to plan for larger fiscal consolidation measures over the next number of years in order to achieve the sizeable improvement in the structural balance that is required for fiscal sustainability.’

There is a lot of meat here so let’s chew slowly for the existence, extent and measurement of the structural deficit is a highly contentious issue, never mind how we go about eliminating it.

Potential output is the level of GDP if the economy was operating at full capacity and all factors of production are being fully utilised. However, when wealth is permanently destroyed, the potential level falls so that, even when the economy is at full tilt, it cannot generate enough tax revenue (or reduce unemployment) to balance the books. Hence we need to engage in fiscal adjustments, i.e. austerity.

There are a number of issues here. First, measuring potential output, or natural GDP, is a highly tenuous exercise. Ask 10 economists to measure potential output and you’ll get twenty different methodologies and forty different answers. Potential output is not something observable like unemployment or the retail sales index. It is estimated, and such estimates widely diverge. Therefore, extrapolating the potential output and, from that, a structural deficit can sometimes be a shot in the macroeconomic dark.

Second, there is a fine line, and sometimes no line at all, between the cyclical and the structural. Is there a point at which a temporary, cyclical dip becomes structural? Let us take the example of an export-oriented company in a high value-added sector employing a high-skilled, well-paid workforce. This company has been years, if not decades, in the making. When external and domestic demand falls for their product in the recession (accompanied by a credit freeze), the company could go bust.

However, after the recession the plant is rebuilt into a shopping mall and all the redundant employees are rehired in the shops. Full capacity has been restored (land, buildings, labour) but the output has been reduced from export, high-valued added activities to low value-added and low-waged work with all the fiscal impact that has.

And herein lies the problem. Full capacity has been restored but not the same level of economic output. And because the economy is not generating the tax and export revenue, the Government cuts its spending (or household spending through tax increases) - which exacerbates the cyclical element of the deficit, which in turn can aggravate future potential output.

Indeed, the pursuit of fiscal adjustments aimed at the ‘structural deficit’ can damage parts of the economy that would otherwise help us overcome structural problems. How many companies, which might otherwise grow - possibly into export markets - will be hit to the point of liquidation by the government cutting its own consumption (i.e. cutting contracts for public services or investments)? What will be the impact of emigration on our skill base, or the early retirement of public sector workers on the public sector skill base? What will be the future economic and social cost of letting too many people spend too long on the dole queues - structural, long-term unemployment? How will education cuts affect knowledge capital in the future?

What Philip does is take the lower potential output as a given and then, like a procrustean bed, cuts the balance sheet to fit which, in turn, puts more downward pressure on future output. It’s a vicious cycle which will end up with an exhausted economy.

There is a better approach. If there is a structural deficit arising from lower potential output - fix the problem: which is the level of productive capacity itself. This calls for investment in key sectors to raise productivity and create a platform which increases the trend growth of potential output. How much would a next generation broadband network, pre-primary education, a state of the art water & waste system, one-on-one tutorials to improve literacy and numeracy skills, a network of free primary health services, electricity generation from ocean and tidal (the list goes on and on) - how much would any or all of these boost potential growth? We can argue the quantitative math but not the qualitative outcome.

And, has been pointed out and measured on numerous posts on Progressive-Economy and here, such investment generates employment in the short-term and higher growth (especially through the supply-side impacts) in the future.

And what about the structural deficit? Well, here’s the real benefit. Growth reduces the structural deficit -just as argued above, lack of growth can exacerbate it. The ESRI, working with x amount of fiscal adjustment, showed that under a low-growth (i.e. 3 percent) medium-term scenario we wouldn’t overcome the structural deficit. However, using the same fiscal adjustment, they showed that higher growth would actually reduce the structural deficit. In other words, the key is not fiscal adjustment, but growth.

This is not to say that fiscal adjustments will not be necessary. But that is a political choice, as Professor John Fitzgerald has pointed out. If we want European level of public services and social protection, we will need European levels of taxation. That, however, is another argument - and requires a detailed discussion of fiscal strategies that get us there without hitting domestic demand or undermining investment streams.

For the situation is deteriorating when viewed through the lens of the domestic economy. When the EU-IMF was signed nominal GNP for 2011 and 2012 was projected to grow by 5.6 percent. The Central Bank and ESRI have radically revised this into negative territory. With even the Government conceding that we will be in a domestic-demand recession next year, the only question is will that situation persist into 2013?

Ultimately, the argument does not boil down to spending cuts vs. tax increases, or the optimal level of (downward) fiscal adjustment. The issue is how we address the productive capacity of the economy. Philip argues that we should drive down our balance sheet to fit a low-growth scenario. The alternative rejects this self-defeating fiscal pessimism.

If we are heading into more difficulties arising from lower future growth, the solution becomes obvious: engage in strategies - namely, investment (public investment which can ‘crowd-in’ additional private investment) - to increase output and productivity.

For if we continue, never mind increase, austerity we will continue to destroy wealth - just as we have done in the last three years. We will end up with a depleted economy, incapable of rising to the new technological challenges facing us. And we will find the goal of fiscal stability as elusive as ever.