Public Spending Cuts Have Been a Waste of Time

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Now that the Troika is leaving town it is a good time to take stock.  We don’t do that very well.  We don’t evaluate, we don’t compare inputs with outputs.  We have policy by feeling, intuition, inertia.

Take public spending; since the beginning of the crisis we have been lectured daily about bringing the deficit under control.  To do that it was asserted that we had to cut public spending.  There was rarely any evidence put forward as to whether public spending cuts would actually result in deficit reduction, or by how much – it was just assumed.  As I said:  feeling, intuition, inertia.

Dr. Rory O’Farrell from the Nevin Economic Research Institute has produced a working paper to help us assess the efficiency of spending cuts – The Effects of Various Fiscal Measures.  And there is no doubt about it:  we have been taken for a ride.  Cutting public spending is one of the most inefficient and wasteful means to reduce the deficit.

Rory produces a number of budgetary examples:  a €1 billion cut in social transfers, investment, public sector wages, public sector employment and non-wage public consumption (purchases of goods/services from the private sector).   Using the HERMIN model which was created to examine the effects of EU cohesion and structural funds throughout Europe, Rory assesses the impact of these measures on a number of indicators:  GDP, consumer spending, employment, balance of payments, the deficit, etc.

It should be noted that this is a model.  It is not an empirical investigation and, just as with the ESRI’s HERMES model, it has limitations and caveats.  So the following should be treated as indicative.

The following compares a cut of €1 billion with the reduction in borrowing, or the deficit, under the various budgetary measures.  I have averaged the impact over the eight years that Rory measures the cut.

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As seen, most of the austerity measures produce a deficit reduction of less than 50 percent of the headline cut.  The highest deficit reduction rate comes from non-wage public consumption but the level of cuts in this area has been relatively small.

One particular finding is that cutting public sector employment actually increases the deficit.  How’s that for perverse and irrational budgeting (this mirrors the ESRI’s finding that cutting public sector employment increases the overall debt).

But it gets worse.  For spending cuts result in a lower GDP.  So when you factor in the reduced GDP, the deficit falls even less.  The following is a stylised attempt to assess the deficit-reduction efficiency of austerity measures between 2009 and 2013 under the three broad public spending categories.  I use 2009 as the base-line and assume that all measures were introduced in one year, using the average impact over seven years.  This is not completely satisfactory (to get a truer picture we’d have to assess the impact in each year the cut was introduced) but it is strongly indicative.

What do we find?

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Let’s go through this table.  Regarding public services, austerity measures (cuts in public sector employment and wage, in addition to cuts in contracts to the private sector) amounted to €6 billion, or 3.7 percent of GDP.  The deflationary impact on the GDP was even greater – loss of employment, consumer spending, reduced wages, etc.  This amounted to 4.1 percent of GDP.  In other words, for each €1 in spending cut, the economy declined by €1.11.  But when it comes to deficit reduction, the measures were largely irrelevant. The deficit fell by 0.6 percent, or 16 percent of the headline cut.

In other words, to reduce the deficit by an effective €1 (equivalent to a percentage of GDP), the Government had to cut public spending by over €6.   That is not very efficient.

Cutting social transfers didn’t achieve a whole lot more.  The deflationary impact on the economy was nearly one-for-one (a €1 cut depressed economic activity by 95 cents) while the deficit has fallen by less than 1 percent of GDP.  Not much joy there.

However, when it comes to investment – this is where the irrationality of austerity comes home.  A €1 cut in investment depresses economic activity by €1.71 (which is particularly deflationary).  Because of this impact the deficit didn’t fall at all – it actually increased marginally in terms of percentage of GDP.

This all comes with caveats – and not only to the ones I referred to above.  For example, public investment should be adjusted for the fall in the Tender Price Index.  If we assume a fall of 25 percent over the period, the deflationary impact lessens but the impact on the deficit is still nil – there is still no effective gain in deficit reduction.

No doubt Rory’s findings (and my own extrapolations) will be challenged.  Good.  Can we please have a debate over the efficiency of public spending cuts and their impact on society.  To date, we have been walking zombie-like down the austerity road under the misguided notion that not only is this the best road, but that is also the only road.

But to my mind, the benefit of Rory’s work is not only to shed light on past policy, but to help guide us in the future.   It should become a platform for an alternative expansionary programme.  The Government will be unveiling its medium-term plan next week.  In all likelihood, it will reflect scenarios that the Department of Finance has already published; namely, that public spending will be depressed below the rate of inflation and GDP growth up to 2020.  This will effectively maintain the austerity regime until the end of the decade.

With this analysis we can start to build alternative budgetary and economic policies. We can walk down another road.  We can return to the land of the living.

This is a theme I will return to in the new year.

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