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Sunday, 14 November 2010

Why Ireland's cuts are sinking them and the UK's aren't

There are many genuine, economically literate arguments against the spending cuts being imposed by the UK coalition government at the moment. Not least the issue of reducing aggregate demand through government spending and relying on the private sector to fill that gap when its' major trading partners in Europe and the USA are also struggling economically (hence the recent cap-in-hand visits by David Cameron to both India and China).

Then there some economically illiterate arguments against the spending cuts. Step forward the "look what's happening in the Republic of Ireland" brigade.

Just to fill you in, Ireland has the highest bank debt in the world of €50 billion, and a budget deficit of 32% of GNP - ten times the eurozone's deficit ceiling. More importantly for this discussion, all this has been exacerbated by the steps that the Irish government felt no choice but to make. They slashed public sector pay by 10% and are taking more than 8% of GNP out of the economy in spending cuts. The point is - the cuts seem to have made things a lot worse, ergo the argument that the UK should observe Ireland and not make similar cuts.

The reason why this is economically illiterate is because of the enormous differences between the Irish economy and the UK's.

1) The boom in Ireland was hugely accounted for by the property sector - which by the time recession hit accounted for 25% of the Irish economy, whilst it was only 10% of the UKs even after our property boom. This was unbalanced growth in the first place. Worse, it was funded by huge lending of low-interest mortgages to borrowers who required no money down. These unpaid debts are what is now holding back the banks from growing again. We don't have this in the UK, where our banks ran into problems from dud investments in dodgy derivatives.

2) Ireland is in the Euro. This means two very important things:

a) They cannot use monetary policy to reflate their economy as monetary policy is controlled by the European Central Bank, so they only have fiscal policy with which to operate their economy (hence raising taxes and cutting spending to reduce the deficit). Not being able to lower interest rates, but possibly more importantly not being able to increase the money supply through quantitative easing is an enormous restriction on the economic control of the Irish government. The irony of this is that it was the lowering of EU interest rates at the beginning of the millenium that caused the boom in Ireland - its' inflation (and that of Greece, Portugal, Italy and Spain) was already high when the ECB lowered interest rates to try and inflate the French and German economies, a good example of the problem of central monetary policy being applied without central fiscal policy

b) They cannot allow their currency to devalue in order to boost exports. Since the start of the recession, Pound Sterling has fallen in value by nearly 25% against other currencies. Ireland has seen the Euro strengthen during this time. This takes away another engine of possible economic growth which might have raised money to help with their debts.

So, the upshot of this is that the IMF has praised the actions of the UK government whilst preparations are being made for what many are seeing as an inevitable moment where Ireland will need to go cap in hand to the European Financial Stability Facility, which has already helped out Greece. Both governments have taken similar actions, but it isn't working for Ireland.

As Ed Balls has pointed out many times recently, the five tests that Gordon Brown and his team came up with that more or less ensured the UK didn't join the Euro have probably been our saving grace as we fight our way out of the mountain of debt we have.

You only have to look across the Irish Sea to see the difference that it made.


  1. Paul, would you say the same differences between the UK, Irish and Greek economies mean that the oft repeated threat that "if we don't do X we'll go the way of Ireland/Greece" is an empty one?

  2. Just because the causes of our crisis aren't the same doesn't mean the medicine has to be different. What the UK has is a greater range of solutions available to it. Ireland in particular is an extreme case and it should never get as bad as a deficit of 32% of GDP BUT I think the range of options available to the UK government in managing their economy AND their willingness to use them is important. In all three of your examples cuts have to be made BUT the difference is that Ireland and Greece have only that one option. You could make an economic argument here to just increase the money supply by £168bn to cover the debt but it's not a great long term one. I don't think it's an empty threat no, but I also don't think it could ever get as bad as Ireland or Greece.

  3. Help me out here Paul as I know bugger all about economics, but shouldn't we be concerned that during the 1920s depression, when the govt implemented cuts (rather than stimulating growth), it made the situation far worse? Shouldn't the focus be on creating jobs rather than purely tightening the belts. And where do you see the financial sector's responsibility in all this? One for the next blog? :)

  4. Well this is the genuine economic argument against the cuts. We need to create jobs - we have a lot of 'slack' in the economy in that we have a lot of people unemployed and if we can employ them we create extra demand from them spending their wages (this is a concept called the 'circular flow of income'). I'm not quite sure given spending cuts costing jobs, a private secotr unable to borrow money to create jobs and depressed export markets where those jobs are going to come from unless the government works to create them. This is the basic argument of the labour party at the moment. And yes, the 1931 emergency budget did make huge cuts, it was deflationary and it did lead to 3 million unemployed and a depression. This is why there are so many different views as to what to do. I think perhaps the government may need to think about temporarily relaxing some regulations to make it easier to hire and fire people.
    As for the financial sector...they didn't cause the structural debt (spending being greater than tax revenue for reasons other than the natural economic cycle). They were also a major factor in the growth that came before (and in which we all shared). The trouble is that they don't seem to be sharing our recession!