Deflation Once Again
The size of the gap between the economic reality and people's expectations is frightening
Wednesday, February 27 is Budget Day. It is a commonplace that decisions are taken well in advance of this but rarely can it have been so easy to pinpoint so precisely when the shape of this month's budget was cast, December 3, when figures for retail sales for the first half of 1979 were published. The relationship between retail sales in the first half of 1979 and the 1980 budget might not be easy to see, but it is crucial because the information on retail sales, once available, provided an explanation for a remarkable growth in imports and the deterioration in the balance of payments that had been going on in 1979 - the explanation being that the economy was in fact experiencing a fast growth in demand but that this demand was being filled by imports, not by home production. The economy was exhibiting "excess demand" characteristics where increased demand was not calling forth an equivalent growth in GNP, and the balance of payments was worsening.
The importance of the retail sales figures is that they completely overturned forecasts for expenditure by households (consumer expenditures). At the beginning of 1979 and indeed for the most of the year it was expected that they completely overturned forecasts expenditure by households (consumer expenditure). At the beginning of 1979 and indeed for most of the year it was expected that consumer expenditure would grow very little in the first half of the year. The reasons for this were as follows.
For those whose incomes were determined by the National Pay Agreement and the National Understanding the second phase of the 1978 Agreement involved a very small payment of 2 per cent in the early months of 1979 followed by a period of no increase until the National Understanding was operative. If covered by PAYE, as indeed all woe1d be, the postal strike affected the ability and willingness of the Revenue Commissioners and their employees to provide new tax allowances as revised in the 1979 Budget. This ate further into disposable income (i.e. income less taxes), as people were pushed into higher tax brackets.
Farmers' incomes were very badly hit by the severe winter of 1978/79. The effect was to reduce output and in. crease inputs of feed to supplement poor grass growth. The effect of these two factors operating against incomes was to cause a fall in money incomes to farmers. Farmers were not of course equally affected and some were more seriously hit than others. In the second half of the year cattle prices col. lapsed and this also did not help.
The postal strike itself caused reductions in levels of activity and this was expected to lead to shorter working hours where overtime was reduced, and indeed is known to have adversely affected many small businesses.
With these factors working on disposable income it was expected that consumer expenditure would fall in the first of the year. Indeed it was not expected to pick up until September when payments under the National Understanding were made to large number of workers. Monthly data retail sales covering a significant proportion of consumer expenditure provide a check to forecasts of consumer expenditure. Unfortunately the postal dispute affects the compilation of retail sales figures.
The June figure available in mid-October, but no data was available covering February to May until early December. VAT receipts were very poor but these also were affected by the postal dispute. Information on new car registrations indicated a fall in new sales during the year. The shortage of petrol also suggested that consumption of petrol might have been reduced though this was difficult to interpret in the t of statements at the height of the petrol shortage. In any event, the forecasts were that consumer expenditure (in quantities, allowing for price changes) was falling in the first half of 1979. Incidentally this was merely continuing downward trend there since the second quarter of 1978. The turning point on consumer expenditure was expected be in the period from September.
In fact it is hard to believe how far from reality these, forecasts were. Retail sales rose in the first quarter of the year and again the second quarter in spite of the adverse movements in disposable incomes and the fall in car sales. It appears that the personal savings rate fell and this enabled individuals to hold up and increase consumption in the first half of the year. With car sales falling it is clear that ere must have been substantial increases in expenditure other items. The failure to forecast this was the principal forecasting error of 1979. This error led naturally to a further error on the import and balance of payments side.
Import growth had been very strong in the first half of 1979. It was assumed that a significant proportion of this growth was going to stocks as firms increased stock levels since consumer expenditure was forecast to fall. Once firms were happy with their stocks a fall in imports was expected.
As time passed and imports failed to fall the forecasts for stocks grew larger. Consumer expenditure is a very big part of demand and once it was known that it had in fact been growing rapidly the whole picture fell into place. Imports were growing rapidly because demand was growing rapidly. Unchecked this would go on forever. By end year also it was clear that the budgeted borrowing requirement of £779 million was going to be exceeded by a very significant amount and this also tended to keep demand pp. It is an illusion to think that unpaid taxes have no influence on the economy.
By the time the year was over the actual performance of the economy was very much different to anyone's expectations, with possibly one exception, the growth rate. The growth rate was 2Jh-3 per cent and this remained essentially unchanged during the year, though not of-course the appreciation of what was going on. What was going on was that the economy was experiencing, for the third year running, a growth in demand that was above average. Unless an economy is extraordinarily responsive on the supply side in increasing output to meet this demand then the demand tends to be met from imports. This is precisely what happened.
The relationship between the growth in demand and growth in imports has risen more in the last three years than at any other time in the last two decades. In the pre-recession years of 1966-1973 the ratio in terms of volume was 1.4. The figures for the following two years are not applicable because there were large variations in opposite directions in imports in 1974 and 1975. The 1977, 1978 and 1979 ratios 1.6, 1.6, and 2.0 respectively - are above the average of pre-recession years, the difference in 1979 being very large.
A sustained rise in final demand is in itself not a problem the problem arises in the source of the rise in demand. If industrial exports are increasing rapidly or if new foreign investment financed by capital inflows grows very fast there is in general no problem on the balance of payments. The stimulus is externally generated. If new foreign investment is very rapid the balance of payments deficit might be worsening but this is not a problem as the deficit is covered by capital inflows.
It is an entirely different matter if the stimulus to demand comes from domestic sources. In this case overall demand is raised for a given level of external receipts from exports and new foreign investment. Even if the economy can respond and produce more the import content of production is high so that imports necessarily rise and the balance of payments worsens. If the economy is supply constrained then domestic output may respond very little to increased demand and imports simply fill the gap. The balance of payments worsens, as it did in 1979, and external reserves fall.
The fall in reserves in itself would introduce contractionary forces to cut back on the excess demand. A fall in reserves had its counterpart in a worsening of the liquidity position of the commercial banks and if the banks are forced to maintain given liquidity ratios there must be a contraction of credit. However for whatever reason this is unlikely to happen. The Central Bank replenishes the lost liquidity of the banks. Indeed in 1979 the extent of this was staggering. Banks can continue to increase lending so long as the Central Bank provides them with the funds. The limit is the extent of the external reserves. If demand levels remain excessive then external reserves continue to fall and they will fall to the point where it will be no longer possible either to trade or to borrow abroad.
It is for this reason that domestically generated increases in demand must be cut back. There are many ways to do this, but one way or another they involve a reduction in the fiscal stimulus given to the economy. Part of the problem in 1979 was the fall in the personal savings ratio. We do not understand the factors governing such movements and since we do not understand the factors it means that variations in the personal savings ratio is not a policy instrument. If it rises then well and good, but it cannot be relied upon. Thus fiscal policy must be directed to reducing personal consumer expenditure - directly through tax increases and indirectly through other measures affecting disposable income. Similarly Government expenditure on current goods and services must be cut in real terms either by non-replacement, directly laying off people, or by cutting non-wage, expenditure. Domestically generated investment is also heavily dependent on Government capital expenditure through the Public Capital Programme and this must also be cut back.
The extent of the fall in domestically generated demand is conditional on the growth in external demand, as between them they determine the balance of payments deficit and the movement in reserves. The change in reserves is the target towards which policy must be directed.
Fortunately we do have a handy reference to measure the impact on demand of factors at least in principle controllable by the Government - the borrowing requirement. The borrowing requirement measures the fiscal stimulus given by Government to the economy and changes in it measure changes in the net fiscal stimulus. The borrowing requirement in 1979 totalled £1,000 million compared with a GNP figure of £7,325 million. If the overall stimulus remained unchanged the borrowing requirement would total £1,150 million in 1980 when allowance is made for inflation. The extent to which the Government cuts back the borrowing requirement will determine the extent of the improvement in the balance of payments and the direction of change in reserves.
Over the medium term a Government should have a target borrowing requirement consistent with the medium term growth in the public sector capital stock. For instance it knows that infrastructural facilities must improve if the economy is to grow and it should borrow to finance such investment so long as the returns are not privately captured - either direct charges for the services or increased taxes from the higher output must provide an adequate return to the State. Similarly if domestic investment is weak and the State is aware of profitable projects - profitable in an economic as opposed to a financial sense - then borrowing to finance such investment is worthwhile. The principle is that the medium term the state should only borrow to finance economically worthwhile projects.
In the short term the situation is more complicated as there may be arguments for reflating the economy when demand is weak but the corollary is that Governments should deflate when growth is more rapid. In an Irish context the target must be to have a current budget balance over the medium term - deficits in some years followed by surplus. Unfortunately we are now in our eighth year of current get deficits. What this docs is increase National Debt corresponding to which no real productive assets exist. This might not matter if the amounts were small and involved all increases in tax rates to pay interest charges. The amounts for Ireland are very large, and the failure to provide for surplus has meant a growing national debt, with interest payments growing at an alarming rate. The continuation of a current deficit of £500 million in real terms could add £50 million to interest payments every year. This could be a continuous increase not a once-off payment. Ideally the Government should be looking for an increase in e borrowing in a year like 1980 when the external stimulus weak. The very state of the balance of payments and .the reserves makes this impossible.
Economists are only too aware of the balance of payments and external reserves situation. If excess demand not pulled back the consequences are very serious in terms of our ability to trade and indeed in terms of the ability of government to function. The question is one of timing. As things now are it is unrealistic to expect a cut lack on the current budget deficit to a current balance. It will take more than one year to do this. The target must be to enter 1982 with the budget deficit approaching some form of balance and thereafter to generate some surpluses with investment projects being economically feasible. If the budget is not severely deflationary then private sector credit will have to be curtailed very rigidly if the State is it to avoid an exchange rate crisis before the end of the tar. The Government should seek a reduction in the borrowing requirement to £800 million or less in 1980 and £600 million in 1981. This can only be achieved by tax increases or expenditure cuts or some combination.
The case for deflation is well established since early December and few economists would disagree. The question is one of timing. How far do you deflate this year could it be done over 2-3 years and so on. Against it are ranged a series of pseudo-political arguments, with an election within the next two years the Government cannot deflate without affecting election prospects. This is the lost simple-minded approach, and ignores the consequences of not deflating the exchange rate crisis. Is it better to have an election in the middle of a deflationary era which is self imposed or to try the same when deflation is imposed from without? This society should not delude itself that there is an easy way out of the present problem. There is not. In fact, the longer it takes for corrective action to be applied the worse the consequences.
The size of the PAYE marches has constrained Government action. The answer to this is somewhat similar. There are really two arguments going on here - the equity argument and the burden argument. Unfortunately most people seem to believe that greater equity will reduce the present burden. It will not. Greater equity will shift some of the burden of increased taxation. If the Government does not deal with the burden and raises taxes, its electoral prospects dim. If it does deal with the burden and equity by reducing taxes the exchange rate crisis will sort out the burden and the equity arguments by ignoring them. It is it mistake to think that foreigners will be prepared to fund internal equity problems here. Having said all this, the size of the gap between reality and peoples' expectations is frightening. It is hard to see what lies at the end of the PAYE - march road.
If it is reduced taxes then it logically includes reduced expenditure. Inevitably the weak will suffer. Rather than marching to pay less taxes people should march to work harder, or longer hours, or to pay more taxes. I have no doubt that the PAYE system provides for inequitable taxation of income because of the conditions of the self-employed. It is not clear if equity can be attained, nor is increasing the number of tax officials going to do it. It is possible to design an indirect tax structure that would be progressive in nature. The difficulty as always is to know how far to go and what to do for low income families. Would the State supplement low incomes to counteract the effect of increase indirect tax on food for instance. This merely shifts the burden of taxation. It does not alter the need to increase taxes, whatever one might feel about the specific equity ruling of the courts.
The problem with such semi-political arguments is that they assume there is no economic constraint. There is another type of argument which recognises the budgetary problem but sees it as one for the Government as if the Government had nothing to do with the people. Typically it goes: the Government cannot raise but must reduce taxes and cannot reduce expenditure. What happens to the borrowing requirement immediately, and control of the economy ultimately, is never considered. Unfortunately head in the sand economics is rife.
The State in fact has really no option but to increase taxes or reduce expenditure or both as the alternative, external control, will be very much worse. No Government can run away from this and if it means that they are not re-elected then that is too bad. There is no trick or device to sort out the balance of payments problem - unless working hard is a trick.