The shift in the fiscal debate towards a focus on the structural deficit as the key target has thrown up some interesting issues about how to think about trends and cycles in the Irish economy, plus their implications for the fiscal position. It is certainly true that the current downturn has a big cyclical component: Minister Lenihan this morning suggested a current forecast for 2009 of about negative 6.5 percent growth in GDP.
However, it is also important to appreciate that forecasts of potential output growth for Ireland have also deteriorated. In Autumn 2008, the European Commission projected potential output growth for Ireland of 1.6 percent per year in each of 2009 and 2010. In the March 2010 analysis of the Irish stability programme, the European Commission’s projections for Ireland’s potential output growth had declined to negative 0.4 percent in each of 2009 and 2010: a two percentage points swing in each year.
Accordingly, it is useful to bear in mind that the current downturn involves a substantial negative shock to supply capacity, in addition to the level of aggregate demand. One factor relates to unemployment: increases in unemployment are difficult to reverse. For Ireland, another factor is out-migration. Through these channels, there is a feedback effect whereby sustained declines in activity negatively affect longer-term supply capacity.
There are several implications to consider.
1. Since the cyclical sensitivity coefficient of the budget deficit in relation to the output gap is 0.4, an output gap in 2009 of 6.1 percent (- 6.5 percent recession relative to potential of -0.4 percent) means that the cyclical component of the 2009 budget deficit is approximately 2.5 percent. Everything about 2.5 percent is structural. [By the way, 2008 output is estimated as being just above potential output: the 2008 recession just returned Ireland from a level of GDP that was well above the estimated potential level of output.]
2. Clearly, in a deep recession, it can make sense to run some level of structural deficit as a ‘discretionary’ fiscal impulse to counter the decline in other components of aggregate demand
3. It is also true that initial conditions matter: since we entered the recession with a sizeable structural deficit, it does not make sense to eliminate it too quickly.
4. The March 2009 European Commission document that records the 9.5 percent deficit target also projects the output gap for 2009 at 4.5 percent. If we update the output gap forecast to 6.1 percent, then allowing the automatic stabilisers to work means that the same target for the structural deficit would mean a revised overall deficit target of 10.2 percent (approximately).
5. The implicit target for the structural deficit behind the 9.5 percent overall deficit was 7.7 percent of GDP. This is the challenge for the government to bring that number down over the period to 2013.
6. It is imperative that as much as possible can be done to improve potential output growth:
(a) A key challenge is to get unemployment down. The various ‘activist’ labour market policies to fight unemployment that are currently being debated are worth serious consideration. As I have argued in several previous posts, fostering rapid wage adjustment is highly desirable.
(b) In designing the new tax system, the promotion of labour supply is a key consideration. This is relevant in terms of the integration of tax and welfare systems for low earners and in terms of the tax treatment of highly-mobile high-skill types (maybe not so mobile in 2009 but more outside options may arise in 2010-2013).
The Autumn 2008 European Commission data are here.
The methodology behind the estimation of potential output (plus the estimates of cyclical elasticities) is here.