The Structural Deficit

Together with my colleagues Adele Bergin, Thomas Conefrey and Ide Kearney we have prepared a note that summarises the preliminary results of research under way at the ESRI examining the current macro-economic problems facing the Irish economy and the possible policy responses. The full analysis and results of this research will be published in the next ESRI Quarterly Economic Commentary to be published at the end of April. The note is available at http://www.esri.ie/research/research_areas/macroeconomics/ireland_in_recession/Maceconomic_Rec.pdf

We estimate that the potential growth rate of the economy over the period 2005-2020 will average around 3 per cent a year. This estimate is derived from research undertaken using the HERMES macro-economic model. This estimate of the potential growth rate is substantially lower than the 3.6 per cent that was estimated as recently as last year in the Medium-Term Review, reflecting the damage done by the current crisis.

Over the period 2008-2010 the cumulative fall in output could exceed 10 per cent. Even with a potential output growth rate of only 3 per cent a year, this would result in a large output gap – the gap between the potential output of the Irish economy and the actual output. (Account is taken of the fact that there was a large positive output gap in Ireland before the recession began – i.e. output was above potential.) This means that when the world economy recovers the Irish economy would be expected to grow well above its potential for several years.

We estimate that the government structural deficit is in the range 6 to 8 per cent of GDP. It is important that the government in its April budget moves to substantially reduce this deficit. If such action is followed up with a further significant reduction in the budget deficit for next year, it could move to halve the deficit by the end of 2010. This would leave a quite manageable task of eliminating the remaining structural deficit by 2015. It would also provide room for manoeuvre if the world recovery occurred later than current forecasts would suggest.

While fiscal policy action this year and next year must substantially reduce the structural deficit, the total deficit could nevertheless be 10 per cent or more of GDP this year and next year because of the exceptional nature of the world recession and the resulting cyclical increase in the deficit. However, with rapid growth in the recovery period (2011-15) the cyclical element of the deficit would be eliminated by natural buoyancy in revenue and the reduction in unemployment consequent on a restoration of employment growth.

11 thoughts on “The Structural Deficit”

  1. I wonder about that 3% percent growth rate. My impression is that in the long run the technological frontier expands by about 2% per annum on average, and that faster growth relies on countries converging to the frontier, or population growth. I am not sure how relevant either of those will be in the Irish context going forward (convergence having largely occurred, and immigration having ended).

  2. John, thanks for the early glimpse at your analysis for the QEC. If you are in a position to comment, it would be helpful to have your take on discrepencies floating around relating to the size of the structural deficit.

    In its most recent Stability Programme, the Commission projects a 9.5% of GDP deficit for 2009. With an output gap 3.5% and a budget sensitivity parameter of 0.4, this implies a structural-cyclical split of 8.1-1.4.

    But this does not appear to have incorporated the recent slippage. The Commission projects a growth rate of -4%. The consensus now seems to be for a growth rate closer to -6.5%. This would add apporximately 1 percentage point to the cylical deficit, bringing it to 2.4%. But it seems the overall deficit projection has increased by something in the order of 2.5 percentage points. This suggests additional slippage in the structural deficit of about 1.5 percentage points, bringing the structural estimate to 9.6%. Needless to say, this is very different from the 6-8% range you estimate, and would have significant implications for the size of the structural deficit reduction required to meet the 3% target by 2013. Any englightment would be appreciated.

    I also share Kevin’s uncertainty on the estimates of potential output growth. Here again there is a significant discrepency with Commission’s modelling: they assume declines of -0.1% in potential output for each of 2009 and 2010. Dicrepencies are not surprising given how hard potential output is to measure. But the difference does raise an eyebrow. (I recognise your estimates are averages over a longer period.) I very much hope you are closer to being right.

  3. @Kevin: But is immigration finished for ever? Blanchard’s suggestion that population and other factors of production are highly endogenous in our small open economy resonates with me. Physical population density is still rather low here and lots of would-be migrants from different parts of the world when the recession is over.

    Huge uncertainties here no doubt. In 1937, Roy Geary published an 80 year forecast of Irish population. It wildly overestimated actual population for 1961, but came in just right for 1986. By 2006 his forecast of 3.3 million was too low by almost a million. We enter into this area at our peril!

  4. @Patrick,

    For ever is asking a lot! Short and medium term might be asking less.

    Yes, you are right, huge uncertainties here. But perhaps there is a case for being conservative when estimating potential growth and structural deficits.

  5. Ireland is a small country, with a highly leveraged economy both with what is left of banking and current social welfare. One attracts the would-be rich and the other attracts “unknown quality” from abroad. I have seen quite a few web sites recently highlighting immigration as an evil in Ireland. Plus ca change!

    All assumptions founder, given that if we do well, a relative measure according to their place of origin, we will attract those who will drag us down. If we do badly, as at the moment, the best leave and are less likely to come back given the barriers to entry, mainly housing, that now exist.

    All of which will further weaken the forecast reliability. A masochistic nightmare for those who forecast. Brave of you and more like propaganda than anything else. In times like these statistics suffer so I expect that while revenues falter the economy will seem to do reasonably well, one of the benefits of a system where corruption is rampant and quite immeasurable.

    A rosy picture then is appropos and sound policy.

    I see there is speculation that the USA has support at some levels, for a new reserve currency. Given that Ireland has so much in common with the USA, this bodes ill. Perhaps you could be even more optimistic in your forecasts? It matters little for most folk as they have no options, due to conditioning and circumstances, but for the fragile few it might help them stick to it and leave more spaces in the lifeboats for others? It is appropriate that the gullible perish first.

  6. On the net migration component of projected labour force change:
    The CSO Population and Labour Force Projections for 2011-2041 present results for the labour force to 2021 on various assumptions about net migration and labour force participation. The key results are summarised on page 30 and in a Box on p. 31 the Report grapples with the issue of the endogeneity of the labour force.
    The lowest migration assumption used was zero net migration. On this basis the projected labour force growth falls from the actual 3.5% a year over the period 1996-2006 to 0.6% a year for the period 2006-2021. But of this 0.6% projected growth, over half is due to the projected increase in labour force participation rates – mainly among women.
    If participation rates were to stabilize and net immigration to resume, then the projected growth in the labour force would evaporate.

  7. It’s good to see a projection of high growth potential for Ireland. How credible is the rosy scenario of an early global recovery though, will it more realistically be a dead cat bounce associated with inflation? The correction required in the US & elsewhere is surely so severe as to portend a long time before real recovery.

    ESRI quote: “If the world recovery were to be delayed by a year so that the Irish recovery began in 2012 rather than 2011, this would cause some further long-term damage to the economy. It would probably add a limited amount to the structural deficit and reduce the long-term potential growth rate of the economy further.”

    Maybe we are likely looking at an inflationary depression in the US at least. The analysis of Roubini & others is quite negative.

    Peter Schiff on CNBC

    http://www.youtube.com/watch?v=wrohccCqbgQ

    Perhaps Ireland should be prudent and plan for a worst case scenario in the world economy and really get its house in order. We are a rich country after all and can afford to take some corrective pain.

  8. Very useful John F and the cautionary uptick from John H
    However, lets put some figures on this. 9% amounts to c 15-16b to close. Unless the govt plan for 7b+ closure on 7 April (the “low hanging fruit” no matter how politically painful and socially poisonus) there is little chance that they would be able to close the rest by 2012. Im not sure we can defer structural deficit elimination for 5 years as John F seems to suggest. We need a plan that will convince the markets and the people that it is credible : 40 – 20 – 20- 10-10% over 5 years may work but that takes us over the next electoral cycle. So I would prefer to see 60-20-20.

  9. With both labour supply and capital stock endogenous, concepts like potential output get very slippery. It is conceptually, never mind empirically, difficult to disentangle structural and cyclical components of the deficit in these circumstances. The smaller the economy and the more open, the harder it gets. It’s not just that Irish net migration has swung round recently, so has the BOP and the counterpart on the capital account. Potential output as conventionally measured is policy-influenced. Philosophical quagmires abound.

    What is the maximand for intertemporal maco-policy? Is it the NPV of consumption for the base-year population? The population at the output peak? Do foreign capital and labour owners get into the welfare function? Policy prescriptions will differ, and substantially.

  10. Brian C is reported as saying in the indo today that the govt have identified a structural deficit of 16b or 8% GDP. Im going to assume that GDP will not be 200b and that the 16b target is what is being worked on. But thats closer to 10% ….isnt it?

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