The Structural Deficit
This post was written by John Fitz Gerald
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.