The ESRI’s Quarterly Economic Commentary (QEC) by Alan Barrett, Ide Kearney, Jean Goggin and Thomas Conefrey, published in December, is now available to download free of charge from the ESRI’s web site here. This QEC contained a number of pieces of research which may be of general interest.
1. Measuring Fiscal Stance
In box 1, entitled “Measuring Fiscal Stance”, the stance of fiscal policy in every year since 1976 is analysed within a consistent modelling framework. This research shows that the 2010 budget, while definitely contractionary, was actually not one of the toughest budgets of the last half century. That “accolade” goes to the 1976 budget, with fiscal policy in 1983 and 1984 and in 1988 and 1989 coming in next in line. After that comes the series of budgets implemented for 2009 and 2010. However as is noted in the box, a futher contractionary budget is planned for 2011 so the cumulative contraction in these years may well ultimately exceed the cumulative contraction in the late 1980s.
This measure is obtained by running the HERMES model with taxation and welfare rates indexed and certain rules on public expenditure. This “budget” is taken to be neutral – generally under this rule the relative size of the public sector in the economy would change little in the long term. This result is compared with the actual outturn with the difference being attributable to discretionary fiscal policy.
This measure of fiscal stance tells us whether a particular budget is deflationary or inflationary. It does not tell us whether it is appropriate. However, as discussed in the box, more often than not the stance has been inappropriate – i.e. procyclical.
While not discussed in the QEC, I think that it is interesting that the day of the budget the Department of Finance published an alternative measure for 2010 using the EU standard methodology. This actually suggested that the budget for this year was stimulatory. This strange outcome arises from the inappropriate nature of the EU methodology. The Department of Finance understandably did not draw attention to this result as they clearly saw that it was not a sensible approach. This problem with the EU methodology is not unique to Ireland but affects its application to other EU member economies under current circumstances. I think that the EU approach was not designed to deal with a crisis of the kind experienced in Europe over the last two years. This issue merits further research to find a more robust approach which can be applied in a consistent way to different Euro area economies.
2. The Balance of Payments and the Flow of Funds
In box 4, entitled “Balance of Payments”, the implications of the economic forecasts for the capital side of the balance of payments is considered. With the government sector likely to borrow over 11% of GDP this year and with a prospective small balance of payments surplus, in 2010 the private sector will have a major net acquisition of financial assets abroad (more properly a repayment of net liabilities). Some of this repayment will not flow through the banking system. However, a significant part of it will affect the domestic banking system as households and companies increase savings or reduce borrowings from domestic banks. In turn, the banks are likely to reduce the size of their balance sheets and, hence, their net foreign liabilities. As shown in the box, there was a substantial reduction in these liabilities (largely to the ECB) in the second half of 2009. If this trend were to continue, with the prospective continuing large net repayment of foreign liabilities implied by the 2010 forecast, there should be a continuing substantial reduction in the banking system’s foreign exposure, especially in its exposure to the ECB. This will be important as the ECB begins to wind down its support for the Euro area financial system. Obviously this must be seen against the background of the government sector’s increasing foreign liabilities, a significant part of which will be needed to recapitalise the banking system this year.
3. Distributional Effects of Budgets
In Box 2 the distributional impact of tax and welfare policy changes in 2009 and 2010 was considered by Tim Callan, Claire Keane and John Walsh. They found that while Budget 2010 was clearly regressive, the combination of Budgets 2009 and 2010 placed most of the burden of fiscal adjustment on higher earners.