Ireland’s Fiscal Strategy
This post was written by Philip Lane
This article is in today’s Sunday Business Post (link tomorrow) and released here with kind permission of its editor.
There has been an intensification in the debate over Ireland’s fiscal strategy over the last couple of weeks, with Minister Noonan’s recent appearance before the Joint Committee on Finance, Public Expenditure and Reforms, the political party think-in events during this past week and the preparations for the imminent new Oireachtas session.
It is important to realise that Ireland retains considerable fiscal autonomy under the EU/IMF programme, such that there are genuine and substantive issues to be decided by the government during the coming weeks. The programme sets down a set of minimum targets for the overall pace of fiscal adjustment but there is considerable latitude in determining the appropriate mix of spending and taxation measures. Moreover, the government is free to pursue more ambitious targets that exceed the lower bounds that are specified in the programme.
For 2012, the government is required to introduce fiscal consolidation measures of at least €3.6 billion (importantly, including the carryover impact of the tax changes introduced in 2011). In addition, it is required to deliver a general government deficit that is no larger than 8.6 percent of 2012 GDP. Indeed, at the time of the deal in November 2010, the assumptions concerning the projected growth of the economy and the projected interest rate on the government debt meant that fiscal consolidation of €3.6 billion would deliver the minimum target of a general government deficit of 8.6 percent of GDP in 2012.
A closer look at the makeup of the overall target balance of 8.6 percent of GDP shows that it consists of three components. According to the Department of Finance’s Stability Programme Update (April 2011), the target overall balance is the sum of a cyclical budget deficit of 0.5 percent of GDP, debt servicing costs of 4.7 percent of GDP and a structural primary (non-interest) balance of 3.4 percent of GDP. (This breakdown does not allow for temporary or one-off factors that can be quite considerable in any given year.)
In one direction, the sizeable reduction in the interest rate on European official funds that was agreed in July 2011 means that debt servicing costs in 2012 will be significantly reduced. On the face of it, this should mean that a €3.6 billion fiscal consolidation package should result in an overall deficit that is significantly lower than the 8.6 percent ceiling – for instance, the ESRI scenario analysis that was published during the week projects an overall deficit of 7.8 percent of GDP for 2012.
However, in the other direction, Michael Noonan has indicated that the government will downwardly revise its GDP forecast for 2012. A lower GDP make it more difficult to hit targets that are expressed as ratios to GDP; lower GDP also means a loss in tax revenues and an increase in welfare payments.
Here, there is an important distinction to be made. If the lower GDP forecast is classified as a temporary cyclical factor, then it means a widening in the cyclical component of the budget deficit but does not adversely affect the structural component that is the main concern in international policy and investor circles. A cyclical decline in the budget balance of itself does not call for additional austerity measures, since subsequent economic recovery will fix the cyclical component of the deficit.
Alternatively, if the lower GDP forecast is classified as a reduction in the long-term potential output level of the economy, then the implication is that the structural budget deficit has deteriorated, since cyclical recovery in the economy will not be enough to restore budget balance. If that is the case, then the government will need to plan for larger fiscal consolidation measures over the next number of years in order to achieve the sizeable improvement in the structural balance that is required for fiscal sustainability.
So far, I have concentrated on what is required to meet the minimum fiscal targets that are specified in the EU/IMF programme. However, the sharp and sustained deterioration in the international financial environment since the negotiation of the deal in November 2010 means that the government should strongly consider extra fiscal consolidation measures in order to move more quickly in closing the structural primary deficit.
Despite the large reduction in spread between Irish and German sovereign bond yields in recent weeks, the European sovereign bond market remains remarkably volatile. In addition, the inter-bank market has also declined over concerns about the exposures of European banks to sovereign risk and a weakening economy. For Ireland to attain the twin policy goals of restoring the government’s access to the bond market and weaning the Irish banking system from its dependence on central bank funding (since market funding costs for banks are closely tied to sovereign borrowing costs for myriad reasons), the shift in investor sentiment means that Ireland needs to set a lower trajectory for its public debt and demonstrate faster progress in reducing its reliance on deficit financing. Furthermore, even if it turns out that an extension of the current EU/IMF deal is required, the bargaining position of the government vis-à-vis its official counterparts will be stronger if it can demonstrate over-achievement in turning around the structural primary fiscal balance.
Importantly, the weak state of domestic demand and high level of household debt mean that the pace of fiscal adjustment should not be accelerated too much. But the €3.6 billion figure for 2012 was determined as a minimum target in November 2010 when the perception of the downside domestic risks facing the Irish economy were considerably more pessimistic than is the case today. One basic factor is that the level of 2010 nominal GDP turned out to be considerably higher than was feared at the time of the deal. In addition, the EU/IMF programme
allowed for the possibility of much greater bank losses than is now envisaged, such that the banking system has an improved capacity to absorb the adverse short-term impact of an accelerated austerity package. Moreover, the EU/IMF programme assumed that the sovereign bond market would re-open to Ireland in 2013 so long as the debt/GDP ratio could be stabilised even at a high ratio around 125 percent of GDP. Rather, the “fundable” peak level of public debt has clearly declined throughout the course of 2011.
Taken together, these factors call for a measured improvement in the pace of reducing the structural primary deficit (even if cyclical factors mean a slower rate of improvement in the overall primary deficit). Accordingly, the fiscal debate in the coming weeks should focus on determining the appropriate degree of extra consolidation in 2012 and in the subsequent years. In this way, the government can demonstrate its leadership by moving the domestic policy debate beyond the narrow framework of just meeting the minimum targets in the EU/IMF programme.
This debate can best be conducted in the context of the multi-year fiscal plan that is due to be announced during October. In addition to providing an opportunity to re-calibrate the overall level of fiscal consolidation, a credible multi-year plan can help reduce the considerable uncertainty that is holding up consumption and investment plans. For these reasons, the next few weeks should be more pivotal for Ireland’s economic prospects than the traditional December budget announcement.