The CSO has released new data today in relation to Q4 2008 and preliminary annual data for 2008. As per Karl Whelan’s preference, I will briefly focus on the Q42008-Q42007 annual changes. The year-on-year decline in GDP is 7.5 percent (GNP declined by 6.7 percent). The current account has declined from a Q42007 deficit of 5.8 percent of GDP to a trivially-small deficit of 0.3 percent of GDP in Q4 2008.
The National Accounts data release is here.
The BOP data release is here.
Kevin O’Rourke has drawn our attention on a number of occasions in this blog to the collapse in world trade and its implications for the depth of the recession. Yesterday, the Financial Times reported that the World Trade Organisation was predicting a 9% drop in the volume of world goods trade this year, the largest drop since the second world war. Today, it reported that Japanese exports have halved compared to a year ago.
Against this backdrop, Irish external trade statistics have been remarkably healthy, albeit two caveats are in order. First, although Japan can report its February trade statistics today, the latest trade statistics on the CSO website (last updated 27 February) refer to December 2008. Presumably the January figures should be published in the next few days. Second, we only get monthly trade statistics for merchandise trade, even though the value of services exports is now about 75% of the value of merchandise exports, so the merchandise trade statistics only tell half the story.
Without attempting to be comprehensive, here are a few principles that are worth considering in designing the April 7th fiscal package:
1. The size of the multiplier. The current empirical literature on fiscal policy throws up a lot of estimates. Some considerations:
(a) Anticipated fiscal policy versus unanticipated fiscal policy. For a few months, Irish taxpayers have been living with a firm expectation that taxes are set to increase, albeit with considerable uncertainty about the allocation of the tax increases. The sharp fall in consumption that has occurred has many sources but expectations of future tax increases is one reason. Accordingly, the extra impact on aggregate demand of raising taxes on April 7th will be less than in the case of an ‘unanticipated’ fiscal shock (the bad news has already been digested to some degree).
(b) The composition of spending cuts and tax increases. The short-run and long-run impact on the economy varies across the different spending and tax components: the aggregate multiplier effect depends closely on the precise details of the package.
(c) A positive slope for expenditure taxes. While it is certainly important that extra taxes are collected in 2009, it is also important to be as specific as possible about the tax schedules that will be in place in 2010 (and beyond). In particular, 2009 expenditure tax rates that are credibly below 2010 expenditure tax rates will be supportive of aggregate demand in 2009 (forward shifting of expenditure plans to 2009).
2. The fiscal target.
(a) In line with the suggestion of Patrick Honohan, the key fiscal objective should be to reduce the structural deficit within a reasonable time period. While there is uncertainty about the precise size of the structural deficit, it is sensible to take the 9.4 percent of GDP estimate that is adopted by the European Commission. Pushing the structural deficit towards zero over a 3-4 year period should be the guiding principle.
(b) If the correction of the structural deficit is accepted as credible, then some passive fluctuation in the overall general government balance can be tolerated, in line with cyclical developments in the economy. Otherwise, if the government simply targets the overall balance, it faces the problem that further unexpected cyclical bad news will either force it to pursue more within-the-year adjustment or miss its announced target.
(c) In communicating its strategy to fellow European governments and the European Commission, this technocratic distinction between structural and cyclical components must be ‘front and centre.’ The good news is that the set up of the Stability and Growth Pact and the monitoring conducted by the European Commission takes such distinctions very seriously and the ‘framing’ of the analysis in this way would be a very natural communications strategy in this context.
3. Front Loading. In an ideal world, it is better to make structural reforms during good times. It would also be better if Ireland had entered the crisis with a sufficiently large budget surplus that a large budget swing could be happily tolerated, with fiscal correction deferred until the recovery takes. However, there are domesic and international factors that support making substantial inroads in the structural deficit in 2009:
(a) Funding Risk. While there are arguments that can be made that Irish bond spreads are an over-reaction to the fiscal/banking situation, we have to live with the judgement of the bond market. Moreover, the risk of ‘contagion’ from possible problems in Central and Eastern Europe should be acknowledged. While such risks are hard to quantify, the high costs of funding crises justify prudential action to mitigate these risks.
(b) Signalling. While the government has implemented some degree of fiscal tightening since Summer 2008, a central source of scepticism in the international markets is whether Ireland can make the switch from a long period of easy fiscal conditions to substantial fiscal retrenchment. The most credible way to demonstrate this capacity is to implement tough decisions.
(c) Domestic Political Economy. By now, the level of awareness of the fiscal problem is much higher among the electorate than was the case in Summer 2008. It is timely to make a significant step forward in the process of restoring fiscal stability.
4. Commitments about the Future.
(a) The tradition in Ireland has been to focus on an annual time frame for budgetary policy. It would greatly help if the April 7th package could include credible commitments about taxes and spending plans in 2010 and beyond. To be credible, the announced tax increases and spending cuts for 2010 and beyond should be as detailed as possible, in order to minimise ambiguity. Moreover, the more credible is the ‘2010 and beyond’ element in the adjustment programme, the smaller needs be the initial fiscal adjustment in 2009.
(b) It is here that the opposition parties have an important role to play, since the period of fiscal retrenchment will likely extend beyond the next general election (whenever that is called). It would greatly calm the markets if the opposition parties could be clear about which elements of the spending/tax package would not be overturned if the composition of the government changed. The historical example is the promise by ‘New Labour’ before the 1997 election to maintain the fiscal parameters of the outgoing Conservative government for it first few years in office.
(c) Credibility about future fiscal plans could be boosted by institutional reforms that would make it more difficult for the government to deviate from its fiscal commitments.
In this article in today’s Sunday Business Post, I analyse some of the factors that are required to ensure that the economy resumes positive growth within a reasonable time period. I focus on non-budgetary and non-credit elements, since those issues are receiving plenty of attention. In turn, the restoration of fiscal and banking health will be greatly facilitated by more rapid real-side adjustment. (I will contribute to the fiscal debate in another post.)
Under the Addendum to the Irish Stability Programme Update (January 2009), the deficit target for 2009 is 9.5 percent of GDP. As a result of the February exchequer returns, it looks as if the actual deficit will be about 2.5 percent of GDP higher. The government must now decide how to respond.
One approach would be to adjust taxes and spending to hit the original 2009 target. As Jim O’Leary has pointed out, achieving a 2.5 percent reduction for 2009 based on changes that will be in effect for only a portion of the year would require an adjustment closer to 3.5 percent of GDP if in place over a full year (see here). Since making permanent changes to taxes and spending part way through a year to hit a single year deficit target would be nothing short of ludicrous, I take it that the gap in question is indeed the 2.5 percent of a full year’s GDP.
In a comment on a previous post of mine, Patrick Honohan made the sensible suggestion that the government should target the structural (or cyclically adjusted) deficit. It worthwhile to return to the Addendum and consider what level of adjustment would be consistent with the framework being applied in that document.
Table 8 of the Addendum contains projections for the deficit, the cyclically adjusted deficit, real GDP growth, and the output gap (i.e. the gap between actual output and potential output as a percentage of potential output). Assuming that the actual deficit as a percentage of GDP (Def) can be written as: Def = Cyclically Adjusted Def + k(Output Gap), we can back out the value of k – -0.4 – being used in the projections. The original deficit target for 2009 comprised of a cyclically adjusted deficit of 6.7 percent of GDP and a cyclical component equal to 2.8 percent of GDP (-0.4 times a negative potential output gap of 7.1 percent of potential GDP).
A key issue is the appropriate adjustment for the recent cyclical deterioration of the economy. In the Addendum, the projected growth rate for 2009 is -4.0 percent. Recent official projections for the contraction of the economy this year have ranged from 6.0 to 6.5 percent. Taking the lower bound, this requires an additional cyclical adjustment to the deficit target of 0.8 percent of GDP (approximately -0.4 times -2 percent of GDP). (I assume here that the potential growth rate of the economy is unchanged and that the deterioration in the cyclically adjusted deficit is due to a larger than anticipated response of taxes to the bursting of the property bubble.) This would lead to a modified target of 10.3 percent of GDP and require a full-year adjustment of 1.7 percent of GDP (i.e. 2.5 – 0.8).
While still very large (I’m inclined to think too large given the fragile state of demand), this is roughly half of the 3.5 percent of GDP adjustment apparently being contemplated.