Category: EMU

Trends and Cycles in the Irish Economy

The shift in the fiscal debate towards a focus on the structural deficit as the key target has thrown up some interesting issues about how to think about trends and cycles in the Irish economy, plus their implications for the fiscal position.  It is certainly true that the current downturn has a big cyclical component: Minister Lenihan this morning suggested a current forecast for 2009 of about negative 6.5 percent growth in GDP.

However, it is also important to appreciate that forecasts of potential output growth for Ireland have also deteriorated.  In Autumn 2008, the European Commission projected potential output growth for Ireland of 1.6 percent per year in each of 2009 and 2010.  In the March 2010 analysis of the Irish stability programme, the European Commission’s projections for Ireland’s potential output growth had declined to negative 0.4 percent in each of 2009 and 2010: a two percentage points swing in each year.

Accordingly, it is useful to bear in mind that the current downturn involves a substantial negative shock to supply capacity,  in addition to the level of aggregate demand.  One factor relates to unemployment: increases in unemployment are difficult to reverse.  For Ireland, another factor is out-migration. Through these channels, there is a feedback effect whereby sustained declines in activity negatively affect longer-term supply capacity.

There are several implications to consider.

1.   Since the cyclical sensitivity coefficient of the budget deficit in relation to the output gap is 0.4,  an output gap in 2009 of  6.1 percent (- 6.5 percent recession relative to potential of -0.4 percent) means that the cyclical component of the 2009 budget deficit is approximately 2.5 percent.  Everything about 2.5 percent is structural.  [By the way,  2008 output  is estimated as being just above potential output: the 2008 recession just returned Ireland from a level of GDP that was well above the estimated potential level of output.]

2.  Clearly, in a deep recession, it can make sense to run some level of structural deficit as a ‘discretionary’ fiscal impulse to counter the decline in other components of aggregate demand

3.  It is also true that initial conditions matter: since we entered the recession with a sizeable structural deficit, it does not make sense to eliminate it too quickly.

4.  The March 2009 European Commission document that records the 9.5 percent deficit target also projects the output gap for 2009 at 4.5 percent.  If we update the output gap forecast to 6.1 percent, then allowing the automatic stabilisers to work means that the same target for the structural deficit would mean a revised overall deficit target of 10.2 percent (approximately).

5.  The implicit target for the structural deficit behind the 9.5 percent overall deficit was 7.7 percent of GDP. This is the challenge for the government to bring that number down over the period to 2013.

6.   It is imperative that as much as possible can be done to improve potential output growth:

(a)  A key challenge is to get unemployment down.  The various ‘activist’ labour market policies to fight unemployment that are currently being debated are worth serious consideration.  As I have argued in several previous posts, fostering rapid wage adjustment is highly desirable.

(b)  In designing the new tax system,  the promotion of labour supply is a key consideration. This is relevant in terms of the integration of tax and welfare systems for low earners and in terms of the tax treatment of highly-mobile high-skill types (maybe not so mobile in 2009 but more outside options may arise in 2010-2013).

Notes:

The Autumn 2008 European Commission data are here.

The methodology behind the estimation of potential output (plus the estimates of cyclical elasticities) is here.

The FT on Ireland

The Lex column in today’s print edition of the FT was pretty sniffy about the Irish public finances.  However, it is interesting to read the new contribution by columnist Quentin Peel who does a ‘compare and contrast’ between Ireland and Greece, praising the Irish government for at least trying to face up to its predicament.

On the 9.5% Budget Deficit Target

In my comments on John McHale’s recent post and also on the radio at the weekend, I suggested that the government should probably stick to the 9.5% target set out in January’s Addendum document.  While the document did not contain details about how the government was going to make these adjustments, it was still a clear commitment to stick to a particular path to get back towards a 3% deficit by 2013.  If three months later, we were seen to already be well off these targets, the concern would have to be that the international bond market would judge us as being incapable of sticking to a plan.

However, having thought about this a bit, I’d be inclined now to argue that there probably has been so much slippage already this year that sticking to a 9.5% target for the calendar year 2009 may not be a good idea. My impression now is that the implementation gaps in getting the changes in the April 7 budget made effective will mean that we will only see about half of the budgetary improvement that these measures would bring in a full calendar year.  So, for instance, suppose that without adjustments the deficit is likely to be 13.5% for 2009. In that case, getting to 9.5% for the year would require 8 full percentage points of full-year-equivalent adjustments.

A better strategy would be to make adjustments that leave the government running an effective deficit in the second half of the year of 9.5%, and so facing into the 2010 budget in exactly the position that they had promised to be in.  In the example of a no-adjustments deficit of 13.5%, this would amount to running a deficit for 2009 of 11.5%, which could be interpreted as 13.5% for the first half of the year and 9.5% for the second half.

In a sense, this is a recommendation to government as to how to “spin” an outcome which looks like slippage from the January plan as still being, in a sense, consistent with it.  Beyond that, those economic commentators that will want to criticise the government for failing to meet its own plan, if indeed it announces a target higher than 9.5%, should keep in mind that meeting this target would require starting 2010 with a budget deficit well below what was envisaged in that plan.

Some Guiding Principles for the April 7th Fiscal Adjustment

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.

The Path to Economic Recovery

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.)