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.
The English language has many ugly expressions about the Dutch. Most go back to the 16th and 17th century, when there was intense competition and armed conflict across the North Sea. Dutch Disease is a more recent expression. Having suffered the consequences first-hand, my definition is not the standard textbook one. The crucial elements, to my mind, are a bloated public sector that crowds out the private sector, a nasty external shock that exposes the weaknesses of the economy, and incompetent politicians who make things worse.
For the current predicament of the Irish economy, it may therefore be useful to look at the solutions offered by the Dutch government. Since the early 1980s, there has been a broad political consensus on how to run the economy, and the Dutch economy has fared well as a result. The plan announced last night is not particularly impressive. There are four options to partly restore order to the public finances, but implementing all four would be too much. Three of the four options are politically tainted for one of the three parties in the governing coalition. In a coalition, all three have to swallow their price or none will. So, only one option will be implemented, and the fiscal balance will be worse than needed.
The one big measure is a clever one, though. The retirement age will be raised from 65 to 67 years. This increases taxes and reduces expenditures. It also means reduced trouble for pension funds, so that contributions (and labour costs) do not have to go up that much. It does of course increase unemployment in the short run, but on balance I would think this is a positive development.
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.
My previous post highlighted that the structural component of the budget deficit is relatively high. Right now, a return to economic growth will not deliver big revenue gains, in view of the reduction of cyclically-sensitive income taxes over the last decade, such that the cyclical element in the budget is measured as low.
One feature of the upcoming fiscal adjustment could be to shift the attribution of the overall deficit between structural and cyclical components. In particular, if cyclically-sensitive taxes are increased, then the cyclical component of a given deficit will increase and the structural component will decrease, since economy recovery will then ‘do more of the work’ in returning the overall fiscal balance to good health.
That is, a X percent deficit reduction package could translate into an X+Z improvement in the structural deficit and an X-Z improvement in the cyclical deficit. This is relevant, since the key target should be to reduce the structural deficit.
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.