The Public Finances – How Big a Mountain?

With a deficit for 2009 heading above 10% of GNP things indeed look bleak. However, some of the comment on the situation exaggerates the task that future Irish governments face. To the extent that the deficit is the result of an extreme cyclical downturn it could come right in the recovery phase of the world cycle. It all depends on when that recovery occurs and how “normal” it is. However, we also know that there was a major public finance problem even before the world recession took over and that problem will still have to be addressed by future Irish governments.

The budget for 2009 was designed to be broadly neutral. The fact that the deficit will be much worse than expected (and worse than last year) will be substantially due to automatic stabilisers reflecting the fact that the expected fall in output for 2009 is much worse than was expected by the Department of Finance when they framed the budget.

The concerns which I raised in an earlier post related to the possibility that the price level in 2009 will be substantially lower than anticipated in the budget. With expenditure fixed in nominal terms this could result in the budget being much more stimulatory than intended. While John McHale is right in suggesting that the depth of the current recession means that it is not the time to cure the public finance problem by deflationary fiscal policy, the gravity of the problem also means that there is no scope for the government to provide a fiscal stimulus. For this reason it is important that the government looks again at its budgetary profile for 2009. It will need to be adjusted as soon as possible to take account of any likely undershooting on the expected price level (including the price of labour).

While this approach to a fall in the price level is, I believe, correct for Ireland, it need not necessarily be the right approach for the Euro area or the US. The difference is that in Ireland the price level is anchored (with a long chain) to the Euro area price level. There is thus no danger that action by the Irish government could set off a deflationary spiral.

If the world economy were to begin its recovery in late 2009 or the beginning of 2010 then a “normal” recovery would see the world economy grow more rapidly than trend for a period. Because the Irish economy is much more highly geared to the world economy (especially to the US) than the rest of the Euro area, the recovery would also trigger a period of above average growth in Ireland. In turn, with a neutral fiscal policy in Ireland, this would be sufficient to produce a major reduction in the deficit. This could ultimately greatly reduce the size of the deficit without discretionary government action.

If the Irish labour market proves sufficiently flexible to price Irish labour back into full employment over a five year period, the resulting rise in output (and reduced unemployment) would eventually further reduce the deficit. (In the short run an across the board cut in wage rates would marginally increase the deficit. The significant positive effects on the deficit would follow with the resulting rise in output in future years.)

Taken together these two changes could eventually halve the deficit. This would still leave a lot to be done by discretionary fiscal policy in the recovery phase. While pretty painful it would, nonetheless, be possible to do it over a four or five year period without jeopardising the economic recovery.

In Karl Whelan’s post he quotes the government’s updated stability programme projections for the decline in the deficit in future years. He comments that the update provides no details on how these adjustments are to be made. However, if half of the adjustment were to be achieved in the way I outlined this would not involve any government measures. It is the rest of the adjustment which will involve significant changes in the public finances. Other posts have dealt with the need to broaden the tax base – something which would be desirable in any event.

The picture I have portrayed above, where a substantial part of the “heavy lifting” is done for the government by market forces – a world recovery and a flexible labour market – is conditional on a “normal” world economic recovery beginning within the next year. However, there is a lot of pessimism about among economists in the US. At the AEA a number of key protagonists (e.g. Rogoff) expressed doubts about the prospects of a “normal” recovery setting in in the near future. If such pessimism were to prove valid it would see the government’s fiscal problems continue to deteriorate in 2010. Under these circumstances the underlying long-term public finance problem would continue to deteriorate leaving a bigger hill to be climbed whenever a recovery set in.

In the EUROFRAME report on the Euro area economy which the ESRI co-published at the end of November, using the NiGEM world model we considered what might be the long-term effects of a permanently higher risk premium on the capital stock, and hence output in the US, the Euro area and the UK. The conclusion was that the permanent damage to these economies’ productive potential would be limited, though significant. However, the current crisis may affect the world economy through other channels than we considered and there remains the possibility that even more long-term damage will be done. In such an eventuality Ireland’s problems will be part of a broader crisis, the solution to which has still to be thought through.