The Structural Deficit

Together with my colleagues Adele Bergin, Thomas Conefrey and Ide Kearney we have prepared a note that summarises the preliminary results of research under way at the ESRI examining the current macro-economic problems facing the Irish economy and the possible policy responses. The full analysis and results of this research will be published in the next ESRI Quarterly Economic Commentary to be published at the end of April. The note is available at http://www.esri.ie/research/research_areas/macroeconomics/ireland_in_recession/Maceconomic_Rec.pdf

We estimate that the potential growth rate of the economy over the period 2005-2020 will average around 3 per cent a year. This estimate is derived from research undertaken using the HERMES macro-economic model. This estimate of the potential growth rate is substantially lower than the 3.6 per cent that was estimated as recently as last year in the Medium-Term Review, reflecting the damage done by the current crisis.

Over the period 2008-2010 the cumulative fall in output could exceed 10 per cent. Even with a potential output growth rate of only 3 per cent a year, this would result in a large output gap – the gap between the potential output of the Irish economy and the actual output. (Account is taken of the fact that there was a large positive output gap in Ireland before the recession began – i.e. output was above potential.) This means that when the world economy recovers the Irish economy would be expected to grow well above its potential for several years.

We estimate that the government structural deficit is in the range 6 to 8 per cent of GDP. It is important that the government in its April budget moves to substantially reduce this deficit. If such action is followed up with a further significant reduction in the budget deficit for next year, it could move to halve the deficit by the end of 2010. This would leave a quite manageable task of eliminating the remaining structural deficit by 2015. It would also provide room for manoeuvre if the world recovery occurred later than current forecasts would suggest.

While fiscal policy action this year and next year must substantially reduce the structural deficit, the total deficit could nevertheless be 10 per cent or more of GDP this year and next year because of the exceptional nature of the world recession and the resulting cyclical increase in the deficit. However, with rapid growth in the recovery period (2011-15) the cyclical element of the deficit would be eliminated by natural buoyancy in revenue and the reduction in unemployment consequent on a restoration of employment growth.

The IMF and the Global Financial System

The first week of April sees two big economic events:  the April 7th Irish budget is preceded by the G20 summit on April 2nd.  There is an interesting article by Simon Johnson on The Atlantic’s website: you can read it here.

Greenspan on Irish Economic Recovery

Ronald Greenspan of FTI presented this paper to a Dublin conference this morning, with Brian Cowen in the audience:FTIgreenspandublin


Improving the fiscal tradeoff

I apologise for yet another post on fiscal policy.  But it is better to err on the side of too much with crunch-time less than two weeks away.  I sense wide agreement on the two most pressing goals for the April 7 budget: minimise the contractionary impulse; and maximise the positive impact on creditworthiness.   Unfortunately, these goals tend to pull apart in terms of their implications for the optimal size of the adjustment.   I read much of the recent fiscal-related discussion on the blog as exploring ways to lessen this tradeoff.  It seems worthwhile to gather a number of the ideas together. 

(1)  Emphasise Type-1 adjustment (wage bill and transfer reductions) over Type-2 adjustment (tax increases and deferrals of positive net-benefit capital projects.  The international evidence (and arguably Ireland’s own experience) shows that Type-1 adjustments are better sustained and less contractionary.  This would allow either a smaller overall adjustment for any given target for creditworthiness, or a greater boost to creditworthiness for any given size of adjustment. 

(2)  Front-load certain structural deficit reduction measures but combine them with a temporary stabilisation offset.   Take immediate actions to lower the structural deficit to boost credibility.   Such actions could include increases in income tax rates or decreases in public-sector wages.   Combine these measures with explicitly temporary stimulus measures.   Possible measures include temporary reductions in VAT rates (which should move some expenditure forward in time) or temporary reductions in employer PRSI rates. 

(3) Pre-announce detailed plans for back-loaded structural deficit reduction measures.  In a post some time back I advocated a degree of “constructive ambiguity” on the details of out-year plans to raise taxes and cut spending.  I was rightly chastised for this economics heresy.   A detailed plan is critical to the credibility of the programme.  (I now put my hopes in liquidity constraints rather than myopia to lessen the contractionary effects of lower expected after-tax/benefit incomes.) 

(4) Reform fiscal institutions to enhance the credibility of future deficit reduction.   In general, credibility is improved by emphasising fiscal rules over annual discretion.   (An example would be a requirement to keep the pension system in balance over a long-time horizon.   Imbalances would require currently legislated actions such as indexing retirement age to longevity.)  It would also help to move to a system of multi-annual budgets. 

(5) Introduce a notional defined contribution (NDC) pension pillar.   This provides a long-lasting revenue injection with relatively benign demand- and supply-side effects.   Properly designed, it would not add to long-term fiscal imbalances.   It also meets a pre-existing need to improve retirement income security.   It should be a valuable component of an overall package from a union perspective.

(6) Formulate the plan in terms of a revised Stability Programme for the European Commission.  The plan should focus on achieving a 3 percent target for the structural deficit by 2013.   A focus on the structural deficit allows for a more politically robust programme and thereby enhances credibility.   It would also help to signal that the government takes its obligations under the SGP very seriously.

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.