Governor Honohan’s Address on the Banks and the Budget

Patrick Honohan’s address to the SUERF conference (Dublin), “Banks and the Budget: Lessons from Europe”, is available here.

While the address contained important observations on the interaction between the budgetary and banking crises, I expect it is his comments on the fiscal adjustment programme that will make most news:

I have recently been looking more closely though at the multi-year prospects for the budget. Of course it can be said, if the economy stays close to the track originally envisaged, the deficit would come close to 3 per cent by 2014. But as the IMF and others have noted, the real economy, the price level and also interest rates on Government borrowing, have evolved in a less favorable way. Servicing of the additional debt related to bank restructuring is also a negative factor.

Some explicit reprogramming of the budgetary profile for the coming years is clearly necessary soon if debt dynamics are to be convincingly convergent. Recent movements in the yield spread on Government debt – both for Ireland and for some other countries – readily demonstrate the costs that can result unless international lenders remain convinced that the budget is going to be kept on a convergent path, as indeed the Government is committed to ensuring.

During the 1980s Ireland paid a high price in terms of borrowing costs because the markets feared much steeper exchange rate depreciation than actually occurred. An equilibrium of pessimism, with the economy struggling, and investors requiring a risk premium that imposed additional costs on the taxpayer, displaced what could have been an equilibrium of self-fulfilling optimism. It is important now to re-set the fiscal path to ensure a virtuous cycle of lower borrowing rates contributing to even faster fiscal adjustment and a lower overall cost of the adjustment to society at large.

While there has been an international debate on this matter for larger countries, there seems to me to be no question, for Ireland and for other small financially-stressed sovereigns, but that national growth is best served by ensuring that the public finances are convincingly on a convergent path: the impact on funding costs and confidence surely more than offsets any short-term adverse impact on domestic demand from lower net public spending.