MINIMISING THREATS TO RECOVERY: THE VALUE OF THE NEW FISCAL FRAMEWORK

MINIMISING THREATS TO RECOVERY: THE VALUE OF THE NEW FISCAL FRAMEWORK[1]

Prof John McHale, National University of Ireland, Galway, Irish Fiscal Advisory Council

  1. Introduction

Recent achievements in resolving Ireland’s economic crisis have been encouraging.   Contrary to concerns that the fiscal adjustment effort would be self defeating,[2] significant progress has been made in lowering the deficit and stabilising public debt – albeit at an extremely high level.  Growth is tentatively returning and the borrowing capacity of the State has been restored at record low interest rates.  Employment growth and a falling unemployment rate have been particularly welcome features of the recovery.   Although the exit from the bailout programme is seen as a major achievement, rather than an end in itself, its real significance is as a welcome sign that the vicious cycles that characterised the crisis are easing.

After years of sacrifices, political attention is understandably turning to ensure that more people feel the benefits of recovery.   While the deficit-reduction effort has been extremely difficult, its relatively phased nature was only possible because of access to official loans once Ireland lost its capacity to borrow at affordable rates on international debt markets.  In turn, official-lender support was dependent on a reputation for meeting programme conditions and, more broadly, to respect the new national/European fiscal framework of budgetary rules and procedures.  The restoration of market borrowing capacity has also depended to a large degree on this reputation; in part due to its value in ensuring support would forthcoming in the future if it were required.   With a debt-to-GDP ratio of roughly 120 percent of GDP and a fragile economic environment, this credibility is an asset that should not be lightly given up in the face of political and interest group pressures.

The Government has made a strong pledge to bring the deficit to below three percent of GDP in 2015, which is required to exit the EU’s Excessive Deficit Procedure (EDP).   Recent healthy Exchequer returns and national account figures have increased the likelihood that the target can be met with an adjustment of less than €2 billion in Budget 2015 – though substantial risks remain, notably in relation to the prospects for domestic demand.

Yet this nominal deficit target is just one element of the fiscal framework that has been put in place.  Ireland has also undertaken to pursue an adjustment path for the deficit adjusted for cyclical and once-off factors.  This path for the “structural deficit” is closely related to the long-planned budgetary adjustment of €2 billion for Budget 2015.  If anything, the planned path of the structural deficit is the more fundamental feature of the new framework, and will become the main focus after 2015.  Following the bailout programme exit and recent elections, any backtracking on planned adjustments could suggest a worrying weakening of the commitment to the new fiscal framework.

The rest of the paper elaborates on these themes.   Section 2 briefly reviews the domestic and international threats to robust crisis resolution that Ireland still faces.   Section 3 summarises the national/European fiscal framework that has been put in place, noting its motivations and also its limitations.  Section 4 then discusses the value of an effective fiscal framework in the context of the fragile economic, financial and political environment.   Finally, Section 5 concludes with some observations on the appropriate fiscal stance for Budget 2015.

  1. Threats from Within and Without

Notwithstanding the significant recent progress, there remain a number of threats to a robust crisis exit given our high post-crisis debt level and other fragilities.  I focus on three: growth, financial market conditions and politics. Each of these has international and domestic dimensions.

Growth

The risks surrounding growth are both domestic and external.   On the external side, the high degree of openness of the Irish economy makes it unusually dependent on demand conditions in export markets.  International-agency forecasts have upgraded the prospects for some of Ireland’s key export markets.   However, international growth prospects are subject to a high degree of uncertainty, in part because many countries are also grappling with their own balance-sheet recessions.  Given the importance of nominal GDP growth to the budgetary arithmetic, a particular concern relates to the ability of the Euro Area to avoid a low inflation/deflation trap, under which the ECB is unable to maintain expectations of inflation at their target of “below but close to 2 percent.”

On the domestic side, there remains uncertainty about the dynamics of the post-bubble recession and recovery.  With balance sheets impaired across the economy, international experience provides cautions about the persistence of weak domestic demand, impaired credit flow and the risk of setbacks.

Finance

The current low risk premiums on riskier assets such as the sovereign bonds of high-debt countries might not be sustainable.   Leading central banks have lowered short-term rates to close to zero levels and also targeted term premiums through quantitative-easing policies.  One concern is that policies that lower the return on low-risk assets lead investors to “reach for yield” by purchasing higher risk assets to maintain the overall returns on their portfolios.  International investors also appear to have shifted funds from some emerging markets given changes in risk perceptions relative to the Euro Area periphery.  To the extent that Ireland and other crisis-affected economies have benefited from such portfolio effects, the normalisation of monetary policies – or a reassessment of relative risks – could lead to higher costs for new borrowing.[3]

The extent of non-performing loans in the banking system remains a domestic financial risk.   The recent Asset Quality Review (AQR) by the Central Bank has provided some reassurance on the capital positions of the main Irish banks, although a full assessment must await the ECB’s stress tests due by the end of October.  Developments on a European banking union have also reduced the risk that the State will be the first port of call for additional capital needs.   Concerns relating to ultimate losses by NAMA have receded.   However, the limited nature of the banking union, combined with the level of non-performing loans, means that explicit and implicit contingent liabilities associated with the banking sector remain a downside risk.

Politics

There continues to be a risk of external policy shocks.   One possibility is that a flare-up of a crisis in another Euro Area country leads to a broader reassessment of risk, or to European-level policy responses that reduce the creditworthiness of still-vulnerable member states.  Even in the absence of such flare-ups, policy could evolve in ways that raises investor fears of future defaults.   The recent German Constitutional Court review of the legal foundations of OMT provides a cautionary example of the potential for setbacks to the institutional and policy developments that have helped reduce fragility within the Euro Area.

Domestically, there is a risk that as crisis memories fades support for a sustainable fiscal policy will fade too.   In countries such as Canada and Sweden, fiscal crises have led to the institutionalisation of strong fiscal frameworks with broad public support.  As discussed in the next two sections, a legacy of the crisis is that Ireland now has a strong fiscal framework incorporating national and European elements.  But support for – or even understanding of – this framework is limited, with the willingness to follow the framework now being tested.

  1. European Politics, Lenders of Last Resort, and the Fiscal Framework

As exposed by the crisis, an under appreciated flaw in the design of economic and monetary union was the absence of an effective lender of last resort to governments that lose the capacity for market borrowing. The crisis thus revealed the fragility of sovereign creditworthiness for euro area countries with high and rising debt levels.  The limited political integration – and associated limits to trust and solidarity – has meant that stronger countries have been reluctant to put themselves at risk of making the transfers to countries in distress that such lender-of-last-resort (LOLR) support requires.  The crisis-driven developments in the EU and euro area fiscal frameworks should be seen, at least in part, as a quid pro quo for the strengthening of support policies, including critical policies undertaken by the ECB.

The new framework is a combination of European-level elements under the reformed Stability and Growth Pact (SGP) and national-level elements that are designed to complement and extend the European Rules.   The Department of Finance has usefully brought the various elements together in its Medium-Term Budgetary Framework (MTBF) document.[4]

The European elements of the fiscal framework are primarily based on the Stability and Growth Pact (SGP).   Probably the best known features of the framework are the reference values of three percent of GDP for the General Government Deficit and 60 percent of GDP for the General Government Debt.  The SGP includes both a corrective arm – operationalised through the Excessive Deficit Procedure (EDP) – and also a preventive arm, which is focused on attaining a structural budget balance over the medium term.

The pact has gone through a number of reforms since coming into being in 1997.  Responding to dissatisfaction and failure to comply with the rules by some large countries in the early 2000s, the SGP was reformed in 2005 to allow for greater country variation in setting the medium-term objective (MTO) for the structural budget balance.

More recently, following widely perceived failures of the framework in the run up to the crisis, a significant set of reforms were made in 2011 under the so-called “six pack”.  The corrective arm of the pact can now be initiated if the debt-to-GDP ratio is not falling sufficiently quickly towards the 60 percent reference value.  In addition to requirements for the level and adjustment path for the structural balance, the preventive arm is extended to include limits on the rate of growth of government spending under the Expenditure Benchmark.    Member states must keep the growth of a key expenditure aggregate to below the growth rate of potential GDP unless offset by discretionary revenue-raising measures, with tighter expenditure limits required along the adjustment path to the MTO.  This reform is meant to prevent large and difficult to reverse expenditure increases that are initially funded by an unsustainable revenue boom.   Other reforms included earlier and more automatic sanctions under the reverse qualified majority voting procedure, broader surveillance of imbalances under the Macroeconomic Imbalances Procedure (MIP), and minimum requirements for national budgetary frameworks.

In addition, further reforms of a more procedural focus were instituted under the “two pack” in 2013.  These reforms include a role for European Commission in reviewing national budgets before they are passed into law, stepped up surveillance for countries with high deficit and debt levels, and a requirement for independently produced or endorsed macroeconomic forecasts underlying budgetary projections.[5]

The intergovernmental Treaty on Stability, Coordination and Governance (TCSG) also came into being at the beginning of 2013.   The primary intention of the treaty’s “fiscal compact” is to put the requirements of the preventive arm of SGP into national law, encouraging greater national ownership of the framework.[6]

As further discussed in the next section, the new fiscal framework should provide a valuable structure to guide Irish fiscal policy.   However, a number of criticisms have been made of its design, and it may continue to evolve in coming years.   Among the criticisms are that it is:

  • too complex, with even experts struggling to understand its workings, limiting its potential for broad public understanding and support;
  • too procyclical, with measures of potential output closely following trends in actual output, limiting the size of measured output gaps, and thus gaps between the actual and structural deficit;
  • too insensitive to the distinction between current and capital spending, with potential implications for future growth prospects, and incentives for governments to seeks to fund public capital spending through less transparent “off balance sheet” measures; and
  • too insensitive to the overall euro zone fiscal stance given its focus on national-level fiscal measures, potentially leading to a overly tight fiscal policy for the euro zone as a whole.

The national components of the fiscal framework are set out in detail in the MTBF.  Core components are the Budgetary Rule set out in the Fiscal Responsibility Act 2012 and the Medium-Term Expenditure Framework set out the Ministers and Secretaries (Amendment) Act 2013.    Taken together the rules and enforcement mechanisms are designed to be consistent with the requirements of the preventive arm of the SGP. The framework also follows the growing international practice in giving a role to an independent fiscal council in monitoring and assessment.

A key feature of the FRA is that the Government is answerable to the Dáil for failures to meet the Budgetary Rule.  Article 6(1) states:

If the Commission addresses a warning to the State under Article 6(2) of the 1997 surveillance and coordination Regulation or if the Government consider that there is a failure to comply with the budgetary rule which constitutes a significant deviation for the purposes of Article 6(3) of that Regulation, the Government shall, within 2 months, prepare and lay before Dáil Éireann a plan specifying what is required to be done for securing compliance with the budgetary rule.

Furthermore, if the Government does not accept the Fiscal Council’s assessment of compliance with the Budgetary Rule – including compliance with any correction plan put in place to meet the rule – the Minister shall, within 2 months of being given a copy of the Council’s assessment, provide a statement to the Dáil on the reasons for why it has not been accepted.

Consistency between the national and EU frameworks allows the two sets of formal rules and enforcement procedures to reinforce each other: the monitoring, peer pressure and financial-sanction procedures of the SGP helps give credibility to the national rules; the monitoring and enforcement procedures of the national rules – including roles for both the Dáil and the Fiscal Advisory Council – provide a degree of domestic oversight and ownership of the overall rules framework.

The link between the strengthening of the fiscal framework and more effective lender-of-last-resort support has been clear, albeit often left implicit.   It is notable that Mario Draghi first called for a “fiscal compact” in an address to the European Parliament before initiating the bank’s Long Term Refinancing Operations (LTRO) in late 2011.   The existence of the compact was also likely to have been essential to the ECB’s Outright Monetary Transactions (OMT), which followed in 2012.   The Treaty also explicitly links access to funding from the European Stability Mechanism (ESM) to participation in the compact.

Overall, while the fiscal framework is not without flaws, the complementary European and national elements provide a valuable structure to guide Irish fiscal policy.   Rather than being viewed as something imposed on Ireland, or even simply an act of shared sovereignty with other Euro-Area members to make monetary union work, it should be seen as a framework that is in the national interest to the extent it underpins sustainable growth in Irish incomes and employment.

  1. Value of an Effective Fiscal Framework

The new fiscal framework is often portrayed in negative terms as an intrusion into domestic freedom of action.   But it is important to recognise that debt markets can be much more demanding task masters in terms of the constraints on deficit and debt levels considered consistent with access to borrowing. In addition to its political role in facilitating needed development of European-level support policies, an effective framework is essential to ensuring that a phased adjustment is consistent with robust creditworthiness – expanding rather than contracting the State’s real budgetary freedom of action.

The national case for an effective fiscal framework has a number of elements: it can help tame the boom-bust cycle that has done Ireland so much damage in the past; it can help us move to safer levels of debt in a phased way; and can help ensure the credibility of Ireland’s fiscal sustainability during the transition to those safer levels.

Taming the boom-bust cycle

The Irish economy has been susceptible to severe boom-bust cycles throughout much of its post-independence history.   This has partly reflected the inherent volatility of a small open economy, especially one with highly mobile capital and labour.   However, the volatility has also reflected policy mistakes.   Such mistakes were apparent in the run up to the most recent crisis, especially in relation to financial regulation.

Pro-cyclical fiscal policy has contributed to this volatility – a phenomenon not unique to Ireland – even if fiscal policy was not the main force behind the pre-crisis property boom.  The pro-cyclicality involves an expansionary bias in good times, although the underlying “deficit bias” can be temporarily hidden by unsustainable revenue windfalls.   The pro-cyclicality then continues in bad times through fiscal contractions, typically forced by the need to ensure debt sustainability and preserve borrowing capacity.

A well-designed fiscal framework should help to tame this tendency towards boom-bust cycles.   For example, an expenditure rule that limits the growth in expenditure to the underlying potential growth of the economy places limits on the extent to which wind-fall revenues are used to fund “permanent” increases in spending or reductions in tax burdens.  Of course, fiscal policy has not been the only source of pro-cyclical bias.   Excessive credit growth was a more fundamental driver of Ireland’s unsustainable property-driven boom.  Even so, in addition to new frameworks for micro- and macro-prudential regulation of credit markets, a fiscal framework that prevents the build up of actual (or hidden) structural deficits should help support a more sustainable growth pattern for the Irish economy.

Moving to safer debt levels

The crisis has left the Irish economy with a legacy of high State debt.   From a low of under 25 percent in the third quarter of 2007, Ireland’s debt-to-GDP ratio reached almost 123 percent in 2013.   This increase reflected both the costs of bailing out the banking system and the large deficits that opened up as windfall property-related revenues evaporated and the economy contracted.  Such a high debt level leaves the economy vulnerable to shocks that bring debt sustainability and creditworthiness into question.

A country’s “fiscal space” can be identified as the gap between its current debt-to-GDP ratio and the ratio that leads to unsustainable debt dynamics taking into account such factors as the capacity to run primary surpluses and growth potential.   The smaller this gap the greater the risk that adverse shocks will put the economy beyond the critical threshold.   Nearness to the threshold also leads investors to demand a risk premium to hold the country’s debt and raises the risk of self-fulfilling confidence crises relating to country’s chances of avoiding default.

While the process of regaining fiscal space should be phased over time, prudence requires that Ireland pursues a path to a safer debt level.  A well-designed fiscal framework should be consistent with delivering the necessary primary balance to put the debt-to-GDP ratio on a declining path.

Credibility along the path to safer debt levels

Recognising the need for a phased reduction in the debt-to-GDP ratio, it will take time before a reasonably safe level of this ratio is achieved.  The credibility underlying the economic and political capacity to make the necessary adjustments will be critical during the transition, and indeed essential to ensure that a phased transition is feasible.  This credibility can be underpinned by a commitment to a well-designed fiscal framework, especially one that is widely shared across the political spectrum.    Such a framework can help signal the political system’s intentions with regard to medium-term debt-reduction goals, and can also raise the political costs of deviating from the planned path as crisis memories fade.  While rules can constrain the ability to follow an “optimal” policy at all times, a credible framework can given policy makers more flexibility when temporary shocks cause deviations from the planned path.   However, when such shocks occur, a credible framework can also give policy makers more flexibility to follow a less pro-cyclical path without damaging confidence in its ultimate capacity to deliver a low and sustainable debt level.

  1. Concluding Comments

In its recently published Fiscal Assessment Report, the Fiscal Council welcomed the Government’s commitment to meet the requirements of the new framework.   In setting out its medium-term budgetary projections and plans, the Government noted its intention to do what was necessary to exit the Excessive Deficit Procedure and also to respect the new national Budgetary Rule/preventive arm of the SGP over the medium term.

But recent suggestions that the Government is considering reducing long-planned adjustments measures for Budget 2015 are a worrying sign of a weakening in the commitment to the framework.  As noted in the introduction, the path for the adjustment of the structural deficit – which is closely related to the plan for €2 billion of adjustment in the upcoming budget – is a central plank of the new framework.

The Fiscal Assessment Report made a number of arguments for holding to the original plan. First, while significant progress has been made in repairing Ireland’s public finances, the gap between General Government expenditure and revenue is still projected to be close to €8 billion in 2014.  Slowing the pace of deficit and debt reduction would leave the public finances more exposed to shocks that create unsustainable debt dynamics.

Second, the SPU’s central projections indicate no margin of safety around the 2.9 percent deficit target for 2015.   While the encouraging Exchequer returns for the first half the year and strong first-quarter growth performance have increased the likelihood that the target could be met with a smaller adjustment, Ireland’s quarterly growth is notoriously volatile and subject to revisions.  Measured real domestic demand has been relatively flat since early 2010.   Recognising the high level of uncertainty surrounding the level and composition of growth, reducing the planned adjustments would increase the probability of missing the target and increase the risk of meeting the requirements for exit from the EDP.[7]

Third, the dramatic reduction in the risk premium on Irish debt has reflected, amongst other factors, the increasing credibility of Ireland’s capacity to follow the requirements of the new fiscal framework.  While the relatively small reduction in planned adjustments in Budget 2014 does not appear to have harmed Ireland’s reputation, a second year of scaled-back adjustment effort – especially one closely following the ending of Ireland’s programme of official assistance – could raise doubts about the political capacity to hold to the framework outside of a formal external programme.

And finally, Ireland faces significant expenditure challenges over the medium term given underlying demographic and cost pressures.   Nominal non-interest spending in projected to be basically flat over the period 2016-18 despite these pressures.  The public investment budget has already been cut to low levels and there are rigidities in many areas of spending, including the public pay bill.  Hopefully, the upcoming Comprehensive Expenditure Review can be used to identify spending priorities and efficiencies so as to limit the damage to public services and protections.  However, given the underlying pressures, care needs to be taken in pursuing policies that reduce revenue-raising capacity or introduce significant new spending commitments as part of a scaled back adjustment package.

___________

[1] Paper presented at the McGill Summer School 2014 session, The Economy – The Threats to Our Recovery from Within and Without.   The paper draws on Chapter 1 of Irish Fiscal Advisory Council’s June 2014 Fiscal Assessment Report.   The views expressed in the paper should not necessarily be attributed to other members of the Irish Fiscal Advisory Council.

[2] The concern was that the adjustments would slow the economy so much that the fiscal situation would deteriorate rather than improve.

[3] This is mitigated by the long average maturity on outstanding debt.

[4] The Framework document is available at: http://www.finance.gov.ie/sites/default/files/131219%20Medium%20Term%20Budgetary%20Framework%20-%20FINAL%20REV.pdf.

[5] Ireland chose the endorsement option, with the endorsement function given to the Irish Fiscal Advisory Council.

[6] Contrary to many claims during the referendum debate on the Treaty, the fiscal compact introduces minimal new rules relative to the existing SGP.   One possible important exception was the requirement to ensure rapid convergence to each country’s medium-term objective for the structural balance according to a Calendar of Convergence set out by the European Commission.  By forcing a more rapid adjustment, this requirement could have imposed considerably more binding adjustment requirements, and indeed this appears to have been reflected in the ambitious medium-term path set out for reducing the structural deficit as in the Government’s Stability Programme Update published in April.  The questionable need for this path under the rules was heighted in the IFAC’s recent Fiscal Assessment Report (IFAC, 2014).   However, in response to a Parliamentary Question, the Minister for Finance has provided an important clarification:

 [T]he Treaty on Stability, Coordination and Governance in the EMU (sometimes referred to as the ‘fiscal compact’) tasked the European Commission with producing an actual timetable for participating Member States to achieve their MTOs.  Last summer, the Commission outlined that Ireland should achieve its MTO by 2018.  On this basis, the April 2014 Stability Programme Update set out a path for achieving a balanced budget by 2018.  Until the 2014 Country Specific Recommendations (CSRs) are formally adopted by the European Council (early July), Ireland remains subject to the requirement of meeting the 2018 deadline.

Following discussions on the necessary consistency between the fiscal compact and the SGP, and ahead of the formal adoption of the 2014 CSRs, the European Commission has clarified that the deadline for MTO achievement is not fixed but the required annual improvement in the structural balance is.  Consistent with SGP rules, Member States not at their MTOs must improve their structural balance by at least 0.5 per cent of GDP per annum. [Written answer to Deputy Michael McGrath, Tuesday, 24 June 2014.  Full question an answer available at: http://www.kildarestreet.com/wrans/?id=2014-06-24a.213&s=MTO#g215.r]

[7] A failure to meet the nominal deficit target would lead to an evaluation of “effective action” in relation to structural budgetary adjustment under the EDP.   Failure to meet both the nominal target and a judgement of non-effective action could lead to the imposition of financial sanctions under the Stability and Growth pact.  At this stage, there is uncertainty as to whether Ireland would be judged to have met the requirement for effective action given the divergent signals from “top-down” assessments of changes in the structural balance and “bottom-up” assessments based on adjustment measures undertaken.  The risk of a negative judgement would increase if adjustments are reduced below the committed level of €2 billion, which would follow the reduction in previously committed adjustments of €0.6 billion in Budget 2014.

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