THE GOVERNMENT SHOULD CONTINUE TO RESTORE ORDER TO THE PUBLIC FINANCES
Dr Alan Ahearne, Lecturer in Economics, UCG, fellow of the Bruegel Institute, Brussels
Over the past five years, successive Irish governments have hiked taxes and cut public spending to reduce the State’s large budget deficit. These policies, introduced during a period of severe economic weakness such as we have experienced over the past five years, are commonly referred to as “austerity.” Ireland is not alone in this regard; indeed, we have seen austerity right across the euro area, especially in the past two years.
I am going to argue that, although painful for the citizens of this country, large-scale fiscal consolidation in Ireland since the bursting of the property bubble has been absolutely necessary to prevent outright national insolvency and a much worse economic situation than we face today. Without these adjustments, there would be no prospect of economic recovery in this country. Looking forward, the Government should continue in its efforts to restore order to the public finances, although given that much progress has been made, there is a legitimate debate about the optimal pace of fiscal consolidation over the next few years.
Though the scale and speed of consolidation has, I believe, been about right in Ireland over the past five years, I will argue that there has been too much austerity in the euro area as a whole. Europe must do more to help promote economic recovery in Ireland and in the other euro-area crisis countries. But we can’t rely entirely on help from abroad. A key message of my talk this morning will be that we in Ireland could – and should – do more to help ourselves.
Let’s go back to 2008 and ask the question: Wouldn’t the best course of action have been to eschew austerity and leave the tax system and public spending untouched? After all, most economists favour so-called “counter-cyclical” fiscal policy to support economic activity during a short-lived temporary downturn. Such policies can be particularly effective in large, essentially closed economies like the United States or the euro area as a whole. Under such a policy, a budget deficit is allowed to persist, typically for several years, since policymakers and debt markets can be confident that the deficit will automatically shrink as the economy recovers from whatever temporary shock caused the recession.
This was most assuredly not the situation that faced the Irish economy in the aftermath of the bursting of the bubble. The property bubble was not going to re-inflate and the economic activity and government revenues associated with that bubble were gone – permanently. We know that at the height of the bubble in 2007 at least one in every three euro of government revenues was generated by the unsustainable boom in property. These revenues included receipts from stamp duty, capital gains on speculative land and VAT on housing supplies. These windfall revenues were used during the boom years to cut income taxes and to fund a surge in spending on public sector pay and social benefits. This level of public spending was “affordable” only if the bubble continuing to inflate forever. It couldn’t – and it didn’t!
When the bubble burst, revenues collapsed and a huge structural budget deficit emerged. The nature of that deficit – a structural deficit – meant that it would not go away unless actions were taken to broaden the tax base and reduce public spending to sustainable levels. An economic strategy that involves running an annual budget deficit of €15bn permanently is a fast-track to national ruin. Of course, a deficit of this size cannot be eliminated in one or two years. To minimise the depressing effects on the economy and employment, deficit reduction in this country has been gradual. This approach contrasts with fiscal adjustment programmes in other euro area economies, which began later and – mistakenly, in my opinion – involved more severe spending cuts over a shorter period of time.
Pro-cyclical fiscal policy during the boom meant, unfortunately, that fiscal policy was inevitably pro-cyclical during the bust. The good news is that the bulk of the work in rebuilding our tax base and reducing public spending appears to have been done. Markets also appear to see it this way, with our long-term borrowing costs now below 4 per cent. And recent weeks have seen a lively debate on whether the Government should scale back on the roughly €5bn in planned austerity over the next two years. There are good arguments on both sides. Determining the optimal speed of fiscal adjustment is not an easy task.
A more radical change in approach was recently suggested by former IMF economist Ashoka Mody. Under his plan, the Government would announce a three-year suspension of austerity policies. The hope would be that – absent austerity – the economy would grow at a rate sufficiently strong to boost tax revenues and lower spending on unemployment assistance and thereby reduce the budget deficit and public debt as a share of GDP.
It might work! But only if the Plan is backed with significant support from Europe. After all, austerity is only one factor weighing on economic activity. Recession in our main trading partners and ongoing problems in our banking system, among other things, are also depressing growth. If the Plan is to have a shot at success, then, first, it must be part of a European-wide strategy to boost growth across the euro area. The European Central Bank, working in cooperation with Europe’s rescue fund, the ESM, could be more innovative in its lending programmes, which may help to increase SMEs’ access to finance.
Public investment is low in the euro area and could be boosted in some countries with more room to manoeuvre on the fiscal side. The EIB has been more active of late, but could do more.
Second, if growth did not pick up as hoped then, under the Mody Plan, the State would accumulate even more debt than is currently envisaged and our public debt would almost certainly have to be restructured. Therefore, if it is to have a chance of working, the Mody Plan would have to be accompanied by a new European programme that would automatically deliver some form of debt relief to Ireland in the event that growth remained sluggish.
Irrespectively of whether austerity is suspended in Europe – and I doubt that will happen – a new framework for orderly debt restructuring in Europe involving such contingent claims would be beneficial, given the very large levels of debt, both public and private, in the euro-area periphery.
Actions at the European level will be critical for recovery in Ireland. But there are resources here at home that we could perhaps use more effectively to better position Ireland to take advantage of a European recovery, if and when it comes.
We have €6½ billion in the Ireland Strategic Investment Fund to invest in the productive economy. We need to be careful to learn the lesson of Japan’s failed attempt to stimulate its economy using public investment following their property crash in the early 1990s. We should avoid building “bridges to nowhere”. In this regard, I hope the term “shovel ready projects” will no longer feature as part of this debate. Public investment should aim to boost the competiveness of the enterprise sector.
Our most valuable stock of capital is not, however, financial. We have stocks of human capital and intangible business capital that are among the highest in the world. In reducing our budget deficit, we must not allow those stocks to depreciate. As Richard Curran said here yesterday, we must focus on “creating sustainable value.” That is our best hope of a return to sustainable growth.