Ireland in Recession: Designing a Fiscal Response

Last week, the Economic and Social Research Institute (the most respected economics institute in Ireland) forecast that GDP growth in Ireland will be negative in 2008 at -0.4 percent. This represents a sharp decline from 5.3 percent growth in 2007 and a long sequence of high growth rates since the mid 1990s.  Moreover, the movement in the terms of trade (especially important for a highly open economy) is also negative, such that the recession in real income will be -2.6 percent in 2008. Some recovery is projected in 2009 – with growth projected to be around 2 percent – with a possible return to trend growth of about 3.5 percent in 2010.

The primary factor behind this slowdown is the dramatic contraction in the housing sector, which means that aggregate investment is set to fall by 15 percent in 2008 and a further 4.5 percent in 2009.  Even though the export sector continues to grow (with the export of services especially strong), the rate of growth is below expectations and is hampered by the decline in cost competitiveness (both due to the accumulation of rapid wage growth at home and the strength of the euro against the dollar and Sterling, the currencies of Ireland’s two most important trading partners).

The sharp slowdown of 6 percentage points of GDP in a single year has fed through to the fiscal position. The general government balance has declined from 3 percent in 2006 to 0.3 percent in 2007 and is projected to hit -2.8 percent in 2008 and, if no evasive action is taken, -3.9 percent in 2009.  The decline in tax revenues has been especially pronounced since Ireland had increasingly relied on asset-based taxes in recent years (in particular, stamp duties on housing transactions) that were plentiful during years of rising asset values – these revenue sources have dried up, with the decline in activity in the housing market and the drop in house prices.  (The decline in the permanent tsb/ESRI national house price index since its peak in January 2007 has been 11.5 percent in nominal terms and 17.7 percent in inflation-adjusted terms.)

Accordingly, a near term issue for the Irish government is how to design a fiscal policy response to the economic slowdown, while operating within the confines of the Growth and  Stability Pact.  In particular, corrective action will be required if the 3 percent budget deficit limit is not to be breached in 2009.

This represents a challenge to the new political leadership –  Brian Cowen was installed as the new taoiseach and Brian Lenihan as the new Minister of Finance in May 2008, even if Mr Cowen was Finance Minister for the previous four years. Moreover, with the exception of some controversial criticism from the European Commission of the pace of fiscal expansion in 2001, it is a novel experience for Ireland to be testing the limits of the Stability and Growth Pact (SGP).

However, the current Irish situation represents a clear case that justifies a temporary breach of the 3 percent limit.   First, a sudden six percent slowdown in economic activity is clearly a large macroeconomic shock of the scale recognised by the terms of the SGP as an acceptable reason to break the 3 percent deficit ceiling.

Second, Ireland has a high rate of public investment (4.2 percent of GDP in 2007), such that the general government deficit can be interpreted as primarily directed at investment spending, rather than consumption. A high level of public investment is required to redress obvious deficiencies in the public capital stock, which has suffered from chronic under-investment during the long phase of fiscal austerity in the 1980s and 1990s. Again, the SGP explicitly recognises a high rate of public investment as an exculpatory factor in assessing breaches of the deficit limit.

Third, after twenty years of sustained improvement in its fiscal position, Ireland’s general government debt stood at only 25.4 percent of GDP at the end of 2007. Moreover, if the assets of the National Pension Reserve Fund are subtracted (each year, 1 percent of GNP is allocated to this fund to pre-finance ageing-related spending from 2025 onwards and this commitment is enshrined in legislation), the net financial debt of the government amounted to only 14 percent of GDP at the end of 2007.  For this reason,  a period of temporarily high budget deficits poses no threat to the sustainability of the Irish public debt position. Moreover, the legal commitment to the National Pension Reserve Fund signals the government’s recognition of the long-term need to prepare for the trend increase in ageing-related public spending, providing an important anchor for the sustainability of the public finances.

Fourth, the central macroeconomic forecast is that the current recession will be of limited duration: the house-building sector had clearly grown too large and once activity in that sector returns to a more sustainable level, the Irish economy can return to its trend growth path. In view of the transient nature of the slowdown, deficits in excess of 3 percent can be justified for a limited period.

Accordingly, it would be unwise for the Irish government to implement a pro-cyclical fiscal contraction just to remain within the 3 percent deficit limit. Since the option to devalue is not possible for a member of the euro area, fiscal policy is the main macroeconomic stabilisation instrument and just letting the automatic stabilisers work in Ireland’s current situation involves a breaching of the 3 percent limit.

The factors outlined above suggest that the economic case for a temporarily high deficit seems fairly straightforward.  However, there are political economy considerations that make the calculus more difficult.  Even a high deficit that is agreed by all to be acceptable under the terms of the SGP would still represent a departure from the budget surplus orthodoxy that has been dominant in Ireland since the 1987 fiscal adjustment that rescued Ireland from the very dark economic conditions that prevailed in the mid 1980s. This requires the government to lay out a multi-year fiscal framework that explains how the medium-term fiscal objectives will be restored once the current phase of economic slowdown and temporarily high deficits is over. To the extent that this involves a medium-term increase in taxes on labour and consumption  (to replace the windfall revenues from the housing boom), this will pose a new challenge for a government that has been long blessed with the capability to combine tax reductions with rapid spending growth.

Moreover,  since Ireland has enjoyed such a long phase of rapid growth in output and tax revenues that have been above the long-term trend for the economy,  even a neutral policy of setting current spending to grow in line with the trend growth path for nominal income of about 5 percent will seem like fiscal austerity to the many beneficiaries of the rapid growth in current spending since 1997, which in nominal terms has averaged 9.7 percent each year.  Again, the government must adjust its political strategy to manage a new era of diminished expectations.

However, it should also be recognised that the new economic environment poses an opportunity to improve the quality of public spending.  It is arguable that the boom in tax revenues over the last decade has slowed down the pace of structural reform in the delivery of public services, since it has been possible to respond to public dissatisfaction with health and education services by increasing the level of public expenditure. The constraints imposed by a tighter budgetary situation may prompt a more ambitious approach to public sector reform, which may a politically-popular complement to the unpleasant task of reducing the medium-term pace of spending growth.

On the capital side, similar issues apply in that not all public investment projects have been subject to rigorous cost-benefit analysis during the boom years. Again, the tighter fiscal position should induce a more selective approach to the appraisal of public investment projects. Since this will involve some pull back from the commitments outlined in the very ambitious National Development Plan 2007-2013, the government may have to suffer some political embarrassment. However, in the other direction, the cancellation or postponement of marginal projects will signal the government’s renewed determination to avoid waste in public spending.

Since the taoiseach is committed to public sector reform as a defining ambition for his leadership, the timing seems right to move on this front.  To this end, it is important to recognise that the SGP acknowledges spending that is related to structural reform as an another acceptable reason to breach the 3 percent deficit limit. Accordingly, since some elements of reform (for instance, a redundancy programme for the over-staffed administration of the health service) may involve short-term increases in spending in order to achieve long-term cost savings, the current budget deficit is no reason to delay reform initiatives.

Finally, there are certainly downside risks to the macroeconomic forecasts for Ireland. In some quarters, these risks provide a rationale to impose greater fiscal austerity, such that the option of fiscal stimulus may be deferred until a truly severe downturn is experienced. However, the stronger argument is that a pro-cyclical fiscal contraction may in itself contribute to the deepening of the recession. Moreover, unlike monetary policy, there is no ‘zero bound’ problem in fiscal policy  –  a fiscal stimulus today (to the extent of letting the automatic stabilisers work) does not rule out further fiscal stimulus in the future, especially for a country that has a very low public debt. The true value of the SGP lies in the institutional commitment to a sustainable path for the debt and deficits over the medium-term which provides the assurance that such fiscal stimuli will be withdrawn once the slowdown is over, thereby providing a framework that reconciles the deployment of stabilising counter-cyclical budgetary policy with the maintenance of a strong anchor for the fiscal position.

This article is also available in a different format at the VOX website.

An edited, shorter version has been published in the Irish Times.