Sunday 24 September 2017

John McHale: Steady as she goes on planned cuts

Were it not for adjustments, our primary deficit would be 20 per cent instead of a projected 2.5 per cent

BACK IN THE MARKETS: NTMA chief executive John Corrigan
BACK IN THE MARKETS: NTMA chief executive John Corrigan

John McHale

THE shift to an October budget under the new European "two-pack" has led to an earlier than usual kick-off in the annual pre-budget debate.

Interest is given an added twist this year by the lowering of the forecast for the General Government deficit by roughly €1bn as a result of the promissory note agreement. This has led to calls to reduce the planned adjustments of €3.1bn for 2014. But with the Irish economy still subject to a range of domestic and international risks, the most prudent course is to hold steady with planned adjustments.

It is often claimed that Ireland's budgetary adjustment has been self-defeating. The argument is that it has failed on its own terms – "dumb austerity" – in the sense of leading to a worsening of the budgetary situation due to adverse impacts on growth.

The facts do not bear this out. The underlying primary deficit – the deficit excluding one-off bank recapitalisation costs and interest expenditure – has fallen from a peak of 9.3 per cent of GDP in 2009 to a projected 2.5 per cent this year. Moreover, simulations conducted by the fiscal council show that, all else equal, the underlying actual deficit would have risen to more than 20 per cent of GDP without the budgetary adjustment.

A central goal of the adjustment has been to restore the State's creditworthiness. After peaking at close to 14 per cent in mid-2011, Ireland's 10-year bond yield has fallen to below 4 per cent, and is now lower than the rates paid by Italy and Spain. From a situation where a damaging default looked likely, the NTMA has been able to return to full market access this year.

While the broad adjustment effort was necessary and effective, reasonable people can disagree on its optimal speed. Cutting spending and raising taxes does slow the economy. The available evidence indicates that €750m of additional measures knock about 0.25 per cent off the growth rate. Taking into account this growth effect, such measures reduce the deficit by an estimated €500m.

If Ireland did not face a borrowing constraint, standard macroeconomic economic analysis would recommend measures to further support demand in a deep recession. Unfortunately, Government must tread a narrow path between supporting spending and securing its ability to borrow. This ability to borrow is in the end critical to being able to phase the adjustment over time. We should not forget that we still borrow close to €1bn per month just to fund the shortfall between spending and taxes.

Does it make sense to slow the planned pace of adjustment for 2014 given this trade off? A number of arguments suggest it is too early to ease back.

First, there remains huge uncertainty around economic growth and the broader stability of the European financial environment. A conservative estimate based on past growth volatility is that there is a one-in-three chance that the key 3 per cent of GDP deficit target for 2015 would be missed even under current plans. The weak performance of the economy in the first quarter is a reminder of how uncertain our near-term prospects remain.

Second, while it could be argued that lost ground due to growth disappointments could be made up later, such a U-turn back to increased austerity could be a severe knock to confidence given the need to see a clear end line in the adjustment effort.

And third, even a relatively small deviation from the agreed path risks reversing investor confidence in the political capacity to see the adjustment through, especially as Ireland prepares to exit its formal bailout programme and we come closer to an election.

The Government is wisely not committing to any easing until it sees the most up-to-date economic data in September. The possibility of reducing the planned adjustment by €750m has been mooted. Intense lobbying is taking place on where the benefit of any such reduced deficit-cutting should fall.

Increased capital spending has the advantage that it can more credibly be viewed as temporary. It is therefore less likely to damage Ireland's hard-won reputation for fiscal control.

It is understandable that people want to see tangible benefits from the promissory note agreement. The best available evidence shows that the agreement is likely to achieve a significant, if as yet uncertain, reduction in the burden of Ireland's debt.

The promissory note agreement has helped underpin Ireland's return to creditworthiness and reduced the chances of needing a further full programme with harsh conditions. It should allow some easing of the fiscal stance in the future. However, all things considered, the best course for now is to hold steady to current adjustment plans for Budget 2014.

John McHale is Established Professor of Economics at NUIG and chairs the Irish Fiscal Advisory Council. He is writing here in a personal capacity

Irish Independent

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