Friday 30 September 2016

In 'fiscal space' no one can hear you scream

This campaign has been ruled by unfamiliar jargon which is unfair and confusing to the electorate, writes Colm McCarthy

Published 07/02/2016 | 02:30

DUBLIN’S FINANCIAL CENTRE: Even if things go well in Ireland, there is no guarantee that the next year or two will not see a re-run of the 2012 sovereign debt crisis. Photo: Shahid A Khan
DUBLIN’S FINANCIAL CENTRE: Even if things go well in Ireland, there is no guarantee that the next year or two will not see a re-run of the 2012 sovereign debt crisis. Photo: Shahid A Khan

The early days of the election campaign have been dominated by controversy about something called 'fiscal space' which must have had voters scratching their heads. What is this apparently precious commodity, and how large is Ireland's newly-discovered endowment? The phrase is borrowed from the vocabulary of debt sustainability analysis and rarely escapes the statistical appendices of IMF reports. It is a little unfair to inflict this unfamiliar piece of jargon on a blameless electorate.

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In plain English the key question is the following: can the proceeds of future economic growth safely be distributed in advance in the form of promised tax cuts or expenditure increases? The answer is that it all depends. If the future growth is guaranteed and if the country faces no great penalties for getting it wrong, the concept of 'fiscal space' has some real meaning: the incoming government could prudently contemplate tax giveaways and extra spending. But if the future economic growth is uncertain and if the government already has high debts and no capacity to borrow its way out of a miscalculation, it is not a good idea to drone on about 'fiscal space'. It is not an undrawn deposit in a bank somewhere.

Future economic growth in Ireland is highly uncertain for various reasons and the government has heavy debts, not all shown on the balance sheet. It is only a few short years since it was unable to borrow at all and had to rely on non-market lending from European institutions and the IMF. Accordingly, it is not a good idea to distribute the proceeds of assumed future growth in advance. If the growth does not materialise there may be no room for manoeuvre and no option but to reverse engines. Countries which have retained their own currencies, such as the United Kingdom, can have more latitude: their central banks are free to create liquidity to finance the government (within limits). Countries with low debts will also be able to borrow even if they get things wrong for a few years. In contrast, a country with heavy debts and lacking its own currency needs to be extra careful if it wants to retain the ability to finance itself in the markets.

The rate of economic growth in Ireland down the years has been volatile, more so than in other small and open economies. It has also been difficult to forecast, even a year in advance. The ESRI and the other agencies which make forecasts have acknowledged this problem and they have not been able to narrow the forecast errors, even with the aid of complex computer models of the economy. The first of these models was constructed in the Central Bank almost 40 years ago and has been fine-tuned continuously by the ESRI ever since. But the forecast errors persist and the volatility in actual outcomes and the likelihood of large forecast errors have to be accepted as a fact of life. When somebody predicts that the economy will expand at a pleasingly steady rate over an extended period it is best not to pay too much attention.

The Fiscal Advisory Council has recently adopted the practice of attaching wide margins of error to its forecasts. If it thinks the growth rate could be 3pc a few years hence, it makes it clear that it could be as little as 1pc, or as much as 5pc, or even outside these limits. The council's candour is commendable and fully consistent with past experience. The political expedition into fiscal space proceeds on the basis that the future is unrealistically visible. Pencil in a suspiciously steady growth rate of 3 to 4pc over the (maximum) lifetime of the next Dail and the budget numbers look attractive. Tax revenues improve and the pressures on social spending diminish. There appears to be room to distribute the fruits of economic growth prior to harvest. The problem is not that this outcome of steady and predictable economic growth is impossible. The problem is that it is highly unlikely, on past experience.

The economy could beat these expectations but it could also come up short. The consequences are not symmetric in Ireland's circumstances. If things go better than expected this is a nice problem to have. But underperformance, with the unharvested fruits distributed in advance, is extremely risky for a country which needs to borrow continuously from easy-to-spook markets.

Even if the budget deficit is eliminated the government will still need to re-finance maturing debt and the figures are enormous. For the next three years the government's gross borrowing needs will be €12bn to €15bn per annum, according to the IMF, but will then rise to over €20bn in 2019 and 2020. Most of this relates to rolling over maturing borrowings. The government will still need access to the markets when the deficit finally reaches zero, and in very large amounts.

Even if the available fiscal space could be determined in advance, and it cannot, it would be dangerous to commit all of it upfront. Economic sovereignty is circumscribed in a globalised world but it is further constrained, particularly for a country without its own currency, by the debt overhang.

Public debt in Ireland remains at levels which could compromise access to the markets should there be another round of the jitters in the eurozone.

Even if things go well in Ireland, there is no guarantee that the next year or two will not see a re-run of the 2012 sovereign debt crisis.

In Italy, the debt ratio is 130pc, youth unemployment almost 40pc and there is no sign of a serious recovery. Italy's banks are fragile, loaded with non-performing loans for which adequate provision has yet to be made.

There are problems too in Spain, where a government has yet to be formed seven weeks on from an inconclusive election and the crisis in Greece is unresolved. The odds are shortening on a UK exit from the European Union and the international financial markets are nervous about a world trade slowdown.

The Irish Government has recently been able to borrow at low interest rates in a remarkably benign sovereign debt market. All the talk about fiscal space assumes that the Irish economy will continue to grow smoothly but also that the cost of issuing new debt will stay at historic lows for many years to come. This happy outlook could unravel very quickly.

In the circumstances it is hardly prudent to defer the day when the budget moves into surplus and the task of reducing the debt overhang is commenced. Both the Fiscal Council and the Central Bank have been urging that no attention be paid to optimistic estimates of fiscal space and that early giveaways on taxes or public spending should be avoided. The last time Ireland found itself with an excessive public debt burden in the late 1980s, it took over a decade of careful budget policy, and decent economic growth, to get the debt overhang under control.

There was an independent currency through those years too, and hence some extra room to manoeuvre. The recent recovery is not a bonanza: it is a lucky break and the chance to re-build national solvency.

Sunday Independent

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