Thursday 22 March 2018

No need to grease economic wheels when we're already going full tilt

The economy is growing but faces many risks. Should we really borrow for a Budget Day binge, asks Colm McCarthy

The latest figures from the Central Bank
The latest figures from the Central Bank
Colm McCarthy

Colm McCarthy

Tuesday's budget will see roughly €1.5 billion distributed between tax reductions and spending increases. All of this money is being borrowed: the economic recovery has improved the public finances but the budget remains in deficit. Had the government opted to make no changes for 2016 the deficit would have continued its decline and might have been close to zero next year. The attainment of a zero deficit and an end to the accumulation of debt is being deferred.

The decision to concede on taxes and spending is moreover a decision to borrow more at a time when the economy is expanding at an impressive rate. That is to say the expansionary fiscal stance is pro-cyclical, pumping a tyre already adequately inflated. The latest figures from the Central Bank give the current picture.

The bank reckons that output in the economy will expand by almost 6pc in the current year, after an expansion of over 5pc in 2014. It expects growth next year to approach 5pc again. That is to say it believes that the Irish economy is in the middle of a very impressive growth spurt: employment is rising at around 2pc per annum or 40,000 net new jobs annually, while the unemployment rate is falling fast. There is no obvious need, aside from the temptations of the electoral cycle, to indulge in a fiscal expansion on Tuesday.

There are lots of reasons to be cautious about the economic outlook into the medium term. Next year may indeed be another year of expansion and falling unemployment. But the recent stellar performance of the Irish economy is partly down to good luck in the form of favourable external developments which could reverse. The overall outlook for the world economy is not encouraging and growth in world trade recently has been disappointing.

There have been three coincident changes in fortune for Ireland in 2014 and 2015. Energy import costs have halved, the euro exchange rate has fallen sharply against both the dollar and sterling, and government borrowing costs have declined to an all-time low.

Ireland is a major importer of energy. Without significant domestic resources, when world prices rise there is no practical alternative but to pay up. Rising energy costs act as a deflationary dampener on economic activity here and it works the other way round too. The collapse in oil import prices has dragged down coal and gas prices as well, both of which we import in significant quantities. This dramatic fall in energy import costs has given the Irish economy a big boost over the last year and a half.

Over the same period the euro exchange rate has finally begun to soften against both sterling and the US dollar. This matters more to Ireland than it does to the continental eurozone countries, since Ireland does rather more of its external trade in non-euro currencies. Early last year the dollar rate was at times 20pc above today's level, the sterling rate 15pc higher. The currency we use, the euro, has been cut sharply in value against currencies that matter a lot to the competitiveness of Irish business firms. This is an additional boost to economic activity, on top of the cheaper energy.

Finally the government has enjoyed a sharp cut in the cost of servicing its very large, and still rising, burden of debt. Part of this is due to better terms from official European lenders and the early repayment of IMF loans with cheaper market debt. Some historic government debt matures every year and it helps if it can be rolled over into cheaper new borrowings.

All three of these favourable developments have come together. This is highly unusual. It is rare when key external factors, over which Ireland has no control, turn sharply positive all at once. It is also most unlikely that there will be any further boost from any of the three. Oil prices could stay down at current levels for a while but the cost of a barrel of crude cannot fall by a further €60, since the price is already down to about €48. Official interest rates in Europe cannot fall either, since they are already close to zero. It is a fair bet that the next major moves in oil and in world interest rates will be upwards whenever they happen. The exchange rate of the euro does not have a target but floats freely. There is no knowing what the next move might be but it would be foolish to presume that it will be as favourable as the recent steady decline.

The economies of the United Kingdom and the USA have been doing rather better than the continental eurozone countries, which helps Ireland too, since the Anglo-Saxon countries are major trading partners. Overall Ireland has had a run of very good luck these last couple of years and the strength of the recovery should be seen against this background. The government, in other words, should not be assuming that growth at 5pc or so can be relied upon out into the medium term. The Irish economy has always been rather volatile with sizeable year-to-year swings in activity. At some stage the external factors will turn negative and domestic policy has limited capacity to respond given the high public debt burden.

There has recently been growing international concern about a worldwide economic slowdown, reflected for example in the recent downward revision of IMF forecasts for the world economy and in the correction in world equity markets. This is not just about China: the emerging market economies are all facing headwinds, including exposure to rising US interest rates whenever the Federal Reserve decides to start moving back to a more normal monetary policy stance. US official interest rates have been close to zero for almost six years now and this will not last if the economy continues to recover. The external environment for Ireland, at the end of 2015, may be about as good as it is going to get.

This, rather than the constraints on government budgets imposed from Europe, is the real argument for finishing the job and getting the deficit back to zero as quickly as possible. It appears that some elements in the Government wanted to have an even bigger pro- cyclical injection in Tuesday's budget than the €1.5 billion that has been flagged but were dissuaded on the grounds that there might be trouble from Brussels.

Aside from the (still rising) level of government debt, the rest of the economy, including households and small businesses, remains heavily indebted. The task of restoring financial balance requires not just that government should exercise restraint but also that there should be no premature boom in private consumption or in private sector investment. Balance sheets need to be rebuilt, a process which is under way but by no means complete.

The strength of the recovery has surprised economists: it is due in large part to a long overdue series of very lucky breaks. If they reverse at some stage, the premature loosening of policy will be regretted.

Sunday Independent

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