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Public debt warning lights are still flashing amber


ECONOMIC policy can sometimes seem like sub-atomic physics: as soon as one observes something, the something changes. Not to mention the uncertainty principle.

Think of inflation - as soon as it was targeted, it disappeared. Or money supply: as soon as it was targeted, it seemed not to matter; and once they ignored it again it turned out to matter very much.

Those remain somewhat mysterious events. There is less mystery about government debt. With the collapse of interest rates, its characteristics really have changed from those which would have been observed even a few years ago. But that still leaves the problem that policies based on those observations may no longer be valid.

That was one aspect of last week's criticism of the EU debt and deficit rules from the International Monetary Fund (IMF). "Changes in underlying economic fundamentals have led to inconsistencies in the current configuration of numeric targets," it said in its inimitable style.

It is not all about the dramatically altered post-crash landscape. The new rules are so complex that only experts can understand them (among whom, I am told, some senior Cabinet members are not numbered).

Such complexity makes political legitimacy for the actions required by the rules almost impossible to obtain. This in turn exacerbates the difficulty of getting governments to obey them - something already much in evidence, as the Irish Fiscal Advisory Council pointed out.

Even worse, the old rules - of which the new rules are a development - were economically illiterate to begin with. Their twin pillars - a maximum deficit of 3pc of GDP and a debt target of 60pc of GDP - could only form the desired structure if an economy grew at 5pc a year in cash terms. Since the inflation target is for something below 2pc, output would have to grow by more than 3pc, which was quite outside the potential of most Eurozone members.

It is now completely outside their potential, because of the damage done by the crash. For much of the euro area, nominal (cash) growth is now put at no more than 3pc a year, which implies that either the debt or the deficit target makes no sense. In another paper, analysts from the IMF - but not necessarily representing its views - suggest the debt limit is the more dubious.

The discussion note, "When Should Public Debt Be Reduced?" is aimed at countries with sound public finances - the creditor nations in a Eurozone context. The note helpfully indicates who they might be, while stressing that a safe level of debt ("ample fiscal space") is very difficult to define and there is no mathematical formula which will determine it.

Needless to say, Ireland is not included, however defined. Admittedly, it is not in the red danger zone - as the analysts see it - but shares the amber zone with Belgium, France and Spain. Interestingly, given the recent election, Britain only just makes it into the green zone, implying that it can be reasonably relaxed about its public debt - but not too relaxed.

That is the message. Countries with comfortable debt levels should not specifically reduce debt further, although they should make use of exceptional revenues when these occur. The reason is that the damage done by higher taxes and cuts in investment is greater than the admittedly genuine gains of reducing the interest cost and protecting against future financial crises.

It will be no surprise if the word "Germany" comes to mind here, where the "black zero" policy of no budget deficits is intended eventually to eliminate public debt. It will also be no surprise if the German establishment ignores the advice.

But it will also be no surprise if countries classified as being in the red or amber danger zones seize on the theory to justify taking a relaxed attitude to their heavy debt burden, even though it is not intended for them.

The analysis is quite explicit about the costs and dangers of high levels of government debt. More debt means slower growth. It notes that advanced economies, where debt increased by around 50pc of GDP during the crash, are growing at barely half their pre-crash levels.

There is also the obvious danger that, in the event of a serious recession, countries in the danger zones will suffer another financial crash if markets take fright at their rising debt.

The Irish Government's budgetary stance, which was the subject of so much comment last week, can only be described as "relaxed." This despite the figures from the Bloomberg financial services that, apart from Greece and Japan, Ireland's debt position is the worst among advanced economies.

Japan headed the debtor table but Japan is a special case - not as bad as the figures suggest but perhaps not as safe as market have always assumed. Excluding Japan, Ireland has the seventh highest ratio of debt to GDP but, as economist John FitzGerald wrote last week in an ESRI paper, GDP is a "seriously defective" measure of Irish income.

Debt per person, where Ireland topped the list, is also defective but may be closer to the truth. If one takes the UK as a reasonable benchmark, Irish per capita debt of $60,000 is 50pc higher.

The IMF paper's assessment is different again, estimating how much further debt could rise before markets would no longer lend. Ireland's debt could double but the UK's could rise by 130pc of GDP. That is regarded as the minimum for safety.

Whatever the precise safe level may be, it is clear that Ireland's debt will have to fall substantially from the current 110pc of GDP - probably to below 90pc.

So before we get too excited about the IMF attack on EU rules, what it recommends is a system focused on debt levels, presumably with the kind of caveats in the discussion paper. Reducing debt implies that spending must rise more slowly than tax revenues for a few years to come, and then not exceed it for several more. Yet the only Irish policy in place is that revenues will be cut even as spending is increased - at least until 2016.

This is the meaning of the meaningless Spring Statement. The uncomfortable fact is that the next government will have to apply - if not exactly austerity policies, then certainly austere policies. This government wants to establish financial parameters within which to fight the election but most certainly does not want to explain what will have to be done beyond 2016.

The danger is that, such will be the unexpected shock when this reality dawns, the next government, whatever its composition, will flunk the challenge. We have been there before.

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