Sunday 22 September 2019

We should heed masters of the dismal science who urge benefits of prudence

The likelihood of a downturn from a starting point of excessive debt should still be stressed, writes Colm McCarthy

STEADY GOES: Philip Lane (above) and Seamus Coffey of the Fiscal Advisory Council are voices for economic caution. Both in their different ways advocate the need for prudence. Photo:
STEADY GOES: Philip Lane (above) and Seamus Coffey of the Fiscal Advisory Council are voices for economic caution. Both in their different ways advocate the need for prudence. Photo:
Colm McCarthy

Colm McCarthy

Small countries exposed to the vagaries of external events have only a handful of effective instruments to moderate economic fluctuations. These used to include commercial policy (the setting of tariffs and quotas for foreign trade) and independent discretion over the conduct of monetary and exchange rate policy. These policy instruments are no longer available in Ireland, given membership of the EU's internal market and the common currency area.

Where volatility is inevitable there is a bounty to be harvested from policy prudence, the latitude to avoid untimely austerity in a downturn. Prudence means making sure that the public credit is maintained and that the banks are solvent. If commercial policy has been abandoned and the independent currency abolished, there can be no reliance on the adjustment of tariffs or the exchange rate when trouble strikes. The only policy instrument left is caution.

Small countries in the European Union cannot manipulate the terms of international commerce and if they are also in the Eurozone they cannot adjust exchange or interest rates, nor are they free to create liquidity to fund government or rescue banks. Ignoring the prudent path is costly when prudence is the only available instrument.

The domestic causative factors in Ireland's descent into economic collapse from 2008 onwards were the mismanagement of the public finances over the full preceding decade and the parallel failures in the banking system. The post-2008 crash was more damaging than its slow-motion predecessor in the 1980s because the second ingredient, banking insolvency, was absent then - only the public finances got into trouble.

The banking system in the 1980s functioned with customary caution and the country was possessed of an independent currency. A combination of exchange rate depreciation, expenditure restraint and tax increases, plus a favourable external environment, allowed a relatively painless recovery without resort to international bail-out from the IMF. And lessons were learnt, for a while anyway: through the 1990s budget policy was pursued with caution and the burden of public debt was managed downwards.

The 2008 collapse was different. The currency had been abolished with the choice of Euro membership in 1999, celebrated perversely with the abandonment of control over public spending. What had become an adventurous banking system, and its inattentive supervision, enabled an unprecedented credit bubble. The resultant buoyancy in tax revenues concealed the fragility in public financial management, producing apparently balanced budgets poised to plunge rapidly into deficit when fortune frowned.

The extent of the fragility was exposed brutally as every single significant bank went under and the combination was enough to see the State forced into reliance on official lenders, the IMF and the European institutions, for the first time in its history. Had public financial mismanagement not been accompanied by collapsing banks, as in the 1980s, or banking failures managed within the capacity of the Exchequer, as in several other countries, there would have been a far less damaging outcome.

Euro membership facilitated banking exuberance and constrained the policy response, but countries outside the Eurozone hit trouble, too. There would have been a crash anyway but membership in the misbegotten currency union ensured the worst downturn since the early years of World War II.

This should have been a transformative event in Irish political culture and may yet prove to be. There has already been a return towards budget balance and a comprehensive, if painful and uncompleted, reconstruction of the banking system as well as a serious reform of bank supervision. But most Irish politicians appear to enjoy the same relationship to prudence as do vampires to a clove of garlic.

There are few voices in the political arena or in the print or broadcast media decrying the perils of an adventurous budget or banking policy, never mind their demonstrably toxic pairing. In the years since the bust, and more especially since exit from the IMF/EU official lending programme at the end of 2013, there have been persistent demands for looser budgets and easier credit.

The case for caution in policy has three simple components:

(i) The economy has done well since 2013, better than many expected, the present writer included. There is persuasive evidence that under-employed resources are no longer plentiful and thus a danger of over-heating and no case for fiscal stimulus.

(ii) The State debt has not gone away, you know. It has been easier (and cheaper) to re-finance because of European Central Bank policy, a policy whose indefinite survival is highly unlikely. Selling Irish government debt could get harder, perhaps much harder.

(iii) The surviving banks are a work-in-progress and their balance sheets only partially repaired.

The budget gap has been closing since 2013 largely under its own steam. The reduction in the cost of debt service has been a lucky bonus, accompanied by improving tax revenues as growth returned. If austerity means expenditure cuts and tax increases, there has been little austerity since the recovery began in 2012. The last three budgets have cut taxes and raised spending while the outstanding State debt has grown each year since 2007.

Meanwhile every lobby group seeking higher spending or tax relief finds enthusiastic megaphones in Dail Eireann, as do mortgage defaulters who have failed to engage with lenders for five years and more. On RTE the presenters of some current affairs programmes persistently confuse debt service with debt repayment.

There are two institutional voices for prudent policy, the Fiscal Advisory Council and the Central Bank of Ireland. The fiscal council is headed by the economist Seamus Coffey, of University College Cork, and the Central Bank by another practitioner of the dismal science, Philip Lane, formerly of Trinity College Dublin. Both testified at Oireachtas committees over the past couple of weeks and both, in their different ways, made the case for prudence.

Coffey drew attention to the uncertainty surrounding revenue from corporation tax, while Lane noted that house prices can go down as well as up. Both argued that the time has come for a deliberate and conscious resort to a policy of modest budget surplus. This is what worked in the past and, coupled with a continuation of economic growth, will eventually bring the risks attendant on the excessive Exchequer debt level back under control.

The risks include the possibility that the banks could get into trouble again, although the Central Bank has, since 2015, been containing mortgage credit with greater diligence. Mortgage credit expansion has been rising but remains well below the extraordinary figures seen in the pre-crash period. But another burst of house price growth, especially in Dublin where prices are again losing touch with reality, will test the effectiveness of the new lending limits.

The next shock to the economy could be poor corporation tax revenues (Coffey), it could be banks struggling with weaker mortgage assets (Lane) or it could be something else entirely: a new Eurozone crisis coming from Italy, a crash-out Brexit or a Trump-induced world trade war.

Neither Seamus Coffey nor Philip Lane need pinpoint the source nor the timing. They need merely stress the likelihood of a downturn from a starting point of excessive debt.

With no other policy instruments available, both are commending caution as the only coherent policy on offer.

Sunday Independent

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