Saturday 20 April 2019

Our economy needs more than luck, we need a Plan B

'If external trade is in currencies, such as sterling and the dollar, where the exchange rate can fluctuate substantially, this is an extra headache'
'If external trade is in currencies, such as sterling and the dollar, where the exchange rate can fluctuate substantially, this is an extra headache'
Colm McCarthy

Colm McCarthy

The life of the 31st Dail is coming to a close and it is time to consider the issues which should preoccupy its successor. First among them should be the identification of policies to ensure steady economic progress in the years ahead without courting any more boom/bust cycles.

The economic recovery has already created jobs, boosted tax revenues, helped close the budget gap and begun to encourage private investment. But it has restored some familiar habits in economic policymaking, including some of the bad habits which created the crisis in the first place. Some of these bad habits are already on public view as the general election approaches. It is also being taken for granted that the eurozone architecture has been fixed and that a renewed crisis in the common currency area either will not happen or will be easy to survive.

Any country which has accumulated large external public and private debts has limited room for manoeuvre in economic policy. This limit can come quickly into play where the country has abolished its own currency: Ireland is a eurozone member and uses what is essentially a foreign currency. Should external finance dry up for either government or banks, it will be made available on terms dictated by the European Central Bank which will impose conditions on the creation of liquidity. These conditions, as Ireland has learned to its cost, can be both arbitrary and punitive.

If there was an unconditional lender-of-last-resort to both banks and government, the costs of a renewed financial crunch would be ameliorated. The reforms to the eurozone since the crisis struck in 2008 have yet to create such a regime: until the eurozone is re-engineered as a full monetary union, member states will have to rely on their own capacity to borrow should things go wrong. Countries in a poorly designed common currency zone need to exercise caution in macroeconomic policy. The higher their external debts and the greater their exposure to economic volatility the more caution is warranted.

Ireland ticks both of these boxes. Overall external debt remains at very high levels, a danger masked by the plentiful liquidity currently available internationally. The economy is notably volatile: output may have expanded by almost 6pc during 2015, having contracted by that amount as recently as 2009. There are few economies exposed to such large swings.

There is no reason to expect that the Irish economy will suddenly become less exposed to external sources of instability in the years ahead. Any economy which is small and heavily exposed to external trading conditions will experience good and bad times for reasons outside its control. If external trade is in currencies, such as sterling and the dollar, where the exchange rate can fluctuate substantially, this is an extra headache.

Finally, heavy dependence on imported energy creates an exposure to uncontrollable oil, gas and coal prices. Ireland has been lucky under all three headings these last couple of years: recovery in key markets in the USA and Britain has helped and the weakness of the euro against their currencies has been important too. Oil prices have halved in euro terms. The combined effect of these three pieces of good fortune explains the strength of the recovery.

The Government's budget deficit has fallen more rapidly than planned despite a relaxation in policy. This is partly due to better tax revenues because of the recovery but is also due to once-off factors, including a sharp and unrepeatable reduction in debt service costs.

There is no guarantee that these favourable factors will persist. Oil prices, in dollars, are now down to levels which will eventually see a tightening of supply. Some producers are already cutting back and budgets for exploration and development have been slashed and production will eventually be affected. Prices could stay low for quite a while but it would be rash to expect $45 crude forever. The exchange rate of the euro likewise: Ireland has had to endure some periods of a strong euro and they could return. The economies of our trading partners, the most important being Britain, continental Europe and the USA, could experience setbacks too and worldwide interest rates cannot stay rock-bottom forever.

The external factors which influence the fortunes of Ireland have been lining up very favourably indeed since the end of 2013. History teaches that you will not be this lucky indefinitely. Moreover, the flaws in the eurozone architecture have been papered over rather than fixed.

Last week the Fiscal Council released its verdict on the recent budget and drew attention to a lack of caution, particularly in expenditure control. If it is unrealistic to expect very rapid economic growth year after year, it is necessary to accept that there is no scope for elaborate tax cuts, or for an expenditure bonanza. The Fiscal Council feels that spending is already off the leash and that there is no margin of error should things get more difficult.

There is already the beginnings of a Demolition Derby on the tax base. The Government is still borrowing money so the State debt continues to rise. If the State had no debt, or very little, continuing modest deficits would be of no great concern. But that is simply not the case and any small eurozone country with a high debt level is vulnerable in a downturn. There are politicians espousing, or at least hinting at, tax reductions which would cost numerous billions. For example, there have been suggestions that the Universal Social Charge could be scrapped altogether. This tax will raise €4bn in 2016, an enormous sum for which, of course, no replacements have been proposed. Other hints and suggestions include reductions in income tax, the abolition of water charges and of the residential property tax.

Meanwhile, every lobby group in the country has been re-energised by the infant recovery and there are demands for increases in public service numbers, restoration of pay, extra spending on social programmes, higher pupil-teacher ratios, more social housing and myriad others. The corporate welfare people are also back in business with proposals for pro-business tax breaks and brand new subsidies for things like solar energy.

There are three critical components in a prudent macroeconomic strategy. They concern the budget, the banks and the euro. The budget target should be a modest surplus into the medium term, providing a better margin of error as the Fiscal Council recommends. The current growth spurt provides a painless opportunity to let this happen without austerity budgets.

The banks have yet to deal decisively with the overhang of non-performing loans - they remain large relative to the size of the economy and need stronger capital. They are still vulnerable to the unreformed eurozone arrangements should there be another crisis. There are no guarantees about lender-of-last-resort support, as the Greek banks discovered at the end of June, and there is no domestic capacity to re- capitalise them again in another meltdown.

Instead of insisting on faster write-offs of bad loans, the State is permitting some of them to pay dividends and is planning to take capital out.

Finally, the long-term survival of the eurozone is not guaranteed and every member should be thinking seriously about Plan B.

Sunday Independent

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