Saturday 23 March 2019

Let's not give our economy another lash - it's time to slow things down

The Government should be in surplus already, and not facing a health overshoot, writes Colm McCarthy

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Colm McCarthy

Colm McCarthy

If the Government really believes that economic growth will continue at a reasonable pace into 2019 and 2020, it should be targeting a surplus in October's Budget. Indeed after five straight years of sustained recovery the Budget should be in surplus already. Instead there has been another large overshoot on health spending in the first seven months of 2018 and the undemanding target for 2019 (yet another deficit, this time €350m) is under pressure.

Opposition parties are happily proposing expenditure increases and tax cuts while independent deputies who support the Government, including ministers, are filling the August news vacuum with assorted wheezes. The proposal to pay people for voluntarily minding their own families, in the form of €1,000 a year for grandparents, has been described by its progenitor, with refreshing candour, as 'novel'.

Small economies are exposed to swings in international trade and to external political shocks. This makes it vital for them to preserve some policy ammunition for when things go wrong, things like a slowdown in their main trading partners, or Trump, or Brexit. Countries with their own currency have a range of short-term options: they can hold down interest rates and let the exchange rate take the strain, and they can run bigger government deficits for a while. Trying to do these things indefinitely is not a good idea - ask Argentina or Venezuela - but used sparingly they can smooth out the rough patches.

Countries which do not have their own currencies (Ireland abolished its currency in 1999) cannot soften the exchange rate or hold down interest rates - these are determined by whoever manages the common currency, in our case the European Central Bank in Frankfurt. The national central banks are not free to create liquidity in Euros, effectively a foreign currency, any more than they can print dollars. So they cannot lend in emergencies to the Government or (without permission) to the domestic banks. The ECB bullied several Eurozone countries on this matter, Ireland included, during the post-crisis troika period. Jean-Claude Trichet will be remembered in Ireland.

There is also the likelihood that the exchange rate and the level of interest rates will not always suit every member in a common currency area - their economic fortunes will often diverge. But each government can borrow and run budget deficits in the bad times, provided it is solvent (has low debts) and is credible to international lenders.

In the Eurozone there have been rules about debt and borrowing limits from its inception but they have invariably been ignored when reality intrudes (including in Germany). The real constraint on budget policy is not EU rules but access to willing lenders in the sovereign debt market. Where the currency has been abolished the only instrument available to smooth the economy through the bad times is the budget. The textbook strategy would be to run the budget into surplus in good times, keeping the overall debt low and the state solvent, so that financial markets will be happy to finance big deficits for a year or two when the need arises.

In Ireland the downturn from 2008 onwards was so severe that, in combination with the collapse of the banks and their costly bail-out by the Exchequer, the State ran up enormous debts and could no longer borrow. The Government withdrew from the debt market in the summer of 2008 because nobody would lend money to the State at affordable interest rates.

The result was to resort to emergency loans from the IMF among others, the first time the State was unable to finance itself since its foundation. This really was a loss of sovereignty. While the economy has staged a vigorous recovery, the State is still over-borrowed and the net debt has stayed stubbornly high. Relative to the annual revenue of government, Ireland's net debt position is one of the weakest in the Eurozone. Better than Greece, if that consoles you, but only a little better than Italy, which should scare you.

Last Thursday's Exchequer returns for the seven months to July suggest that the 2018 Budget is veering off course. Corporation tax revenues, known to be volatile, have been flattering the figures and expenditure control is looking spotty. The National Competitiveness Council released a report last Wednesday noting that a large slice of this tax bonanza comes from alarmingly few multinational companies. Last year's budget loaded some of the tax burden back on to transactions in commercial property, another volatile revenue component.

At the MacGill Summer School in Donegal a week earlier, the Central Bank governor Philip Lane gave a thorough speech on the role of macroeconomic policy and made the case for caution in October's Budget. Central Bank governors in Eurozone member countries have effectively been relieved of their direct responsibilities in monetary policy - the exchange rate and the general level of interest rates are beyond their control, and the supervision of major banks has been centralised in Frankfurt. They can offer advice though, and Philip Lane's advice during the bubble years, when he was an economics professor in TCD, was to pursue a more 'counter-cyclical' budget policy than the one actually chosen.

There would have been a downturn anyway, but it is a pity that Lane was ignored. Crudely, run surpluses when things are going well, thus enhancing the ability to loosen policy when the tide goes out. He listed four reasons in Donegal why the current expansion may not last much longer:

n The risk of an unexpectedly sharp tightening in international financial conditions, as might be triggered by an increase in risk aversion among investors;

* A downgrading of future global growth prospects, with an international trade war one possible catalyst;

* A shift in global tax practices that adversely affects small countries that host global multinational firms; and

* Hard Brexit scenarios.

The Bank of England raised interest rates last Thursday, following several earlier increases by the US central bank, the Federal Reserve. The European Central Bank has kept rates rock-bottom for now but has signalled an end to its purchases of government bonds.

The next move in Eurozone interest rates, whenever it comes, will be upwards and government interest costs will eventually rise.

Decoded, Lane's phrase "an increase in risk aversion among investors" means that heavily-indebted countries should not assume that easy access to bond markets will last forever. Maybe the risk is low, who knows, but what happened in the summer of 2008 could happen again.

Let's cut to the chase. If Paschal Donohoe and his colleagues decide to shoot for a balanced budget, or better again a surplus, in 2019, how might this be accomplished?

There appears to be a limited capacity, in a pre-election atmosphere, to control spending.

Then let's raise taxes. Why, for example, is there a concession rate of VAT on hotels and restaurants when they are booming again? Why is the tax on diesel lower than the tax on petrol? If the economy is running close to capacity, slow it down - why give it another lash?

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