The Complexity of the Fiscal Options

SBP June 19th by Jim Power
Earlier this week the Irish Fiscal Advisory Council (IFAC) published its latest Fiscal Assessment Report. This body was set up as an independent assessor of Irish fiscal management on the back of Ireland’s bailout conditions. The theory is that having an independent overseer of how Government conducts policy in relation to taxation and public expenditure might or should ensure sensible and prudent management of the public finances. In the period between 2000 and 2007 these are two adjectives that could certainly not be used to describe how we managed our public finances. Presumably if such a body had existed during the first seven years of the century we would not have been treated to the debacle of the benchmarking of public sector pay; the total failure to control current expenditure; the removal of thousands of workers from the income tax net; and a fiscal policy that was generally very pro-cyclical. That is the theory at least, but in practice since IFAC was set up, the Government appears to acknowledge what the body is saying and then turns around and basically ignores most of its advice. If it had been set up in 2000, McCreevy and his successor in the Department of Finance would most probably have made a virtue out of ignoring the advice dished out by the body.

As always, the latest report contains a lot of very interesting material, but the headline grabber is the advice to Government to press ahead with the delivery of the planned €2 billion adjustment in Budget 2015, due to be delivered on October 14th. It puts forward three reasons as to why it would be sensible to pursue such a course of action. Firstly, to reduce risks to debt sustainability by putting the debt-to-GDP ratio on a firm downward path; secondly, to provide a reasonable probability that the requirement of a deficit of below 3 per cent of GDP is achieved in 2015; and thirdly, to protect the hard-won credibility of Ireland’s capacity to follow through on adjustment commitments.

To date we have shown an amazing capacity to follow through on adjustment commitments, but ‘austerity fatigue’ is very definitely setting in, as demonstrated very vividly in the recent local and European elections. It is one thing for the Council to issue this advice, but it is a very different and difficult matter to point out where exactly the €2 billion should come from. That is not the job of IFAC, but it would be interesting and instructive to see exactly how the body would envisage a further adjustment of €2 billion being delivered.

The Department of Finance is predicting a deficit just under 3 per cent of GDP by the end of 2015. That projection is heavily predicated on GDP growth of 2.1 per cent in 2014 and 2.7 per cent in 2015. If growth turned out weaker, the GDP part of the budget ratio would be lower and the borrowing percentage higher – this is a case of simple maths. However, tax revenues and expenditure are heavily driven by growth, so if growth turned out to be weaker, obviously tax revenues would be lower and pressure on social expenditure greater. Much does depend on economic growth.

However, economic growth cannot be viewed in isolation. It is actually the product of many factors, not all of which are fully understood by anybody, not to mention economists. Of particular concern at the moment is the impact that the proposed adjustment might have on growth. Given how fragile the economic recovery story is at the moment, and particularly the consumer side of the economy, there is a distinct, but largely unquantifiable risk that such an adjustment coming on top of what we have already endured since 2008, could have a very negative impact on economic activity and end up making the deficit worse rather than better.

There is in my view a simplistic argument to the effect that the Minister for Finance should opt for an adjustment of at least €2 billion in case growth turns out weaker than anticipated and the deficit higher than anticipated as a consequence. Surely there is a danger that if growth turns out weaker than expected, a budget adjustment of €2 billion would just make growth even worse and the deficit higher. An adjustment of €2 billion would not result in a commensurate reduction of €2 billion in the deficit. Fiscal multipliers are important, but such multipliers are not easily calculated, particularly in an economy that has endured such a dramatic shock in recent years and which is only now showing very tentative signs of recovery.

The economic impact of a further €2 billion adjustment would of course be heavily determined by the nature and quality of the adjustment. It is just not clear to me at the moment how such an adjustment would be constituted so as to do the minimum damage to the economy. I would like to see IFAC’s remit be widened to include detailed policy recommendations. Only then would we really be in a position to judge the soundness of its advice.