There are too many downside risks to relax fiscal discipline now
If the opportunity to adjust is missed in electoral mid-term it is unlikely to be taken later
Minister for Finance Michael Noonan: Budget day has been shifted forward and we are already in the throes of debating the options for October. Photograph: David Sleator
The shifting of budget day to mid-October (in line with the new EU fiscal calendar) means that we are already in the critical phase of the policy debate about Budget 2014.
Under the Troika agreement, Ireland committed to making fiscal adjustments of €3.1 billion in 2014 and €2.0 billion in 2015, which were projected to deliver a budget deficit in 2015 just below the 3 per cent ceiling that is enshrined in the Stability and Growth Pact. However, the interest savings generated by the promissory note deal mean that these fiscal adjustments are now projected to result in a 2015 budget deficit of 2.2 per cent. In some quarters, this projected “overperformance” has given rise to the suggestion that the level of fiscal adjustment could be scaled back.
However, the end of the Troika funding this year means that Ireland will have to finance its very high public debt level and planned fiscal deficits from market sources in the coming years. While the NTMA has built up considerable cash balances that provide some breathing room, Ireland’s capacity to obtain market funding on reasonable terms depends on demonstrating its commitment to maintaining fiscal discipline and gradually reducing the debt-output ratio.
Since there are many downside risks to Ireland’s fiscal position, the relaxation of fiscal targets in Budget 2014 appears premature and runs the risk of eroding this government’s hard-won reputation for delivering on its promises.
It is useful to run through the list of these risks in relation to the fiscal position. It is true that despite the troubling nature of events in Cyprus the euro crisis has calmed down over the last year. Some of the reasons have been the announcement on “Outright Monetary Transaction”, the exercise whereby the ECB will on request buy a member state’s bonds in the secondary market in return for its adherence to bailout-type oversight and conditions; initial optimism about progress on the creation of a banking union, and despite the troubling nature of the events in Cyprus), various triggers could reignite the crisis.
In addition to the still-high uncertainty about growth prospects for the distressed economies and their ability to implement planned fiscal adjustments, the upcoming European-wide bank stress tests could provide a focal point for a new phase of market uncertainty about the fiscal implications of any required recapitalisations that could be indicated.
This is relevant for Ireland, even if any new capital requirements for the Irish banks turn out to be minor and even if any extra capital (for the Irish banks) could be successfully sourced from the ESM.
Rather, the results from the stress tests could generate considerable market turmoil, with banks in various countries seeking to raise new capital and the intensification of the debate about the bailing in of bondholders and large depositors. In such a risk-averse environment, spreads would increase and the funding environment for all peripheral economies would deteriorate. At the same time, uncertainty about the bank recapitalisation process would have an adverse impact on growth prospects for the wider European economy, which in turn would result in a marking down of growth forecasts for the Irish economy.
Second, even if risk premia remain contained, recent developments in global bond markets indicate that long-term interest rates may be set to rise for all borrowers, including even low-risk governments. This reflects greater optimism about global economic recovery (especially in the United States), which in turn has raised the probability that central banks call a halt to quantitative easing programmes and begin the process of returning interest rates to normal non-crisis levels.
While the policy rates set by central banks are not likely to move sharply upwards in the short term, the anticipation of higher policy rates over the next five-10 years is sufficient to induce a jump in medium-term and long-term funding rates. While improved global growth prospects are welcome news for Irish exporters, a generalised increase in interest rates would be quite damaging for the state of Irish public finances.
In addition to these external risks, a deceleration in the pace of fiscal adjustment would prolong the task of closing the fiscal gap. In addition to adding to the stock of debt, a delay in the adjustment process is also risky, since it would raise questions about the commitment of the government to fiscal stability. To many international analysts, a decision to defer fiscal adjustment in a (modestly) growing economy by a mid-term government with a large majority would raise questions as to its longer-term determination to complete the task. Governments are less likely to undertake tough fiscal actions close to a general election: if the opportunity to narrow the fiscal gap in Budget 2014 is missed, it could be asked whether the extra fiscal measures would be taken this side of the next general election.
Taken together, these considerations reinforce the case for Ireland to maintain its record of gradual but sustained fiscal adjustment. While 2013 has seen a global debate about the appropriate speed of fiscal consolidation, it is important to understand that the main targets of this debate were: (a) those governments (eg Germany, United Kingdom, United States) that have sufficient fiscal capacity that the bulk of austerity measures could be postponed; and (b) those governments that were asked to make very large fiscal adjustments in a very short period (the 2012 planned austerity measures in Greece, Italy, Portugal and Spain were much larger than in Ireland).
The acceptance by the Troika in 2010 that fiscal adjustment in Ireland should be stretched out over a fairly long time frame has been a more successful approach in relative terms. At the same time, further delays relative to the agreed time schedule seem unwarranted at this point.
The myriad downside fiscal risks laid out above also suggest that Ireland should take out some insurance by setting up some version of an ESM/IMF contingent credit line that would provide extra comfort to market funders in the coming years. Such a contingent facility should be welcomed as an appropriate risk management measure and would still allow the Irish government considerable leeway in determining its future fiscal strategy.
Philip R Lane is Whately Professor of Political Economy at Trinity College Dublin.