Budget must focus on cutting structural deficit

OPINION:Tuesday's budget must obviate the need to return to the well for further adjustments, writes JIM O'LEARY.

IN A COMMENT piece last week I wrote on the CSO’s latest national accounts estimates, and I hinted at the prospect of a near-10 per cent fall in GDP this year.

I didn’t intend it as a forecast; more as a means of making a point about the need for Government to avoid getting impaled on a percentage-of-GDP target for the budget deficit when the denominator in that ratio is falling fast.

In the meantime, however, what data have been published suggest that the prospect of a 10 per cent drop in GDP has become very real. I’m thinking in particular about the March Live Register numbers.

The Live Register is not a measure of unemployment, but is used by the CSO to update the estimated unemployment rate. On that basis, the unemployment rate for March is put at 11 per cent, more than twice its value of 12 months earlier, and the average rate for the first quarter of this year is put at 10.3 per cent, which is 5.3 per cent points above the average for the same period of 2008.

The scale of this increase suggests a very steep fall in GDP. If the historical relationship between the two variables has continued to hold, real GDP will have fallen by more than 10 per cent over this period and, if that is the case, a decline of this magnitude would become likely for 2009 as a whole.

This is a much steeper fall than is being forecast by any commentator at the moment, and it contrasts starkly with the 4 per cent fall forecast by the Department of Finance in January, which brings me to the first point I want to make today about next Tuesday’s supplementary budget.

It is this: the budget must get ahead of the curve, and the approach adopted on Tuesday must obviate the need to return to the well for further adjustments in the months ahead.

One way of doing so is to adopt a set of economic forecasts, especially for 2009, that errs if anything on the side of pessimism. To do otherwise elevates the risk that the budgetary projections will once again come off the rails, with further corrosive effects on confidence and credibility.

Another requirement of next Tuesday’s exercise is to place it firmly in a medium-term perspective. It is at least as important that, in readdressing the public finance crisis, Brian Lenihan maps out a credible and coherent plan for 2010 and beyond as it is that he announces measures to reduce Government borrowing in 2009.

There appears to be a growing consensus amongst economists, and an acceptance by the Government itself, that the conceptual framework best suited to this purpose is one based on the distinction between the cyclical and structural components of the budget deficit. That distinction clarifies what it is that budgetary policy should be targeting (the structural component) and what it is reasonable to suppose will automatically disappear when the economy returns to full employment (the cyclical element).

This is an intellectually respectable and logically foolproof framework. However, it is not without its operational problems.

The structural deficit cannot be observed; it must be estimated and it is difficult to do so reliably, especially in an economy as open as Ireland’s is. Part of the reason for this is that it rests on another measure that cannot be observed and must also be estimated: the economy’s potential output or the level that GDP would reach were the economy operating at full employment.

Perhaps another day this column will take a non-technical walk through the difficulties involved in estimating the structural budget deficit. For now it will be enough to observe how wide the range of current estimates is and how radically estimates can be revised after the event.

As far as estimates for 2009 are concerned, the ESRI in a pre-budget paper published last weekend suggested that the structural deficit might be as low as 6 per cent of GDP, while the European Commission and some academic economists think it is close to 10 per cent.

It is also worth observing that as recently as December 2006, the estimates prepared by the Department of Finance (and, presumably accepted by the European Commission) suggested that the Government had run a large structural budget surplus that year and the previous year. Now, of course, almost everyone is agreed that the Government was running large structural deficits throughout the building boom.

Estimates of the structural deficit are clearly subject to wide variation and large revision. It follows that a fiscal strategy based on the structural deficit is more than averagely susceptible to manipulation and obfuscation. That being the case, if the structural deficit is to be the primary target of fiscal adjustment – and, despite my reservations, I think it probably should be – the process of estimating it should be carried out by an entity other than the one responsible for executing the fiscal adjustment programme. In other words, not by the Department of Finance.

This is not to belittle the competence of the department’s officials, but to insist on a proper separation of responsibilities in the interests of accountability and transparency. Neither the rules of the game nor the score should be determined by the players.