Contradictions abound in finger-wagging over Budget surpluses and inflation control

European Monetary Union is still in its early days, and it will take some time for Brussels and Frankfurt to produce a co-ordinated macroeconomic strategy for euro-zone member-states. Unfortunately, this co-ordination is sadly lacking, producing inconsistent assessments of Ireland's economic performance by the European Commission.

Specifically, the Commission has been extremely critical of Ireland's fiscal policy. Although Ireland has produced GDP growth of 11 per cent for 2000 - as compared with 3.5 per cent in the euro zone - and is expected to grow by 8.6 per cent compared with 3.2 per cent for the euro zone in 2001, the Commission has expressed considerable discontent at Mr McCreevy's policy and is contemplating issuing a "formal recommendation" that the policy be changed.

The Commission wants Ireland to use fiscal policy to curtail what it calls "overheating" of the economy. It says: "Budgetary plans for 2001 are expansionary and pro-cyclical and are therefore considered inconsistent with these guidelines [the EU's economic policy guidelines]. They will add to the overheating problem rather than abate it."

Adding weight to the Commission's objections, the President of the European Central Bank has suggested that Ireland should introduce less inflationary economic policies.

Ireland's GDP is only 1 per cent of the EU's GDP so why is Brussels devoting so much time to the activities of such a small economy? Is Ireland to be the test case pour discourager les autres? Even here the Commission faces a difficulty if it acts harshly against Ireland: onlookers in the UK will perceive it as another example of unwarranted heavy-handed action by Brussels and a taste of what awaits Britain should it join EMU. These political questions aside, it may be asked whether it is good economics to ask Ireland to change its fiscal policy?

In the 2001 Budget the Government has certainly reduced taxation and increased public sector expenditure. Part of the reductions in taxation represent an attempt to trade off lower taxes for reduced wage demands by the trade unions. Such a policy, if it works, could be regarded as helping the fight against inflation rather than the opposite as it helps prop up the Programme for Prosperity and Fairness. It may be argued that part of the increased expenditure is to improve infrastructural investment which is still much needed in the Irish economy. But even with the tax reductions and expenditure increases, can the stance of Government policy be regarded as inflationary? The traditional method of assessing expansionary fiscal policy is to measure the size of the Government deficit. Here the Republic presents a paradoxical picture to the Commission because it has no such deficit. Instead it has a surplus and a pretty large one at that. The Republic is running a Budget surplus of more than £6 billion (€7.62 billion) representing 6.7 per cent of GDP. As the accompanying graphic shows, the broader-based deficit, the General Government Balance (GGB), is projected to produce a surplus of nearly £4 billion or 4.3 per cent of GDP. Future projections are that the Budget surplus will grow to 7.3 per cent and the GGB to 4.6 per cent in 2003. So how can fiscal policy be contribute to overheating when such substantial governmental surpluses are being run? Does the Commission want the surplus to be greater? Evidently it does - but how much greater does it want it to be?

Suppose the Government was obliged to raise income taxes to yield an extra £1 billion and to trim public sector expenditure by £2 billion. Leaving aside the massively complex problems of producing such tax increases and expenditure cutbacks the result would swell the budgetary and GGB surpluses. What could the Government do with such money? The Budget surplus would almost be 10 per cent and the GGB more than 7.5 per cent of GDP. The money could be used to reduce the national debt. But Ireland has already worked hard on this. In 1987 the national debt/GDP ratio was as high as 116 per cent. By 1999 the national debt/GDP ratio had been reduced to 50 per cent, well below the Maastricht criterion of 60 per cent. On the basis of existing policies it is expected to fall to 33 per cent at the end of this year. How much more does the Commission want the State's national debt/ GDP ratio to fall? Does it want the Republic to abolish its national debt within three to four years?

But even here the policy of running budgetary surpluses to cut national debt needs to be reassessed. In recent years there has been an increasing emphasis on an approach called Ricardian Equivalence. Originating from the work of David Ricardo, and more recently developed by US economist Robert Barro, the approach suggests the public recognises that when government is increasing public sector expenditure through budgetary deficit financing there will be no free lunch. Deficit financing today implies higher taxation tomorrow. So to stabilise expenditure over time the public will save more today out of the lower taxes to pay tomorrow's higher taxes.

The converse of Ricardian Equivalence implies that public reaction to budgetary surpluses may be to spend more today on the assumption of fewer taxes to pay tomorrow. If one takes this line of reasoning the Commission should be careful about recommending a country to run a sizeable budget surplus particularly as its national debt moves towards zero. Even if Ricardian Equivalence does not hold absolutely this effect will substantially reduce the impact of a budgetary surplus.

The Republic's problem is somewhat unique in the euro zone since much of its trade is denominated in sterling and dollars - not euros. Trade statistics show that 22 per cent of Irish exports go to the UK and 33 per cent of imports come from there. Some 16 per cent of exports go to the US and 17 per cent of imports come from there. No other euro-zone member-state has this aggregated trading exposure to the dollar and sterling. Given the euro's weakness against the dollar and sterling since the euro's inception, it is inevitable that a sizeable proportion of the Republic's inflation has to be of the imported variety.

But this is a problem for the Irish economy that arises in Frankfurt where the exchange rate stance of the euro is decided. The Republic is an exchange rate taker from Frankfurt and this exchange rate stance makes it also an inflation taker. Because of the euro link, Ireland is also an interest rate taker. This creates a further problem in that the high rate of inflation of 6 per cent combining with lower interest rates (the three-month interest rate is around 4.8 per cent) has produced an environment of negative real interest rates. Negative real interest rates will certainly contribute to economic overheating. Here the Central Bank of Ireland has no power because monetary policy has effectively been handed over to the ECB. With monetary and exchange rate policy vested in the ECB the Commission should be raising questions about the Republic's inflation performance in Frankfurt rather than in Dublin. The Commission's suggested fiscal strategy for the Republic is inherently contradictory - running greater budgetary surpluses is not the way to slow down appreciably inflation.

Antoin E Murphy is professor of economics at Trinity College, Dublin.