The Department of Finance’s chief economist John McCarthy made what seemed like a flippant remark at Tuesday’s post-budget briefing, suggesting Ireland’s economic outlook was “contingent upon what the weather will be like on continental Europe”.
He was, however, reflecting the very real possibility that a severe winter in Europe could trigger further gas shortages and another round of energy price hikes, an event that will almost certainly push the economy here into a full-blown recession. As it is we will come very close to recording back-to-back quarters of negative growth (the technical definition of a recession) anyway.
The department’s Budget 2023 economic and fiscal outlook report sees modified domestic demand (MDD), which measures domestic performance, contracting by 2.4 per cent in the third quarter of 2022 before expanding again by 1.3 per cent in the final quarter.
That fourth-quarter expansion, however, reflects the impact of the €4 billion in temporary, one-off measures to support households announced in the budget, most of which come into effect in the final part of the year. They will boost consumer spending, the biggest component of domestic growth.
An unexpected uptick in investment linked to multinationals paying for remote working retrofit projects is also said to have pushed the dial. Without those elements Ireland would have recorded a modest recession in the second half of 2022.
“Budget 2023 is framed against the backdrop of an economy that is broadly operating at full-employment, but where near-term prospects have deteriorated significantly,” the department’s outlook report says.
That deterioration means inflation, according to the department’s projections, will now average 8.5 per cent this year (it is expected to peak at 10.4 per cent in the final quarter) and over 7 per cent next year. These were big revisions on its previous projections. In April it was predicting inflation of 3 per cent for next year.
The department also notes that the acceleration in inflation is now far from being solely an energy price shock. “The more generalised mismatch between demand and supply means that inflationary pressures have broadened. For instance, the latest data show that annual price increases for 80 per cent of the goods and services in the inflation basket are in excess of 5 per cent,” it says.
Despite the significant measures announced in the budget these levels of price growth will depress real wages, resulting in the biggest decline in living standards here since the financial crisis. On the basis of current inflation projections, real wages will decline by an average of 4.5 per cent this year and by 3.1 per cent next year.
These figures might sound abstract and technical but they translate into households not being able to pay electricity bills or struggling to pay for the weekly food shop.
Consumers also have to contend with a series of interest rate hikes from the European Central Bank (ECB), which flow into more expensive mortgages, loans and credit card debt. This will be a cold winter financially regardless of the temperature outside.
“The key question is whether the economy is in line for a period of weaker growth or whether an outright recession is in prospect,” the department’s report says. “While this is difficult to answer it is important to recognise that the domestic economy is in reasonable shape, with few of the imbalances that characterised the situation in the mid-2000s,” it says, noting household and SME balance sheets are in a “fairly solid position”.
“If short-lived, therefore, the energy shock can probably be absorbed without excessive economic fallout,” it concludes.
That uncertainty, combined with a noticeable deterioration in the growth outlook internationally, cast a long shadow over the Government’s €11 billion budget giveaway. The package, the biggest on record outside of the Covid era, appeared to place additional money in most people’s pockets and stymie or at least stall Opposition claims that the Government wasn’t doing enough.
The once-off measures on child benefit and energy credits are worth over €1,000 for a family with three children. Similarly, extending the 20 per cent income tax rate to cover income up to €40,000 for a single person will see the take-home pay of single taxpayers improve by €640 next year with pro rata increases for married couples and those in civil partnerships. There was also a once-off €1,000 reduction in the contribution fee for third-level students.
“While the package is large it is not irresponsible, with surpluses still forecast for the coming years. In other words it packs a punch but is judicious,” Goodbody economist Dermot O’Leary says. Ireland will still run a budget surplus in 2022 (equating to 0.4 per cent of the Central Statistics Office’s bespoke measure of national income GNI*) and in 2023 (2.2 per cent of GNI*) even with the big budgetary spend.
Dublin will be one of the few governments in Europe to be running a budgetary surplus this year so soon after the massive outlay on Covid.
“Normality has not been resumed yet to fiscal policymaking in Ireland after the Covid splurge, with the energy and cost-of-living crisis necessitating another aggressive set of policies to help households and businesses through what is likely to be a tough winter,” O’Leary says.
Even the Irish Fiscal Advisory Council, which has been at loggerheads with the Government over its spending plans in recent years, gave it a qualified endorsement. “By broadly following the 5 per cent spending rule, Budget 2023 strikes a balance between providing support and avoiding adding excessively to higher inflation,” it said.
The Government’s budgetary largesse has a lot to do with corporation tax receipts, which have provided it with a spending platform it wouldn’t have had otherwise. Anxiety around the concentration risk of having just 10 big firms accounting for such a large portion of the tax base has been softened (somewhat) by the Minister for Finance Paschal Donohoe’s decision to set aside €2 billion this year and €4 billion next year in a new reserve fund, beginning a long overdue project of buffer building.
Having this windfall wash in and out annually is simply too dangerous for the exchequer. The pot has got so big – receipts are expected to be in the region of €21 billion this year and €23 billion in 2023, surpassing VAT as the second largest income stream for the Government – that the usual dance between political pressure to spend and economic incentive to save has been avoided. The Government has effectively been able to do both.
That said, the measures announced in the budget were never going to be enough to compensate for higher prices or shield households from the full extent of the inflationary shock. The once-off supports also have a shelf life of just a few months, and there have already been calls and suggestions that the Government will have to come again with more measures, particularly when the winter heating bills kick in.
Tánaiste Leo Varadkar has played down the prospect of another mini-budget in the new year but failed to rule out further intervention, saying the situation would be examined in January or February.
Similarly, while the Government’s new €1 billion Temporary Business Energy Support Scheme, aimed at helping businesses with the increased cost of energy, was welcomed, a survey conducted by the Association of Chartered Certified Accountants and consultancy Grant Thornton indicated that more than two-thirds (68 per cent) of SMEs believe the budget has not done enough to help struggling businesses survive this winter.
Nonetheless, Kieran McQuinn of the Economic and Social Research Institute (ESRI) says “overall the impact of the budget should help to (partially) stabilise household incomes and provide businesses with a certain buffer to deal with increasing energy costs”.
While noting the scale of the budgetary package is likely to fuel some inflationary pressures, he also says that “more assistance may be required”. How inflationary the budget will be (economic orthodoxy says it has to be, the question is how much) lingers in the background, perhaps overshadowed by the more pressing needs of struggling households but the Government has to tread carefully.
McQuinn notes that the deteriorating geopolitical situation has exacerbated pre-existing inflationary pressures, giving rise to further concerns about European energy security. “Despite this the domestic economy is still expected to increase,” he says, noting the export-led ICT and pharmaceutical sectors have been largely unaffected by global slowdowns.
However, he warns that in addition to externally-determined inflationary issues the Irish economy is set to encounter domestic pressures, particularly in the context of a tight labour market. Unemployment was put at 4.3 per cent in August. Economists believe unemployment rates of 4 per cent and under are tantamount to full employment in the Irish economy.
In his post-budget briefing, Donohoe referred to the new accelerated inflationary and higher interest rate environment as “regime change”.
The rapid increase in government borrowing costs (bond yields) has focused attention internationally on the ability of certain countries to carry debt, something that was down the agenda in the era of quantitative easing (QE) and zero interest rates. The rapid loss of market confidence in the UK government’s financial position, as evidenced by the collapse in the value of sterling, is a case in point. The UK’s increased borrowing requirement – necessitated by the new government’s controversial tax-cutting strategy – wouldn’t have spooked markets to the same extent or prompted an unscheduled intervention by the International Monetary Fund (IMF) if interest rates had remained on the floor.
Yields on UK 10-year bonds, the government’s implied borrowing costs, have risen above 4 per cent, the highest since the 2008 financial crisis, and more than triple the 1.3 per cent rate at the start of this year.
The yield on Ireland’s 10-year bonds has jumped to 2.7 per cent, up from 1.5 per cent a month ago and less than 1 per cent a year ago. Ireland, however, remains in a relatively strong position due to the expected budget surplus this year and next, and the large cash balances held by the National Treasury Management Agency (€35bn).
While the economic outlook here is by no means dire, it’s clear that the stellar growth of recent years and the strong bounceback from Covid has stalled in the face of the current crisis, which has no clear end in sight. There’s also no getting away from the fact that the financial strain on households is going to get worse before it gets better.