EU must factor in our real economic gains

Europe’s methodology for determining the right fiscal stance is wrong for Ireland

During the last decade policymakers in Ireland were far too optimistic: the boom was expected to continue forever and hubris set in. Since 2008 we have seen the consequences when reality caught up with fiscal forecasts that proved to be fantasy.

Today, knowing the catastrophic effects for society of how wrong we got it, the approach is, correctly, to err on the side of caution. Since 2010 the public finances have consistently outperformed the Department of Finance's forecasts. This is as a result of a deliberate policy, introduced under Brian Lenihan and continued under Michael Noonan.

This approach is not just a rebound from the past. Rather, it reflects a view that the Irish public, who have endured a lot of pain to put the public finances right, would be even crosser if that goal were not to be achieved. The Department of Finance also recognises that the financial markets have heavily penalised past underperformance on the public finances.

In late 2010 the outgoing government put in place a politically-feasible adjustment plan and under-promised what could be delivered on the public finances.

This facilitated the incoming Government. While sticking to the broad outline of the 2010 plan, budgetary targets have been exceeded each year under the current administration.

It’s a bit like an airline overestimating a flight-time to a destination so it can play a fanfare for making it on time.

By contrast, in Spain the outgoing government over-promised, leaving the incoming Rajoy government with an impossible hill to climb when it took over in 2012. The result was a loss of Spain’s credibility at home and abroad.

Ireland’s consistent outperformance of budgetary targets over four years has been substantially rewarded by the financial markets through a dramatic drop in Irish interest rates.

While the political system has consistently done better than promised on the public finances, this has not earned much kudos with the voting public, although getting the public finances wrong on the downside could have proven even more unpopular. The conservative approach to forecasting the public finances has proved difficult for the European Commission and the Irish Fiscal Advisory Council (Ifac) to take on board: they are more geared to expect governments to exaggerate likely progress on budget deficits.

Tougher line

The EU Commission generally takes a government’s forecasts and adds a dollop of additional conservatism, taking a tougher line than governments on the scale of fiscal adjustment required. While this approach may be appropriate when dealing with over-optimists, it sends the wrong signals to governments that are being cautious in their budget strategy.

It appears likely that the Government, while still underestimating how well the finances will work out, will make cuts of less than €2 billion in the coming budget. The EU Commission is likely to view such a target unfavourably, though it is likely that some fudge will be found to avoid a dispute. However, the EU stance on the 2016 and 2017 budgets could mean a bigger headache.

The methodology used by the European Commission suggests it will demand reductions of €2 billion a year in 2016 and 2017. However, if the economy continues on its current course it may move into budget surplus without any further action in 2016 or 2017. The EU methodology for determining the right fiscal stance is inappropriate for Ireland. In a recent article we suggested an alternative approach. The EU, to be credible, needs to factor in Ireland’s economic and budgetary progress.

The conservatism of Department of Finance projections also poses problems for Ifac. Ifac has endorsed the department’s projections, but its recommendations on the public finances have been consistently more hawkish. The department’s policy approach in 2013 and 2014 has been proved correct and the department’s more moderate approach to the 2015 budget may also be proved right.

Ifac has established its independence of government but, with the benefit of hindsight, its tougher policy prescriptions are also proving to be unnecessarily harsh.

We need Ifac to be respected as a wise and independent organisation so that when governments pursue inappropriate policy, IFAC’s advice will be heard.

IFAC’s independent voice could play a really constructive role if it was to review the inappropriateness of the EU’s prescription for Irish fiscal policy in 2016 and 2017.

John FitzGerald is research professor at the ESRI