State must 'do more, go faster' to tackle deficit
Implementing the terms of the agreed EU-IMF programme may no longer be sufficient for Ireland
THE TURMOIL in the financial markets is the result of the convergence of two major negative forces in the world economy: the ongoing euro crisis and rising concerns about a potential decline in global growth prospects.
The lower prospects for global growth are driving the sharp decline in stock-market valuations, while the deepening of the euro crisis has resulted in upward pressure on the sovereign debt yields of Italy, Spain and, to a lesser extent, Belgium and France.
Excessive debt levels are at the heart of both problems, with renewed fears about public and private debt levels in the US pressing on global growth prospects, while investors remain skittish about the institutional capacity of the euro area to deal with the sovereign debts of its member states.
In terms of policy issues, the world awaits greater clarity about how the US plans to combine monetary and fiscal measures to assist near-term recovery with medium-term adjustments that will ensure the post-recovery public debt level stabilises at a safe level.
With fiscal control divided between the Democrats and the Republicans, there is little prospect of any short-term resolution of the fiscal issues, so the US Federal Reserve will be mainly responsible for ensuring that the US does not fall behind in its recovery process.
In relation to the euro area, there are several open policy issues. If it turns out that growth prospects for the euro area have substantially declined, the ECB may delay its plan to return interest rates to more normal levels and may even reverse its most recent rate increase.
In terms of stabilising the sovereign debt markets, there is considerable tension between the ECB and some national governments.
The stance of the ECB is that it can only purchase the sovereign bonds of troubled member states through its secondary market purchase programme under two conditions.
First, there must be evidence of disruption in these markets, in the sense of a rapid climb in the spread that is driven by destabilising momentum trading strategies. Second, there must be a demonstrated willingness of the government in question to allay concerns about its fundamentals through measures to improve its fiscal position and underlying growth prospects.
Not all member states enjoy receiving such requests to undertake major policy reforms.
It is important to appreciate that the current ECB approach is limited to smoothing out spikes in sovereign spreads. In particular, it is does not seek to impose a pre-announced ceiling on spreads.
To defend such a ceiling might require the ECB to make extraordinarily large bond purchases, which would pose credit risks that would ultimately be passed on to the member governments of the euro area.
Rather than the ECB initiating such fiscal commitments, this is more properly the responsibility of the member governments, either through the European Financial Stability Facility or by explicitly indemnifying the ECB for potential losses.
Since the fiscal positions of the member governments are limited, bond-market interventions are unlikely to reach the “shock and awe” level that would definitively calm the markets.
Moreover, the ECB currently seeks to neutralise the monetary implications of its sovereign bond purchases by offsetting liquidity- absorbing operations. This is disappointing to advocates of quantitative easing that would like to see faster expansion of the monetary base in the euro system.
However, so long as the euro area still shows prospects of overall growth, it is unlikely that the ECB will adopt a quantitative easing strategy soon.
Even more so, there is no sign that the ECB might actively consider a temporary increase in its inflation target (say from 2 per cent to 4 per cent) as a mechanism to ease the pressure of nominal debt levels in some member countries.
The main implication for the Government is that the darker fiscal environment in Europe means it should “do more, go faster”. Since the fiscal prospects of more member governments have declined, there will be more pressure to ensure countries that do receive official funding are more aggressive in undertaking fiscal adjustment and implementing structural reforms.
Implementing the terms of the agreed EU-IMF programme may no longer be sufficient for Ireland to contribute positively to the stabilisation of the euro crisis.
First, the Government could improve the clarity of its fiscal strategy by announcing multi-year expenditure and taxation plans in early autumn.
Second, it could commit to a larger adjustment target for its 2012 budget. Third, it could do more to provide reassurance about medium-term fiscal sustainability by moving more quickly to introduce the fiscal responsibility law and locking in pension reforms.
Fourth, the pace of structural reform of sheltered sectors and the labour market can be accelerated. Fifth, measures to resolve the economic drag imposed by high levels of personal indebtedness could also be introduced more quickly.
After three years, it is surely demoralising for policymakers and policy officials around the world to face the prospect of a new and intensive phase of crisis management. (Even more so for the many households suffering economic distress.)
However, Ireland has a new Government with a large majority. It should be well placed to take on this new challenge.
Philip R Lane is professor of international macroeconomics at Trinity College Dublin.