Getting Ireland’s budget balance right

Unwise fiscal policy choices in the 1977-1981 and 2003-2008 periods played a major role in the subsequent economic crises that did so much damage to Irish society. The consequences of adopting the wrong policies were high unemployment and emigration, cuts in public services, reduced personal incomes and a legacy of personal indebtedness.

With a general election in 2016, the next budget will be the last one of the outgoing government. Over the coming year parties will be preparing their election manifestoes to cover the period to early 2021. So it is important to consider what should be the budgetary strategy to 2021 to guide the decisions of political parties and the wider public.

Under normal circumstances, the role of fiscal policy is to maintain the level of GNP close to its potential. When GNP is growing more rapidly than the underlying potential, this brings a risk of inflationary pressures and bubbles. In that case policy should dampen demand through higher taxes or lower public spending. When the economy is below potential it would be appropriate to apply a fiscal stimulus.

However, since 2008, successive governments were not in a position to provide a fiscal stimulus at a time of deep recession, as the economy was exceptionally indebted and there was a massive deficit. Instead, over the last six years the economic sustainability of the State had to take priority.

A preliminary assessment of the budget for 2015 suggests that it is mildly stimulatory. Because of the continuing high level of borrowing and debt, it would probably have been better to have taken a more cautious approach. However, if growth continues to be vigorous there may be no adverse consequences and borrowing will be significantly below 3 per cent of GDP.

Delivering an “appropriate” budget for 2016 a few months before an election will be difficult. If the economy continues on its recovery path, it will be right to adopt a neutral fiscal stance and run a small surplus in 2016.

However, if the wider European economic malaise were to affect Ireland over the next 18 months, then a more limited reduction in the deficit from its 2015 level would be appropriate.

A large number of new EU rules have been introduced, governing fiscal policy in Ireland and elsewhere. But we need to move beyond just obeying these rules, to consider what would be the appropriate fiscal policy for Ireland over the rest of the decade. In the run-up to the crisis in 2008, compliance with the EU rules gave the government and the wider public a false sense of security.

Thus, mere observance of the fiscal rules over the next six years will not provide any guarantee that fiscal policy will be appropriate to the needs of the economy. It is important that the guidelines for policy over the coming decade are based on a full assessment Ireland’s economic circumstances.

Unfortunately, the documentation with the recent budget provided only pro forma numbers to 2018, which are consistent with the fiscal rules but are not grounded in considered scenarios for the Irish economy.

The Irish Fiscal Council could play a useful role in conducting a medium-range assessment of policy, possibly building on the work already conducted in the ESRI.

In considering budgetary strategy for the rest of the decade, policy should be formulated to be robust in the face of very different possible out-turns.

If all goes well the economy will grow more rapidly than potential, significantly above 3 per cent a year, as the labour market gradually returns to full employment. In that case it would be appropriate for the government to run a surplus averaging between 1 and 2 per cent of GDP each year between 2016 and 2020. Because of the rapid growth this would be consistent with some improvement in public services, or possibly some reduction in taxation. The reason for running a surplus would be to provide adequate room for the government to provide a stimulus, should the economy unexpectedly slow down.

If the recovery progresses steadily over the next four or five years, before the end of the next Dáíl, there could be a return to full employment. Under those circumstances fiscal policy should be tightened to deliver an increasing surplus, to slow the economy and keep economic growth in line with its long-run potential, avoiding unsustainable bubbles. The failure to rein in policy in 2003-8 was a major contributory factor in the disaster that ensued for Ireland.

Other countries, such as Denmark and Finland, recognised that danger in the last decade, and ran large surpluses of 2-4 per cent to prevent their economies overheating.

The success of that approach was reflected in the very limited damage they suffered as a result of the great recession. This could be a difficult issue for budgetary policy before the end of the next Dáil.

In the more pessimistic scenario, a continuing miserable performance in Europe could see serious underperformance by the Irish economy, with growth between 1 per cent and 2.5 per cent a year, well below its potential. Policy mistakes at home could also contribute to such a scenario. Because of continuing high levels of public debt, expansionary fiscal policy to stimulate the economy would not be the right course.

Under those circumstances there could be a continuing small deficit in 2016 and 2017. However, a tightening of policy to hasten a return to budget balance would not be the correct approach either, as the remaining deficit would be purely cyclical in nature.