John FitzGerald: Policymaking in the face of uncertainty
Too often policies are formed on the assumption that tomorrow will be very like today, and that surprises, pleasant or unpleasant, never happen
Minister for Finance Michael Noonan’s budget documents present some limited alternative scenarios on what might happen if world growth were lower than assumed or if euro area interest rates were higher than expected. Photograph: Dara Mac Dónaill
The economic crisis, from which we are now recovering, taught us many lessons. Some of them will be remembered for some time to come.
One of the most obvious is the need for caution in policymaking to take into account the fact that the future will certainly be different from what we expect. Too often policies are formed on the assumption that tomorrow will be very like today, and that surprises, pleasant or unpleasant, never happen.
One way to approach this problem of uncertainty is to consider a range of “what ifs”: how would policy be affected if things turn out worse than expected and also how robust is policy to higher growth than expected?
Such an approach requires a move away from reliance on a single, often optimistic, forecast instead testing out a range of possibilities.
Over 25 years publishing medium-term projections for the Irish economy at the Economic and Social Research Institute (ESRI), one of the most difficult issues we faced was how best to present the uncertainty that necessarily surrounded such an exercise.
In every case a range of scenarios was published rather than a single set of numbers. However, in each case there was substantial pressure, especially from the press, to identify a single “most realistic” scenario because of the difficulty of presenting a very complex picture to a wider audience.
The Irish Fiscal Advisory Council (IFAC) in its reports has included a useful tool which illustrates the uncertainty that surrounds short-term forecasts using an illustrative “fan” chart showing a range of possible outcomes with varying degrees of likelihood. As a result of taking the uncertainty about the future into account, the IFAC’s recommendations on fiscal policy have consistently been more cautious than those of the Government.
Alternative scenariosFor many years now, as part of the budgetary process, the budget documents present some limited alternative scenarios on what might happen if world growth were lower than assumed or if euro area interest rates were higher than expected.
However, these scenarios receive very little attention, possibly because the circumstances under which these outcomes might arise is not discussed in any detail. Nonetheless, it is important to consider their implications.
Over the rest of this decade there are a number of obvious risks to the relatively benign forecasts available from different sources.
The sensitivity analysis in the budget, which considers the possible effects of a one percentage point rise in interest rates on the Irish economy, is particularly important. It suggests that such an increase in interest rates would have a major impact on the Irish economy: it could reduce the level of GDP by 2 per cent and increase the government deficit by over 1 per cent of GDP.
Thus the impact on the economy could be quite severe, not just because of Irish indebtedness but also because a rate rise would negatively impact on growth in the euro zone.
While it seems clear that European Central Bank interest rates will remain low for at least the next two years, if the euro zone area economy recovers and when the effect of the fall in oil prices on inflation wanes, a significant rise in interest rates would be on the cards.
Even after the surge of debt repayment that is going on in Ireland today, the State will remain quite indebted in 2018.
This risk to future economic prospects from an interest rate rise in 2018 or 2019 argues for caution today. One implication is that the government should reduce future risk from a rise in interest rates by gradually reducing the debt burden.
Rise in ratesA related approach, adopted by the National Treasury Management Agency, is to borrow now for longer periods of 10 or more years so that debt interest payments will be less impacted by a rise in rates later this decade. Similarly, companies and households can fix their interest rate for a number of years at a price. Such a strategy can make sense.
One effect of the financial crisis over the period 2009-14 was that, when considering uncertainty about forecasts, all of the attention focused on what might go wrong. Because of the massive problems which the economy faced, it was eminently sensible to consider downside risk and to try and prevent it or to prepare contingency plans to deal with it.
However, over the course of the crisis such a fixation on disaster scenarios also blocked out the need to consider the implications of a vigorous economic recovery.
Even as the economy began to recover in 2013, it took some time to convince policymakers and the public the worst was truly over.
Some of the obstacles to a recovery in building, especially in housing, could have been addressed in 2012 or 2013. However, the prevailing pessimism meant there was no focus on the possible needs that might arise from a successful recovery.
As a result of inaction in 2012 and 2013, a significant risk to future economic and social development in Ireland arises from a shortage of key infrastructure today – in particular housing.
The rapid rise in rents and the rise in house prices has reflected the growing pressures as housing supply has been very slow to recover. This increase in rents is giving rise to serious social costs and it will also adversely affect competitiveness if not rapidly addressed.
This highlights the need to consider upside as well as downside scenarios for the economy in formulating policy.