IMF analysis underlines flaws in its earlier estimates

 

ECONOMICS:Last week's startling figures raise questions about the quality of previous external policy surveillance, writes JIM O'LEARY

THERE WERE a couple of truly arresting numbers in last week's IMF report on Ireland. One was that august body's estimate of the size of the so-called output gap at the height of the construction boom in 2007, at 7.1 per cent of GDP. This, crudely speaking, is a measure of the extent to which economic activity at the time was boosted beyond what was sustainable by a bubble, or alternatively a measure of the scale of overheating.

As overheating goes, this is about as hot as it gets: estimated output gaps of this magnitude are extremely rare.

Another striking number was the IMF's estimate of the 2007 structural budget deficit - the deficit that would obtain with unchanged tax and spending policies, if the economy returned to normal - at 8.7 per cent of GDP. This is another big number, one that doesn't have too many precedents.

These numbers convey the impression of wilful mismanagement of the economy and the public finances at the height of the boom, a point Opposition parties no doubt will be keen to hammer home in today's Dáil debate. And, mismanagement there undoubtedly was. But it is worth pointing out that the IMF's damning estimates have been constructed with the benefit of hindsight, and that the corresponding numbers contained in the last IMF report on Ireland, published in September 2007, were very different.

Then our Washington-based friends estimated that Ireland's output gap would amount to just 0.2 per cent of GDP in 2007 (tantamount to saying that there was no bubble) and that the structural budget would end the year in surplus to the tune of 0.7 per cent (tantamount to saying that fiscal policy was prudent).

In fairness, elsewhere in its 2007 report the IMF struck cautionary notes about inflationary pressures, declining competitiveness and the risk of a slowdown in the housing market. Still, the whole episode raises interesting questions about the quality of the external policy surveillance to which Ireland was subject at the time.

Interesting questions about methodology also arise. If an unsustainable construction boom and the fragility of a boom-driven surge in tax revenues were prominent on the radar of relatively simple-minded commentators in the mid-Noughties, what value was being created by the more sophisticated analysis carried out by the IMF (not to mention the OECD, the European Commission and our own Department of Finance)?

The answer, it would seem, was well less than zero. Perhaps, one of the lessons to be drawn is that common sense is the most robust analytical technique of all.

I will return to the policy surveillance question at a later stage. The much more important point at this juncture is that the IMF analysis (now fully aligned with common sense) is essentially correct: GDP grew well beyond what was sustainable in the years up to 2007, boosting tax revenues well beyond what it was reasonable to expect would endure, and the big fiscal policy mistake was to parlay these huge windfall gains into recurring expenditure commitments and cuts in tax rates. Recovering from that policy error has required and continues to require that tax rates be raised again and spending cut to bridge a yawning gap.

Which brings me to a curious notion that I think it is especially important to dispel as "An Bord Snip Nua" puts the finishing touches to its report. It is the notion that nobody, except a small minority comprising bankers, developers and the like, benefited from the boom; that somehow or other the Government contrived to spend the multibillion euro windfall from property and construction-related taxes on . . . a ball of smoke. This belief is part of what has stiffened popular resistance to cuts that have already been put in place, and will no doubt animate opposition to the big cuts yet to be announced.

This notion is entirely false of course. There is hardly a citizen of the State who didn't benefit considerably from boom-time government largesse across all the major areas of spending. Consider public sector employees, for example, whose earnings increased at an annual average rate of almost 6 per cent over the boom years, thanks in part to the first round of benchmarking.

Take social welfare, where average annual increases ranging from 7 to 10 per cent (compared with an average inflation rate of 3.4 per cent) took place in the main rates of payment. Take education, where real expenditure per student increased at cumulative rates of 39 per cent, 36 per cent and 12 per cent at primary, secondary and tertiary level respectively. Take health, where current spending rose by a cumulative 78 per cent in the five years leading to the peak of the boom (compared with a 45 per cent increase in money GDP) and numbers employed increased by more than 15 per cent.

Or consider income tax, where cuts totalling €3.2 billion (the greater part of which was accounted for by increases in tax credits) were made in the budgets of 2003 through 2007.

The point is that these gains were financed by the boom time surge in tax receipts that has since receded, and that a substantial portion of them will have to be given up if the current crisis of the public finances is to be resolved.

There is plenty of room for legitimate debate about which gains should be rolled back and by how much, and those affected have an undeniable right to protest. But let's not start the debate and foment the protests with denials that the boom yielded widespread benefits.