Instead of a stimulus package we have gone in the other direction. It could be the worst own goal in our history

 

ECONOMICS OPINION:WHEN AN economy goes into recession, its government gets less revenue from VAT and income tax, and has to spend more on unemployment benefits; the public finance deficit widens automatically, writes MICHAEL CASEY

Sometimes a government may decide to "let the deficit ride" and borrow money to bridge the gap. Our Government has decided not to do this, but to reduce the deficit as much as it can - by about €5 billion in 2009 and by about the same in each of the next two years. The target is to get the deficit below 3 per cent of GDP by 2013, in line with EU guidelines.

This means raising taxes and cutting expenditure over a long period, and runs the risk of deepening the recession. Higher taxes will hurt consumption, investment and work effort. Lower spending will mean less demand and perhaps less essential infrastructure.

The fact that the "stabilisation" will continue for three or more years means people may hoard. Household incomes - already reduced - will be budgeted carefully, not just to pay this year's higher taxes and levies but also in anticipation of new carbon, property, and other taxes in the pipeline. People also have to allow for the fact that they may not have a job next year.

It is hard to overestimate the fear factor. It seems unlikely that non-essential consumer spending will pick up soon. It doesn't matter much if our consumption of imported goods falls, but falling demand for domestically produced goods will mean more job losses and bankruptcies.

Instead of a stimulus package - which other countries have introduced - we have gone in the other direction. It could prove to be the worst own goal in our history. If the Government's top priority of "stabilising the public finances" does extinguish the last spark in the economy, all bets are off. It might not even succeed in reducing the deficit. If economic activity falls further, so will revenue, and the Government will find itself chasing a target from which it is constantly moving away.

But why would the Government take such a huge risk? There are several reasons.

First, it is claimed that it would be difficult and expensive to borrow abroad. Second, if we are not seen to take some pain, our international reputation will suffer. Third, we need to widen the tax base. Fourth, we have to be seen to respect EU guidelines. Losing Lisbon was embarrassing enough - in a doomsday scenario, we may need the EU to bail us out.

Fifth, we may yet need to borrow to bail out the banks; we don't want to exhaust our borrowing capacity too soon. Sixth, the period of fiscal stabilisation that occurred in the late 1980s did not slow down the economy.

Most of these reasons are valid, but not en-tirely compelling. They are mainly assertions without much research support. For example, the last fiscal stabilisation in the late 1980s was successful for a variety of reasons - reasons that no longer exist. The international economy was growing well; there was no problem with banks, no credit crunch and no fear factor arising from deep recession and job losses.

Today we are in uncharted waters. Let's hope fiscal stabilisation does not depress the economy further, but if it does we should be in a position to reverse engines, at least in terms of taxation. This might sound dramatic, but it could become necessary if people are on the brink of losing all confidence. We could be facing an L-shaped recession - the worst kind.

Evidence from the IMF and World Bank indicates that the majority of countries fail to complete three-year stabilisations; the pain and civil unrest almost invariably throws the programmes off track. In the few cases where programmes have been successful, the governments involved have been able to convince people that there is light at the end of the tunnel. In Ireland, the absence of a plan is regrettable.

It is interesting to note that one trade union leader referred to the reduction in mortgage interest relief as "the last straw". Actually, it is only the first straw; the boom years may have made us incapable of making any sacrifice.

The essential point is that, when there is uncertainty about the effects of fiscal policy on the economy, there should be a contingency plan.

If tax increases were seen to be driving the economy into the ground, they should be abandoned. The Government could cut unproductive spending, sell assets and borrow more.

Substantial amounts could be raised domestically. In this regard, there is an extraordinary irony. When our banks were losing deposits just before the announcement of the deposit guarantee, where was most of the money going? Into An Post. In other words, the Irish community was directly lending to the Government in vast amounts. So what did the Government do? By guaranteeing the banks it put a stop to the kind of funding it so badly needed.

By bailing out the banks, the Government stopped a large flow of domestic funds into its own coffers. The point is that there is considerable scope for the Government to borrow on the domestic market, if it offered reasonable terms. Some years ago there were Government bonds that were exempt from inheritance tax; they hoovered up a lot of money from the domestic market.

Huge risks are being taken with the economy on the basis of inadequate research. If the risks do not pay off, policies will have to be quickly changed.

In the mid-1950s there was a fiscal stabilisation that lasted only a year. The economy nose-dived. But it led to the momentous First Programme for Economic Expansion - a plan that gave hope and a feeling that someone was minding the store. What are the chances of that kind of enlightened follow-up this time?