Recovery strategy needs to integrate investment focus


ECONOMICS:An upsurge in consumer confidence and domestic demand is needed for a faster recovery from recession

IN HIS recent speech to the Institute of Taxation, Brian Lenihan reiterated the three Rs of the Government’s macroeconomic recovery strategy: restore order to the public finances; repair the balance sheets of the banks; and regain competitiveness.

But the most interesting part was the addition of a fourth element: investment to create new jobs. A faster recovery is possible if this new element is more than just a hodgepodge of cheap measures introduced for political cover. If the Minister really means it, the next phase of the recovery strategy should integrate this investment focus with the core fiscal, banking and competitiveness plans.

It is important to emphasise the central role that domestic demand has played in Ireland’s output and employment collapse. Although recession in our trading partners has been a drag on growth, the outstanding fact of Ireland’s recession has been the huge drop in spending by Irish businesses and households.

The ESRI estimates that real investment spending fell by 30 per cent in 2009, with a further fall of 17 per cent projected for 2010. Consumer spending held up better, but the numbers are still dismal: a 7 per cent fall in 2009 with a further marginal decline projected for this year. Consumer confidence fell back again in February. A durable recovery strategy must have a plan for the recovery of domestic demand.

The Government deserves admiration for sustaining the creditworthiness of the State in very difficult circumstances, even if the self-congratulation following Greece’s woes was overdone. The shift to focusing on expenditure over tax adjustments, despite political costs in the December budget, also showed a willingness to learn from international lessons.

However, the international evidence points also to a crucial difference between the effects of current and capital spending cuts. Cuts in public payroll and social welfare signal control over the public finances, in part because they are so politically difficult, and also because they have a permanent impact on the budget.

Quietly shelfing capital spending plans does not signal the same political courage. Moreover, capital projects are inherently temporary and build the growth, and ultimately, the debt-repayment potential of the economy. Not all expenditure cuts are equal. In continuing to curb the capital programme – in his speech the Minister announced plans for a further €1 billion cut for 2011 – a chance is being missed to fund the human and physical infrastructure for the next phase of Ireland’s development. Of course, any new capital spending must be subject to rigorous cost-benefit analysis. But this analysis must recognise the significant slack in the economy. This recession has lowered investment costs and raised investment multipliers. With this slack, the case for capital spending is stronger today than it was five years ago, and (hopefully) stronger than it will be five years from now.

We should not compound the mistakes of a history of pro-cyclical fiscal policy by cutting capital spending just when it makes most sense.

Unfortunately, with the continued precariousness of the fiscal position, an ambitious investment programme would likely mean even larger required cuts in current spending. Although nominal current spending did take a significant hit last year, ESRI analysis shows that the adjustment in 2009 fell disproportionately on the capital side once allowance is made for deflation. The current spending changes announced in the 2010 budget will actually provide inflation-adjusted stimulus this year, even as capital spending is cut deeply again.

The second pillar of the recovery strategy is to repair the banking system. The focus to date has been overwhelmingly on lenders. But while repairing the balance sheets of the banks has received most of the attention, it is clear that the collapse in new credit flows is also due to the deterioration in the balance sheets and cash flows of potential borrowers. The demand for credit (and creditworthiness) of many of these borrowers is affected by weak market conditions. Supporting domestic demand in a fiscally sustainable way is thus a complement to shoring up the banks.

The final element in the original triumvirate is to restore competitiveness. With the (tentative) recovery of our trading partners, the expectation is that improved cost competitiveness will allow Irish businesses to win market share and drive export-led growth. Although I am sure the Minister would not put it this way, the policy has been one of “opportunistic deflation”, whereby unemployment induced by falling domestic demand is reluctantly tolerated as a means of lowering relative costs.

While restoring competitiveness is essential, Government strategists may have undersold the risk and oversold the benefit of deflation. The risk relates to the unpredictable dynamics of declining domestic demand. These dynamics include negative feedback loops through deteriorating balance sheets, incomes and cash flows. It is not hard to see these adverse dynamics in the decimation of some retail sectors. The benefit of deflation is that it improves the relative cost position of Irish firms on international markets. However, exports and export-related employment are dominated by foreign-owned firms. An important recent paper by Frank Barry and Adele Bergin documents that foreign-owned firms have been a significant stabilising force during the recession despite an accumulated loss of cost competitiveness in the years leading up to the crisis.

Barry and Bergin also point out that cost competitiveness is only one factor affecting Ireland’s attractiveness for multinational firms. As underlined by the IDA this week, other elements such as the corporate tax regime and access to an appropriately skilled workforce, are, if anything, more important.

The response of foreign-owned exporting firms to improved cost competitiveness may thus disappoint. This again suggests the importance of well-targeted investment strategy that supports domestic demand in the short run and underpins productivity in the long run.

Prof John McHale is professor and head of economics at the J E Cairnes School of Business and Economics, NUI Galway