Ireland's stability may be threatened by the fiscal rules

Since the Stability and Growth Pact rules were agreed in 1997, the EU has had a fiscal framework designed to prevent governments making unwise budgetary decisions. These rules were ignored by France and Germany initially, and then revised in the light of the experience of the great recession.

However, for the Republic, and now possibly for Germany, the inadequacy of the rules-based approach may actually provide cover for dangerous pro-cyclical fiscal policy. Ireland might be better off without these particular rules, relying instead on the wisdom of ministers for finance, overseen by a critical media.

In the period 2004 to 2007, Irish fiscal policy fully complied with the rules, but it was pro-cyclical, making a major contribution to the growing bubble that subsequently wreaked so much havoc.

However, when the Economic and Social Research Institute suggested to the International Monetary Fund and the European Commission that they should give Ireland a "speeding ticket", they couldn't do so, because Ireland was not breaking the rules. More economic wisdom, and less attention to rules would have produced a better outcome.

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Today the presence of fiscal rules may also accommodate inappropriate stimulatory fiscal policy in both Ireland and Germany. Political pressures may see caution forgotten and policies being pursued in both countries which may raise economic dangers.

Last decade

Over the last decade, the Irish and German economies were generally on a very different track. As a result, the appropriate fiscal policy for each was very different. However, today these two economies face the same sorts of challenges, and the correct fiscal policy today for Ireland and Germany would look rather similar.

While the collapse in world demand in 2008 and 2009 saw a major fall in output in Germany in 2009, rapid growth in the following two years restored its output to its pre-crisis level. The problems of the German economy in 2009 and 2010 pale into insignificance when compared to the problems faced by other EU states, especially Ireland. However, a consequence of that temporary economic setback was a German government deficit of over 4 per cent of gross domestic product in 2010.

Based on a German fiscal “rule” of no deficits, the response of the German government in 2011 was to dramatically tighten fiscal policy. They reduced the government deficit from over 4 per cent of GDP in 2010 to under 1 per cent in 2011. While this was an exceptional pace of adjustment, nonetheless the German economy grew that year.

The pain of the crisis could have been greatly eased for all EU members

While even for the German economy the policy of fiscal retrenchment in the face of an output collapse was inappropriate, for the rest of the EU it was extremely serious.

What the EU needed at that time was a substantial fiscal stimulus. With countries such as Ireland, Spain, and Italy in no position to provide such a stimulus because of soaring debts, Europe needed those countries which were not facing a funding crisis to stimulate rather than contract their economies.

If that had happened over the period 2010-2014, the pain of the crisis would have been greatly eased for all EU members.

Capacity constraints

Today the EU economy is growing rapidly and a German stimulus is not required. While for many EU economies there is room for substantial further growth without running into capacity constraints, in both Ireland and Germany there is a need to put on the fiscal brakes. In both countries the property sector is showing signs of excess demand and an increase in taxation is warranted. However, for both Ireland and Germany, a fiscal stimulus in 2019, while very unwise, would be within the fiscal rules.

In the case of Germany, the new government is committed to fiscal changes which will add to demand, while still leaving the government in surplus. In the Irish case, while the Minister for Finance has signalled a need to tighten fiscal policy, the Oireachtas may not share his wisdom, and the Government is dependent on the confidence and supply agreement to get the next budget through.

Because inflation is substantially below target, interest rates will remain low next year. With such a stimulatory monetary policy, in the absence of any fiscal tightening, both the German and the Irish economies run the risk of seeing dangerous domestic bubbles beginning to grow in 2019 and beyond. In the German case the danger is currently less acute, but in the Irish case the continuing exceptional growth suggests that the economy will hit full employment next year, and that action will be needed in the 2019 budget to slow the economy.