Far greater co-operation may be cure for our crisis

 

ANALYSIS:A commitment to economic stimulus and co-operative policymaking must be made a priority, writes JOHN McHALE

FUTURE HISTORIANS looking back over the sweep of Irish economic growth are likely to stare at the numbers for 2009 with astonishment. Between 1950 and the current recession, there were only three years of outright real gross domestic product (GDP) decline: 1956 (1.2 per cent), 1958 (2.2 per cent), and 1983 (0.2 per cent). The International Monetary Fun (IMF) projects Irish real GDP will fall by 8.5 per cent this year alone.

Late in the 1950s and the 1980s, the governments of the day faced down vested interests to forge a new policy consensus. They also managed to break through cycles of self-fulfilling pessimism.

It is distressing to see we now appear bent on the opposite course, with mechanisms for nationally focused co-operation breaking down just when most needed to avoid a self-defeating battle over shares of a shrinking economic pie.

With investor confidence in the Irish economy slipping fast last year, the Government had no alternative but to begin a large fiscal adjustment. Combining the measures taken since summer 2008, the discretionary deficit-cutting measures have amounted to 5 per cent of GDP.

And there is much more to come. In April, the Government announced its intention to shrink the deficit by €16.4 billion by 2013, with a significant start coming in the December budget. The recession-deepening effects of this adjustment look set to be made worse by deteriorating industrial relations.

It is not too early to start thinking about whether a less contractionary course is feasible as part of a more co-operative response to the crisis. In considering the policy options, it is worth keeping in mind the international evidence and Ireland’s own experience with economic turnarounds.

A number of lessons stand out. One critical lesson is that (current) expenditure-based adjustments have tended to be less contractionary than adjustments based on tax rises and capital programme cuts. They have also enhanced credibility in the Government’s capacity to stick with the adjustment for the long haul.

While cutting expenditure will be hugely painful, this form of adjustment could allow a more gradual stabilisation effort overall. This may be as close as Ireland can come to real economic “stimulus” in the current circumstances.

A second lesson is that actual real wage demands will be brought into line one way or another when there is a fall in the level of real wages the economy can pay given its productivity and available external financing.

The most painful – and wasteful – mechanism for bringing wages into line is higher unemployment. High unemployment makes private-sector workers fearful of losing their jobs and puts a fiscal squeeze on public-sector pay. A more centralised system of wage determination allows the implications of unaffordable wage demands for unemployment to be taken into account more directly. The result is that rising unemployment does not have to do all the work of achieving consistent claims on national output.

Ireland’s social partnership model of tax relief in return for wage restraint served the economy well during the post-1987 adjustment. While it seems to have gone off course in recent years, becoming primarily a mechanism for raising public-sector pay, it would be much better to re-embrace the successful phase than to abandon partnership when it is most required.

Finally, recent international crises – Japan’s “Lost Decade”, Mexico’s “Tequila” crisis, the Asian crisis, among others – show that unhealthy balance sheets and cash flows in the banking, business and household sectors are a huge drag on economic activity.

On the other hand, apparently minor improvements in conditions have sometimes produced phoenix miracles, as countries have rebounded surprisingly quickly from output collapses. While attention has rightly focused on restoring the health of the banks, more attention needs to be put on improving the finances of businesses and households.

As outlined in the macroeconomic and fiscal framework accompanying April’s supplementary budget, the Government plans a cut of €4.8 billion in the (full-year) deficit for 2010, followed by a €4.6 billion cut in 2011.

Some 51 per cent of the proposed adjustment is to come in the form of tax increases, primarily through broadening the tax base. These adjustments are to be followed by (as yet unallocated) cuts of €4 billion in 2012 and €3 billion in 2013.

My reading of the international evidence and Ireland’s own experience is that confidence could be maintained with a less contractionary, though still painful, policy course.

This alternative policy has four main elements.

First, pursue a comprehensive implementation of the recommendations of the McCarthy report over a two-year time frame. The total package of cuts promises to save €5.3 billion.

While one can reasonably argue over the details of McCarthy’s proposed cuts – and indeed each affected interest group has reacted angrily – the report does provide a useful focal point for shared sacrifice. The sum is more than the parts. It offers a chance to break through the political log-jam of vetoes from individual interest groups. Importantly, the front-loading of expenditure reduction should bring a credibility bonus that allows a more gradual and more stimulative policy package overall.

Second, the McCarthy cuts are supplemented by a 5 per cent cut in public sector pay phased in over a two-year time frame. This would save roughly an additional €0.7 billion. It would be part of a balanced reduction in wages and benefits in the economy, achieved through a renewed social partnership agreement.

Third, as part of the quid pro quo of a renewed agreement, there is a significant roll-back of the income and health levies. These levies have brought the marginal tax rates facing many workers to over 50 per cent. The Government was correct to put the burden on the better-off in the first phase of the adjustment. But continued increases in marginal tax rates will damage incentives and hold back growth.

The tax-cutting package should also include temporary reductions in employer PRSI to the extent affordable. International evidence shows that even small improvements in business cash flow could pay significant dividends in seeding the turnaround.

The total reduction in taxes for 2010 could be as large as €3 billion. The €4.6 billion in tax-base-broadening measures committed to in the April budget in anticipation of the Report of the Commission on Taxation are phased in, starting in 2012.

Fourth, proposed cuts in capital expenditure (€0.8 billion and €1 billion in 2010 and 2011 respectively) are delayed by two years. Cutting capital expenditure as the economy falls into a deep recession just continues the pattern of pro-cyclical fiscal policy.

Overall, the credibility bonus from the combination of an expenditure-based adjustment and renewed social partnership should allow the Government’s total proposed adjustment of €16.4 billion to be complete by 2015 rather than 2013. Even more importantly, under this illustrative alternative plan, the adjustment for 2010 would go from a contraction of €4.8 billion to a neutral budget.

From there, the path would be difficult, with deficit cuts of €3 billion, €4.5 billion, €4.4 billion, €2.8 billion, and €2 billion over the following five years. (This includes the additional unallocated cuts of €7 billion projected in the April budget.)

Together with the tentative signs of an international turnaround, this more stimulative policy would support a recovery in demand, cash flow and confidence.

Is this alternative something the social partners could realistically sign on to? While I am not under any illusions about how difficult some of the elements would be to swallow, the commitment to stimulus and the re-establishment of co-operative policymaking could provide the necessary compensations.

The present path of rising unemployment and diminished policy influence must be a less attractive option.

John McHale is established professor of economics at NUI, Galway. This article draws from his presentation at the Merriman Summer School’s symposium, Economy: Prospects and Possibilities

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