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Government must hold its nerve on borrowing as it reboots economy

Merits of appeals from businesses for funds will need to be scrutinised closely

With Ireland’s success to date in bringing the outbreak of infection down to a low level, and the rapid bounce-back in economic activity now in progress, an optimistic tone has begun to emerge in some commentary. Nevertheless, and despite the potential for some good news on vaccines and treatment, most forecasts do not predict a return to last year’s level of employment and aggregate income before 2023.

The large defensive spending measures that have already been undertaken by government to meet the jump in healthcare costs, to subsidise wages and to provide financial support to those who lost jobs, will have to continue for some time. In addition, the new Government will soon have to embark on a second wave of spending to support recovery and repositioning of the economy, with an announcement due shortly as part of what is being called the July stimulus.

As in most other countries, the Government has chosen to finance all of this spending through borrowing, without trying to seek more tax from those whose incomes have not been cut by the pandemic.

This means an unprecedented jump in public debt. But there should be no loss of nerve in fully deploying the State’s financial strength – so recently restored – to ensure that economic recovery is complete and broadly based.

It is the very low interest rates currently prevailing, not only for Irish government borrowing, but across the board, that make borrowing on such a scale conceivable. Some of the credit for low interest rates is rightly attributed to the European Central Bank, but world real interest rates have been on a downward trend for almost four decades. This is mainly due to high savings coming from demographic forces, and from rising inequality and other structural features in some of the largest economies.

Interest cost

Ireland's debt ratio jumped higher in the financial crisis than ever before, but the interest cost of servicing that debt did not increase in proportion. This reflected both the lower euro area interest rate and the EU-IMF loans which protected Ireland from much of the default-risk premium being demanded by the financial markets. In 2019 only one euro in every 12 collected in income tax was needed to service the debt – compared with one in three back in the 1980s.

It is vital that the scale of borrowing now being faced is managed in such a way that a risk premium does not re-emerge. The key here is distinguishing between measures that lock in long-term future spending commitments, and those which are once-for-all and will not persist after the pandemic crisis is over. Both defensive and recovery measures can be in the latter category. Given the low interest rates, even large amounts of borrowing need not cause a problem if they are clearly for one time only.

Not all spending is worthwhile in the public interest, though, even in the defensive and recovery stages. Temporary wage subsidies for affected firms have helped avoid destructive and socially costly bankruptcies, as have debt moratoriums. For potentially viable and well-behaved firms, more may be needed. But in providing such assistance through loan guarantees or otherwise, the State should try to ensure that it has built in a way of sharing in the profitability of firms that end up recovering more strongly than expected.

And public funds should not be wasted in financial assistance to firms that have no realistic post-pandemic business model; such payments will end up benefiting creditors and landlords rather than the firms themselves. The merits of appeals from business will need to be scrutinised closely.

Looking to the future, the new Government will rightly want to reposition the economy in a number of ways ranging from mitigating global warming to lowering inequality and reducing the precarious nature of income for the low paid. Some of these may entail permanent increases in public spending; some likely entail tax changes, including an increase in carbon tax.

The old rule of thumb that permanent spending increases should be matched by permanent sources of additional tax revenue remains valid – at least for a small country determined to maintain its credit rating and financial stability.

Quantification

In what will be a challenging time of change and experiment in public financial policy, there are many pitfalls that require careful attention through quantification and analysis. Many features of the Irish economy are unusual and some are poorly measured. It is well-known that GDP, the most widely used international measure of economic activity, is worse than useless as an indicator in Ireland; it misleadingly suggests a level of prosperity much higher than is really the case.

The fact that prices in Ireland are relatively high is also rarely taken into account in international comparisons. Data (recently published by the World Bank) that does take account of price differences places Ireland as low as 25th in the world by consumption per head – a salutary corrective, with lessons for public policy.

Conventional macroeconomic statistics failed to warn of the build-up of dangerous imbalances in the years before the financial crisis, not only in the property market and the banks but also in tax revenue. Indeed, thanks to the boom in tax payments by multinational corporations, something similar may be happening now. Corporation tax and various capital-related taxes accounted for 21 per cent of total tax revenue in 2019 – exactly the same share as in 2007. Just as the growth in this element was not predicted five years ago, a sudden decline cannot be ruled out.

Ireland can afford the fiscal measures necessary to reposition the economy, but the task will require care and skill.