How Ireland can stage an economic recovery

 

ANALYSIS:After months of unrelenting bad news, no one can be in any doubt as to the depth of the economic crisis facing the country. The issue now is what should be done about it? The Government is seeking savings of €2 billion from public expenditure and has begun outlining a range of options to the social partners. Negotiations have started, if battle has not yet been joined. ‘The Irish Times’ has asked a number of our leading economists to explore how, and where, spending might be cut, and how, beyond cutting, the economy might be turned around. Their ideas will be published throughout next week. Here, in this first article, John FitzGeraldexplores the component parts of the problem and some possible areas where action might be taken

WITH UNPLEASANT surprises coming every day since the autumn, it was probably difficult for the Government to develop a coherent strategy.

However, the key tasks facing Ireland have not changed over the last few months: restoring order to the banking system, to the public finances and returning the labour market to full employment through improving competitiveness.

What has changed is that the mountain to be climbed has grown and it is now more than time to develop a strategy for recovery. Of necessity any strategy must also deal with the massive uncertainty concerning the timing of a world economic recovery.

The latest “surprise” is the likely fall in the price level this year, which has not been taken on board by policymakers and citizens alike. On the basis of the December figures, the consumer price index for 2009 is likely to fall by at least 3 per cent, possibly by 5 per cent or more.

A major factor in this turnaround is the fall in sterling. While its immediate impact was a scramble to shop across the Border, we can be certain that that is being replaced by Irish retailers flocking to renegotiate the euro prices paid to suppliers in the UK.

This will result in a fall in prices in shops as the year progresses, which will be superimposed on the fall in energy prices, falling interest payments and plummeting rents.

Those whose wages or welfare payments are fixed or rising will, as a result, be much better off this year, provided that they do not lose their jobs. This improvement in living standards will be in stark contrast to the 9 per cent fall in output per head since 2007, returning us to the output level of 2005.

In the private sector the fall in the price level is beginning to translate into a fall in nominal wage rates in businesses. In the short term this fall in prices means tax revenue will be even lower than expected. However, in the medium term, lower wage rates will substantially improve competitiveness. This will be the key to the restoration of full employment, also helping to restore order to the public finances. The collapse in the building sector requires a major refocusing of the economy. When the economy recovers the new jobs will be in businesses supplying the world market, not in construction. In December the Government outlined its “Smart economy” programme designed to improve productivity in the longer term.

What Ireland needs now is a strategy for digging ourselves out of our current hole and restoring normal growth. Here I suggest an a la carte menu of policy measures open to the Government and other policymakers. However, as I discuss later, a plethora of initiatives does not necessarily add up to a strategy. In this article I am not attempting to second guess the likely outcome of the Government’s deliberations or, at this stage, to suggest what I feel would be the best solution.

THE MOST urgent task facing the Government is to restore order to the domestic banking system. Whether this can best be done by recapitalisation or whether further nationalisations are required is being actively discussed. What is essential is that convincing action is taken quickly.

For Ireland it is vital that action is taken to boost the euro economy to complement that being taken in the US. Some debate has taken place on whether a fiscal stimulus would be appropriate in Ireland. However, the crisis in the Irish public finances means that it is not feasible or desirable to do so. Nonetheless, the surprise fall in prices means that the 2009 budget, unless amended, will end up pumping money into the economy, money the Government does not have.

What are the options for the Government in seeking to cut expenditure this year by around €2 billion?

One widely suggested option is a cut in public service pay rates. Other variants of this proposal would involve the freezing of increments or a contribution towards pension costs. These options would have a similar economic impact, preserving employment and related services in the public sector, but cutting the cost of these services. If the cut in public sector pay rates mirrored cuts in private sector wage rates there would be a very significant gain in competitiveness, with a consequential big reduction in unemployment after three or four years. The beneficial effects on Government borrowing would eventually also be substantial.

Another key option would be to make substantial numbers of public sector employees redundant, either directly or by closing agencies. There is considerable scope for efficiency gains involving reduced staffing in the public sector; the question is how quickly these can be identified and acted upon. This option would undoubtedly cut borrowing.

If the cuts in numbers could be achieved without affecting services, or if the services being provided were redundant, this could contribute to improving the long-term competitiveness of the economy. However, if, as in the 1980s, many of those fired (eg teachers or nurses) are to be rehired in a few years time, this could be very wasteful. Generally public sector redundancy programmes attract the most marketable employees and the schemes themselves are very expensive. The same problem of high cost applies to early retirement schemes.

This year welfare rates have risen by 3 per cent. With a fall in prices of at least 3 per cent this represents a dramatic rise in the real value of welfare payments. Can Ireland afford such an increase this year and what are the implications for poverty traps? Without doing an “Ernest Blythe” and taking a shilling off the old age pension, what could the Government do this year and in the budget for 2010 to reduce costs?

There is general agreement that Ireland needs to improve its infrastructure, including its investment in human capital and RD (research and development). However, the recession means that some significant infrastructural projects could be delayed a year or two without a major impact on the economy’s productive potential. Already the second runway at Dublin has been postponed.

Also, the National Development Plan was gold-plated and there are projects, which never stood up to critical assessment that could be cancelled. The fall in the cost of land and building should see a dramatic fall in the cost of delivering the essential infrastructure. Savings of 10 per cent or more should be attainable from price falls.

Beginning with the possible recovery of the economy some time in 2010, the Government will have to choose between further cuts in employment and public services or raising taxes. Philip Lane and others have argued in this newspaper that Ireland’s public services are not over generous; it is our tax system that is exceptional in its limited coverage and even more limited yield. If the Government shared this view it would mean that there should be a substantial increase in taxes over the next five years once economic recovery has begun.

All taxes have negative repercussions on output and employment. The question is what taxes will do the least damage, while raising serious revenue and also what taxes will prove least unpopular? The Second Commission on Taxation will report in the summer. Among the options for reform is an expansion of the numbers paying income tax and an increase in rates for those on high incomes, including the possible abolition of the social insurance threshold.

The tax base could be expanded by following the last taxation commission’s recommendations and abolishing tax expenditures. A widening of the tax base by the imposition of a carbon tax and a property tax has attractions in that they would have least effect on the cost of working. The end result of whatever reforms are undertaken is likely to be a substantial increase in the tax burden.

The other policy implications of the recession need to be addressed. The focus of labour market policies needs to be reconsidered.

We need to adopt policies that ensure that those becoming unemployed eventually find good jobs rather than swelling the numbers of long-term unemployed.

Possible obstacles to preserving jobs arising from the minimum wage may be considered. A consistent policy on how the welfare system deals with those becoming unemployed with substantial mortgages merits attention.

In this article I have set out a range of different weapons the Government could use to tackle our current problems.

A mixture of bank restructuring, tax increases, expenditure cuts and lower wage rates constitutes a very unpleasant cocktail, not a strategy. What we need to know is how the very unpleasant medicine will get Ireland back to stable growth.

We need reassurance that the burden of adjustment will be shared fairly, not just by the unemployed and that the unemployed will find new jobs within a reasonable timescale.

John FitzGerald works for the Economic and Social Research Institute and is responsible for its research into macroeconomics and energy policy