State must revise fiscal strategy immediately to avert disaster
OPINION:An agile and swift response is required by Government to restore health to the economy and banking sector, writes PETER SUTHERLAND
IRELAND FACES three intertwined crises. First, the economic crisis is severe, with falling output and sharply increasing level of unemployment a source of misery for many workers and their families.
Second, the banking crisis sees the Irish banking system facing large projected losses on ill-advised domestic property loans, with the capital squeeze contributing to a credit crunch.
Third, the projected Government deficits for 2009-2010 are well above 10 per cent of gross domestic product (GDP), raising questions about the sustainability of public finances. I could add a fourth, and not unrelated topic, the ratification of the Lisbon Treaty, but I leave comment on that for another occasion.
While the economic and banking crises are very troubling, these problems are shared to varying degrees by many countries across Europe and around the world. In addition, the scope of the banking crisis is by now well understood, with an emerging consensus on the scale of potential losses. And the Government’s strategy for handling the banking crisis is well-advanced, even if it is still to evolve in the coming months.
Rather, the key differentiating factor that has put the international spotlight on Ireland is the sustainability of the public finances. Although the European Commission has launched excessive deficit procedures against six member countries, Ireland’s projected 2009 deficit of 11 per cent of GDP far exceeds the next highest in this group (Spain at 6.2 per cent of GDP). Its projected 2010 deficit of 13 per cent of GDP is more than twice the next highest (Spain at 5.7 per cent of GDP). This has created a terrible crisis for Ireland.
Concerns about the fiscal situation are reinforced by the patterns in public spending and taxation since the crisis began. While much attention has focused on the decline in tax revenues, this is comparatively minor relative to the sharp growth in the ratio of public spending to GDP.
Again the comparison with Spain is most telling. Tax revenues actually fell more sharply in Spain than in Ireland between 2007 and 2009: from 41 per cent of GDP to 36.4 per cent of GDP in the Spanish case, versus a decline from 35.7 per cent of GDP to 33.7 percent of GDP in the Irish case. In contrast, government spending has increased from 35.7 per cent of GDP to 44.7 per cent of GDP in Ireland, but only from 38.8 per cent of GDP to 42.6 per cent of GDP in Spain. While the difference can, in part, be attributed to the sharper output contraction in Ireland, it has raised concerns about the scale of the fiscal problem.
The Government has made some progress in responding to the fiscal crisis, including the measures taken in the October 2008 budget, the attainment of agreement with the social partners as to the broad mix of policies required and the implementation of the public sector pension levy. However, the deterioration in the international financial environment in recent weeks means the gradual adjustment process it set out in the five-year fiscal strategy published in the middle of January is no longer appropriate.
In particular, there is increasing concern that the withdrawal of capital from central and eastern Europe could trigger major crises in the new member states of the European Union, which in turn could be quickly transmitted to other European economies. Among the western European economies, those that are most vulnerable include Ireland, Greece, Austria, Portugal and Spain.
Such concerns are placing upward pressure on the spreads these governments must pay to issue bonds, and increase the risk of a funding crisis, by which investors refuse to rollover maturing debt. In turn, the high spread on Irish sovereign debt raises funding costs for the banking system and for corporations, contributing to the economic slowdown and the problems in the banking sector.
At one level, it might seem far-fetched to believe Ireland may face a funding crisis. After all, Ireland entered this crisis with a low level of public debt, plus sizeable sovereign wealth in the form of the National Pension Reserve Fund. However, the very large Government deficits mean the ratio of debt to GDP is set to grow quickly: from 24.8 per cent of GDP at the end of 2007 to 68.2 per cent by the end of 2010.
More importantly, the high level of risk aversion in the international markets means many investors are unwilling to give debtors the benefit of the doubt and promises of future fiscal corrections are being heavily discounted. Moreover, the funding risk for the Irish Government is amplified by its guarantee of the liabilities of the covered banks. While even the higher end of the projected scale of losses for the banking system does not pose a threat to the solvency of the Irish Government, a substantial decline in deposits in the banking system would increase funding pressures on it.
In this fragile environment, it is imperative the Government revises its fiscal strategy within a very short time horizon. In particular, it needs to front-load the correction in the public finances, with more action taken to reduce the 2009 and 2010 budget deficits.
In line with the broad consensus across the social partners, this must include a significant increase in the tax burden. This cannot wait until the 2010 budget, as is the current wish of the Government. While the Commission on Taxation may well have good ideas for expanding the tax base, much of the adjustment involves the existing set of tax instruments, and the process of reducing tax bands and increasing tax rates can begin immediately.
The fiscal adjustment also requires that the Government move more aggressively to curb public spending. While the focus has been on current spending (and there is much to be done across the many different lines within that category), it is also time to suspend many of the larger-ticket items in the public capital programme. The priority must be to improve the financial position of the State – those public capital projects that promise high benefit/cost ratios can be restarted once fiscal stability has been restored, while a suspension also allows less worthy projects to be weeded out.
Since the upward pressure on interest rates means that the currently loose fiscal policy is not helping the recovery in the economy or in the banking sector, a fiscal retrenchment now in fact is the best move open to the Government in restoring health to the economy and banking sector. A decline in spreads will improve asset values and enable the banks to increase the provision of credit. Such factors dominate any loss in domestic demand that would be induced by a mix of higher taxes and lower spending. Moreover, domestic consumption is more likely to be boosted by increased confidence in fiscal stability than by the current situation, whereby any putative benefits from delayed fiscal adjustment are being swept away by the cloud of uncertainty dominating the economy.
If the Government responds in an agile and confident manner to the current crisis, the medium-term future for the Irish economy remains bright. However, an important characteristic of successful government is knowing when to act quickly in defence of its fiscal reputation. Now is such a time.
We must have an urgent response to the crisis notwithstanding the difficult background of likely public disquiet about any measures proposed. The alternatives are not pleasant to contemplate.