Swift fiscal adjustments could hasten recovery
ANALYSIS:LAST WEEK’s European summit has sharply changed the external financial environment facing the Irish Government, and it is timely to consider the macroeconomic strategy in the light of the new situation.
Over the last eight months, the most pressing challenge has been to restructure and recapitalise the Irish banking sector. Through the Prudential Capital Assessment Review processes that concluded at the end of March, new capital requirements were imposed on the Irish banks, together with commitments to shrink the size of their balance sheets through deleveraging programmes over the 2011-2013 period.
The banking system is going through a reorganisation process around the two pillar banks, with Anglo Irish and Irish Nationwide in shutdown mode. The extra capital required by the system is being partly financed through new private-sector investment in Bank of Ireland and aggressive writedowns of subordinated debt, with the taxpayer acting as the major source of funds. The recapitalisation process should be completed soon, with a target of the end of July.
However, the vitality of the banking system ultimately rests on the fiscal health of the Government. Accordingly, the main challenge now facing the Government is to restore Ireland to long-term fiscal sustainability.
The new European bailout framework provides important benefits to Ireland. An interest rate of about 3.5 per cent on funds from the European Financial Stability Facility is much more conducive to fiscal sustainability than the previous deal. The lower cost of official funds relative to the market interest rates faced by countries such as Italy and Spain means policy conditionality is bound to be even stricter on programme countries, to make sure the duration of official support is no longer than strictly necessary.
The burden sharing with private investors in sovereign debt that is a feature of the new Greek deal means it will be more difficult for Ireland to re-enter the private market until it has much more sharply proven the sustainability of its fiscal position, with the “safe” level of public debt lower than before.
Finally, the assurance of ongoing official support means the negative feedback loop between the market perception of the sovereign position and the funding position of the banking system is somewhat attenuated.
For these reasons, the optimal response for Ireland is to move more quickly on fiscal adjustment. One step is that savings from lower debt-servicing should be committed to lowering the fiscal deficit, rather than seeking to increase spending or cut taxes.
In terms of the non-interest component of the fiscal balance, Ireland should increase the pace of consolidation. In particular, the cumulative €15 billion target that was agreed last November reflected the environment Ireland faced at that time.
First, the relatively benign market conditions for non-crisis countries suggested Ireland could soon return to private funding, even at a high level of public debt. Second, there was a high degree of uncertainty about the prospective level of losses in the banking system and the potential for growing Ireland’s gross domestic product (GDP). While the projected bank losses are horrendous and the domestic component of GDP continues to shrink, the bank stress test showed the likely range of losses for the banks was not as severe as envisaged last November, and the extreme downside risks to GDP have not materialised.
While the ongoing risk profile continues to justify a gradualist approach to fiscal adjustment, the reduction in uncertainty and the altered European financial environment calls for a partial shift in fiscal strategy.
In terms of near-term fiscal policy, the target is a €3.6 billion discretionary adjustment in the 2012 budget, corresponding to 2.3 per cent of projected 2011 GDP. A revised target of €4.4 billion would correspond to 3.0 per cent of GDP – a large enough difference to demonstrate to Ireland’s European partners and the markets that Ireland recognises the change in its financial environment, while not being so large to pose an excessive risk to the recovery in GDP.
In terms of the spending and revenue decisions behind fiscal targets, the in-train spending review to be published in September can provide a basis for a “smart” approach to cuts. A multi-year strategy that makes clear choices between high priority and low priority expenditure lines is superior to a blunt approach that seeks to impose uniform reductions, regardless of the relative value or effectiveness of different programmes.
On public investment, the Government may well have scope to achieve further reductions in nominal spending with little efficiency loss, through a combination of further reductions in tender prices and a more rigorous approach to cost-benefit analysis of projects.
On the revenue side, the uncertainty facing households and firms would be alleviated by more information concerning the tax strategy of the Government.The quicker it can decide the contributions of different elements to the required overall increase in tax revenues, the greater the boost to consumption and investment through the reduction in planning uncertainty. Just as there is no reason to delay the publication of the spending review until the budget, there is no strong rationale for the Government to delay providing greater clarity over its multi-year tax strategy.
A broad-based tax/welfare system that is as employment-friendly as possible should be the target. The challenge is to find the combination of taxes that strikes a balance between efficiency and equity concerns. The desirability of collecting revenues from a property tax, water charges and other user fees and the elimination of many types of tax expenditures has been well ventilated in the Irish debate. In addition, the capacity to collect more income tax through reducing bands and allowances is also well understood.
The scope for collecting more VAT has been underplayed in the Irish debate. The tax base for VAT in Ireland is too narrow. An increase in general VAT rates can alleviate pressure on other types of tax rates that might have a more negative impact in terms of reducing employment.
Substantial future increases in VAT rates could help to bring forward consumption, boosting current levels of demand. The increases need not be uniform. It is possible a lower rate may be warranted for tourism – and leisure-related sectors that are quite labour intensive.
Ireland should continue to press for further changes in the European bailout framework. Beyond the desirability of expanding the financial capacity of the European Financial Stability Facility, an issue that is especially important to Ireland is that last week’s deal still leaves the full financial burden of publicly funded bank recapitalisations and the provision of guarantees for bank liquidity funding lines with national governments.
As has been repeatedly emphasised by Central Bank governor Patrick Honohan, financial stability would be more quickly restored if there were greater risk-sharing among European governments in respect of the tail risks in domestic banking systems.
Philip Lane is professor of international macroeconomics at Trinity College Dublin, and director of the Institute for International Integration Studies. This article is an edited version of an address he gave this week to the MacGill Summer School