Tanker-like ship of public finances heading for the rocks

 

Official figures understate the gravity of the deterioration in the State's budgetary position, writes DAN O'BRIEN

THE GOVERNMENT has lost control of the public finances. The implications for the economy and Ireland's relations with Europe are dire. Since it became clear that the property-fuelled boom would not end with a soft landing, the conventional wisdom has been that the Government should not curb public spending excessively, even if this means breaking EU budget rules.

The conventional wisdom would be correct if the public finances had been managed conventionally before the bubble burst. Unfortunately they were not - on multiple levels.

The results of this mismanagement are to be seen in the Government's own numbers. Following a massive recent revision, the Department of Finance now expects a general Government deficit of nearly 3 per cent of gross domestic product (GDP) this year, having enjoyed a surplus of a similar magnitude as recently as 2006. This six percentage point deterioration amounts to the most rapid two-year decline of any euro area country at any time since the single currency was launched.

Bad and all as the official figures are, they understate the gravity of the position. To achieve the new target, general Government revenues in 2008 would have to remain at last year's levels. Given a rapid and accelerating decline in tax revenues in the first half of 2008, this would require a miracle in the next six months. Without such a miracle, the deficit will be closer to 4 per cent of GDP.

In 2009, even assuming no further reductions in revenues and a curbing of the rate of expenditure growth, the deficit is set to rise towards 6 per cent of GDP or above. Such a scenario is the most likely outcome given the nature and composition of the economy's slowdown; trends and dynamics in expenditure growth, tax revenues and debt servicing; and the Government's repeated commitment to maintain budgeted investment spending come what may.

The two most important pillars of the domestic economy - consumer and investment spending - accounted for three quarters of GDP last year.

The latter is now contracting even more rapidly than in any year during the benighted 1980s and forward-looking indicators, such as new housing starts, point to continued collapse. The former is flat-lining as the factors that influence it - employment, wages, asset values (including both homes and equities), inflation and interest rates - all move in the wrong direction. In 2009 private consumption spending is more likely to shrink than to expand. These developments augur awfully for tax revenues.

On the other side of the ledger, the immediate outlook is marginally better, if only because the room for manoeuvre is greater. But even with the belated evasive action now being taken by the Government to control expenditure, curbing its rate of growth will be difficult given existing commitments, rising welfare costs and the slow pace of steering the tanker-like ship of State spending.

A further double-headed risk to the public finances comes from the rising cost of servicing a low-but-rising Government debt. The recent upward movement in interest rates on most Government bonds reflects rising inflation expectations. If fears of higher global inflation come to pass, this trend will accelerate.

Making matters worse for Ireland has been a re-pricing of risk by those who invest in Government bonds. As recently as last year, investors considered Irish Government debt to be as risk-free as any in the euro area. In 2008 investors have been demanding a premium to take on and hold Irish public debt that is closer to the one demanded of Italy, a perennial fiscal basket case, than to rectitudinous Germany.

Worse still, if this trend in the bond market continues, a larger Irish deficit will widen premia even further, introducing a self-reinforcing negative dynamic into an already deteriorating fiscal position (having suffered so badly from just such a dynamic within living memory, it is hard to believe that any government has allowed even the possibility of such a scenario to re-emerge).

Given all these factors in combination, the budget deficit is now crashing through the 3 per cent of GDP limit to which the Government is officially committed and in 2009 looks set to approximate the largest deficits of the euro era - a 7.8 per cent deficit recorded in Greece in 2004 and 6.1 per cent imbalance recorded in Portugal in 2005.

But the reaction of other EU countries can be expected to be different to Ireland's breach of budget rules. In the cases of Greece and Portugal, new governments inherited these deficits. They blamed their predecessors for past profligacy and were given the benefit of the doubt by their euro area partners.

Brian Lenihan will not be able to pass the buck to a previous administration when Ireland is scrutinised by its partners. Moreover, when the other euro area countries analyse the reasons for Ireland's precipitous move into the red, it will be obvious that its cause was not global economic conditions or some other misfortune, but mismanagement of spending, revenues and the wider budgeting process.

The most cursory glance at spending patterns over the past decade shows how big the impact of the electoral cycle is. While most governments loosen the purse strings as elections approach, pre-election spending growth in Ireland before the 2002 and 2007 contests was spectacular. The surge in spending before the last election explains a large part of how an unusually big surplus in 2006 had all but evaporated in just 12 months.

On the revenue side, the Government appears to have believed the sophists on property market "fundementals". Instead of firewalling windfall revenues from property-related taxes (for instance, by putting them into the national pension fund), it acted as if these revenues would continue to flow into the exchequer's coffers, and increased spending accordingly. This was imprudent, if not reckless. The Government is also culpable for its inaction on reforming basic budgeting processes. Rather than using the policy space provided by the boom years to adopt best practices, successive finance ministers provided little leadership. Existing-level-of-service budgeting is antediluvian but remains the allocation method of choice in the Department of Finance.

Rigorous evaluation of all spending programmes, both before and after implementation, is increasingly the norm in EU countries, but is far from standard practice in Merrion Street.

The one extenuating circumstance Brian Lenihan will be able to plead when the excessive deficit procedure against Ireland is initiated will be the very sharp decline in economic growth. This will earn him breathing space. But as the margin by which Ireland breaks the rules becomes clear, scrutiny of the public finances will increase. As the Government is so demonstrably the author of its own fiscal misfortune, forbearance will dwindle fast.

To plead for special treatment for breaching fiscal rules by a wide margin without having another administration to blame will create an unprecedented situation in the euro area. In order to protect the (already-strained) credibility of these rules, the other member countries will feel pressured to subject Ireland to the full rigour of the rules. Given the Government's mismanagement of the public finances, they are unlikely to have much sympathy for Lenihan's plight, and those who resent Irish voters rejection of the Lisbon Treaty may be tempted to throw the book at him.

The Government has got itself into an appalling position. The choice it is now facing is between worsening the economic downturn by slamming the brakes on public spending, or risking what could be the most serious clash among euro area members since the currency was launched. The awfulness of the former scenario needs no elucidation; the seriousness of the latter is made graver still now that Ireland's very participation in the EU is at risk following the rejection of the Lisbon Treaty.

• Dan O'Brien is a senior economist and editor at the Economist Intelligence Unit in London