Monday, 2 March 2009

Liberal Policy Choices to Blame for the Crisis

Sean O Riain: The dishonesty and incompetence of individuals in charge of running and regulating our financial system has been spectacular. However, it should not distract us from the roots of the current economic crisis in a set of policy decisions taken in the late 1990s, under the banner of economic liberalism. Fuelling the building bubble, giving a free hand to financial speculation, and cutting taxes failed to generate productive investment, weakened households and has ultimately brought us to the perilous state in which we now find ourselves.

Since the late 1990s economic growth has become increasingly dependent on the speculative financial and property boom. Meanwhile the tax structure became dependent on taxes linked to the boom – stamp duty, capital gains and VAT, among others. When the speculative bubble burst, both private and public investment were hard hit. Tackling the crisis will involve financial measures but, more importantly, a re-orientation of the economy towards development of productive and innovative firms, creating a more sustainable tax base and significant investment in the skills and well being of the population. This crisis is so severe that we cannot cut our way out - although cuts wiill surely play a part, the core of a strategy has to be investment in growth through upgrading.

The booming Celtic Tiger of the late 1990s depended upon a whole set of measures to coordinate the economy – significant initial spending on social and regional infrastructures; social pacts that coordinated wages, taxation and employment; an industrial policy where state agencies worked closely with firms to develop them; and public subsidies for social services such as education, mortgage relief and pensions, that played an important part in the growth of the new middle classes. Just when we needed to invest further in strong international businesses and skilled workers, supported by better resourced public services, we turned away. We rode a wave of property and financial speculation and cut taxes so the public finances became dangerously addicted to continuous growth.

In 1998 capital gains tax was cut from 40 to 20%. Capital surged into the economy, with bank lending between 1998 and 2007 increasing almost five fold. But where did this capital go? 67% of the increased bank lending went into property (construction, developers, mortgages). A further 14% of the increase went into lending between financial institutions. While the rest of the increase was spread across different sectors, relatively little investment went in to the productive sector. In 2007 less than 1% of bank lending went in to high tech - computer hardware, software and research and development.

This showed up in investment. While capital investment increased from 22% of GDP in 1998 to 26% in 2006, that increase was entirely taken up with construction as non-housing investment decreased as a percentage of economic activity. Spending on technology by manufacturing businesses increased only marginally between 1998 and 2007. Underneath the boom, the financial, speculative economy was overwhelming the productive, innovative economy.

But the boom also masked serious problems in the public finances. Irish tax revenues in both 2000 and 2006 were 32% of GDP, well below the EU average of 40%. What was more serious, however, was the changing structure of tax revenues. Revenues shifted so that an increasing proportion of taxes came from taxes on turnover and growth – the percentage of taxes from VAT, stamp duty and capital gains taxes grew from 35.7% in 2001 to 44.3% in 2006. By 2008 the tax structure was dangerously vulnerable – when growth slowed, the revenues from capital gains, corporate taxes, VAT and stamp duty collapsed.

Despite the rhetoric, the current crisis is not generated by excessive public spending. Irish public spending remains among the lowest in Europe. Public spending on health, education, pensions and social protection are all only around the OECD average, or worse. This despite the fact that we face massive accumulated infrastructure deficits, from twenty to thirty years of underspending - remember that in the 1990s around a third of public spending went to pay off the national debt.

In fact, this low public spending in Ireland threatens Ireland’s future – when this crisis is over, the winners will be those who have weathered the storm and continued to build knowledge economies supported by high quality public services. But Ireland is now poorly placed to be among them, despite entering the millennium with a booming high tech sector, improving public investment, managed inflation and having resolved the public debt.

Where do we go from here? By all means, let us tackle waste in the public service – where it actually exists. But this is not the problem, nor the solution. To build the knowledge society that we have long been promised will require much greater investments in education, in innovation policy, in developing small firms, in child care, in supporting 'return to learning' among laid off workers, in providing the high quality public services that will sustain our workforce and benefit their employers. Our budget deficit may make it difficult to inject major additional financial stimulus this year but we should use the maintenance of public services as a form of financial stimulus that will help us through the short-term and simultaneously be an investment in future development. A pause on foreclosures and other measures to maintain household living standards will improve both social and economic outcomes. As the crisis eases, we will need to rebuild the tax structure so that the top rates of tax will have to be raised to generate more sustainable government revenues.

At the same time, we need to restructure the banking system so that investments in the productive economy are the main thrust of banking activities, rather than financial speculation. Unfortunately, the sale of the banks to private equity firms, whether privately or government held, seems to have come back on the policy agenda. If the banks receive significant private equity investment, we may well end up with a banking sector owned by international financiers and governments - but with their risks guaranteed by the Irish taxpayer. These private equity owned banks would be highly unlikely to make the kinds of investments in new and growing firms that have now been belatedly recognised as a critical contribution of the banking system. Ironically, while the government was promoting a speculative private financial system over the past decade, its own industrial development agencies have put their funds to much better use in growing firms and priming new funds for supporting start-up companies.

Choices were made in the late 1990s that diverted the economy away from industrial upgrading and new investment priorities onto a path of speculative booms, a weakening tax base and public finances that were dependent on boom-time growth rates. In tackling this crisis we must not reinforce the weaknesses this model has created. Trying to go back to where we were before the crisis will not generate the kind of growth we need to get through this time. Instead we must take the opportunity to rebuild and extend private and public investment so that sustained economic and social development is possible.
Professor Sean O Riain teaches at NUIM


Patrick Honohan said...

Nice post Sean, I hope the debate will not become too polarized and that will not demonize We have a lot in common.

The deliberate erosion of the core reliable taxes -- which actually goes back to the late 1980s -- and the possible shape of a restructured income tax is the topic of my post on that site:

Seán Ó Riain said...

Thanks Patrick. Indeed, I think there is quite a bit of common ground here that can be figured out. I appreciated your post on getting taxes back into shape and I would have referred to it in my piece if I had seen it in time. I have some figures that I'll get up here later that reinforce your point. I do think the capital gains tax cut was fairly disastrous - we basically ended up with a lot of capital sloshing around and precious little non-housing investment to show for it. One of the big challenges for us now will be to get that investment going ... with one of that capital around. Ideas welcome!!

Anonymous said...

Fine article, Prof. Ó Riain. You might consider sending it to one of the newspapers, where, I suspect, many readers would appreciate it.