Friday, 23 October 2009

Prudence in the Face of the Unknown is Key

Stephen Kinsella: It is almost never correct to sacrifice a present benefit for a doubtful advantage in the future. Ireland's political classes understand this truism at the genetic level. In a world where less and less seems predictable, Ireland faces multiple uncertainties: we cannot afford to splurge on one by neglecting the other.

The coming budget will unhinge whatever remains of social partnership, and may even bring down the Government. The coming wave of mortgage defaults will ensure our banking system remains under extreme pressure and international scrutiny, no matter how well NAMA does or does not perform in cleaning up the balance sheets of recalcitrant banks. It is uncertain how many indigenous Irish businesses will weather the unprecedented economic storm they find themselves in, and what the resulting level of unemployment may be. The slow, but steady, international recovery may leave many parts of Irish society not directly tied to export industries behind. These are short-term concerns.

The negative social consequences of mass unemployment are starting to be felt. The cost to families and communities of increased domestic violence and criminality is incalculable. The security of every family against unnecessary hardship is an invisible social asset on which our culture is dependent: we don’t see this asset until it is gone. These are longer-term concerns.

In the midst of these uncertainties, the government must display prudence in the face of the unknown. Freeing up resources through increased efficiencies in the public sector will take time. One swipe of a pen can reduce incomes of public sector by thousands. A cut in public sector pay is inevitable. An increase in efficiency in the public sector—doing more with less—is not. Which course of action is more prudent, and which more likely to save taxpayers’ money in the long run?

In attempting to be prudent in some areas— fiscal policy, for one—the government may lose the good will of its citizens. By being extremely imprudent, in the cases of NAMA, the stalled reform of the taxation system, the crawl toward accountability, and most of all in a claw back of frontline public services, the government may damage the long run interests of its citizens.

The government has a duty to provide the highest standard of living for its citizens the nation can afford. That appears to be at 2003 levels of income at the moment. Our spending remains at 2009 levels. Prudence dictates the most likely course of action for the government in the coming budget. Actions are not without consequences, however, and a prudent public will do well to remember the choices made on their behalf come election time.


Michael Taft said...

Stephen - your argument that Government should base its policies on prudence is a sound one. Of course, that begs the question - what is prudent. Fiscal policy to date has failed to take account of its impact on the economy which, in turns, feeds back into the fiscal dynamic. This failure has resulted in the Government has fallen into a deficit-trap: the more it contracts fiscally in order to reduce the deficit, the more it actually maintains the deficit-burden because the fiscal measure has contracted economic activity. This can best be seen in the ESRI’s modelling of the proposal to cut 17,000 public sector jobs (never mind that we have one of the smallest public sectors in the EU-15 and, according to the OECD, in the industrialised world). Cutting these jobs would reduce public spending by €1 billion. But the impact on the economy would be severe – cutting growth, consumption and employment. The net impact would be to cut GNP by €1.2 billion and reduce the borrowing requirement by only €480 million (48% of the headline cut). Okay, so you saved €480 million, but because you cut the GNP, the deficit burden remains relatively unchanged (cuts the borrowing requirement by 0.1%). So, you have maintained a high deficit-burden but in the meantime you have weakened the economy’s ability going forward to deal with rising debt levels.

Normally, the primary focus of fiscal policy in a recession would be to end the downturn earlier and at a higher level than would occur without such intervention. Unfortunately, Ireland has an additional problem. If all we had to worry about was the cyclical deficit – then once the economy returned to optimal growth, the deficit would disappear. But we have a structural deficit – thanks to Fianna Fail’s fiscal policy earlier in the decade. This will have to be dealt with outside of cyclical issues, requiring permanent changes in the balance between spending and revenue.

What is required is a more sophisticated mutually supportive two-track strategy: stimulus investment to address the cyclical aspect of the deficit, and fiscal consolidation to address the structural deficit. Of course, there is much to debate on the contents of each element. I would suggest two principles. Regarding investment, it should be investment we would need to make in any event to improve our competitiveness and productivity. Addressing our woeful physical infrastructure (ranked 65th in the world by the WES) and our poor educational infrastructure – especially early childhood education, where rank bottom in the OECD. These would provide real returns down the line while boosting employment, wages and consumption.

On the other side, given that, coming into the recession, Ireland had the lowest level of public expenditure in the EU-15, bar Spain, the majority of the consolidation would fall on the taxation side (though, of course, there are efficiencies to be made in the public sector). Even here, we must be careful, initially selecting the least deflationary revenue sources (examples are carbon tax, increased taxation/social insurance on high incomes/wealth, reform of regressive tax expenditures, etc.). As the economy gets back on the growth-path, higher taxation could be progressively increased though always ensuring that increased taxes are consistent with growth so that we don’t undermine recovery.

This, more sophisticated, non-deflationary approach holds out better hope for ensuring that fiscal policy facilitates recovery rather than postponing it. And in all this, prudence is the word.

Stephen Kinsella said...

Hi Michael,

Excellent comment, of course what we each mean by prudence needs to be examined carefully. Prudence from the government side seems to stem from a neo-classical/balance the books/deficits are bad/ set of concepts, in which case further fiscal stimulus of any kind along the lines that you suggest are, as Morgan Kelly said of Brian Lenihan, 'not even wrong'. Convincing politicians weaned in the 1980's when the economy was floundering with a debt:gdp ratio of 160 that further spending is important will take some doing. I understand the debt-fetishist arguments, and, while I don't agree with people using the 'national debt' to push through unnecessary and damaging policies, I recognise that the majority of politicians and decision makers *do* think that way, so that is something which needs to be addressed asap.

My point in this piece is to get the TASC contributors and readers thinking constructively (and vocally) about what constitutes a prudent set of measures along a longer time horizon, which I'm obviously interested in talking about.

Let's take two issues, first off, infrastructure. If we could spend through the downturn and come up with a world class broadband network, which is a fairly modest ask, we could get ourselves in position to increase the 'creative economy' types who might actually generate enough taxation revenue to plug the hole in the government's finances. But the reality is that any minister trying to get anything out of the DoF today will have a fight on their hands, however, and so they need to come fore armed to do so effectively. Also, it would not be prudent for them to blow their political capital with Finance when there will be an election to win in a year, perhaps. The quick-win options will be selected I think. So prudence goes out the window in the face of political pragmatism.

Second, plugging the structural deficit will require higher taxes at some point, I would say just below the level consistent with economic growth, implying a return to a marginal effective tax rate of close to 60% over a 3-5 year period. Prudence implies we would all cheer such a measure on, as it would leave us in a desirable position for the future in terms of public services, but again, reality gets in the way, and the prudent thing for the decision maker to do is to go for the salary increase, the increased service provision, or the consultant's report, rather than paying down a debt run up by another party which they can use to beat the other party around the houses of the Oireachtas, as Labour did to the conservatives for years.

Either way, a positive set of sophisticated proposal which are long-term prudent would be a great outcome of this discussion, and you've put a few on the table already!