Monday, 22 March 2010

Fiscal recklessness and the TINA mantra

Tom McDonnell: The startling change in mood that has come upon the Irish people in this post Tiger era is reminiscent of a hangover after the ball. Indeed the drunken sense of hubris during the boom was such that our leaders seemed to have genuinely felt we had moved beyond such trivialities as economic cycles. The Government had reached such arrogant heights that Bertie Ahern even saw fit to recommend suicide to those few with the clarity of vision and understanding to warn of the impending collapse. Questioning the narrative was forbidden. Just as questioning the narrative that ‘there is no alternative’ (the TINA mantra) is now forbidden.

The Government was asleep at the wheel. Budgeting and economic planning had become so dysfunctional under Brian Cowen and Charlie McCreevy that the country’s public finances had become reliant on a single commodity rising in price year-on-year. A decade of giveaways had opened up a huge structural fiscal deficit which could remain hidden provided that the value of this one asset kept on surging. But asset prices move in cycles, and when the property crash inevitably took place (and it was inevitable) it was suddenly revealed to all that Ireland had a gaping hole in its public finances. It’s important to understand that this gaping hole already existed at the time the crisis struck. The crisis merely removed the illusion. During a time of unprecedented boom the Government had done all of the wrong things. They pursued pro-cyclical policies to remain in power, and now the taxpayer is left with the bill. The result of these policies is that at a time of severe economic crisis we have no nest egg available to provide any sort of stimulus. We are told that there is no alternative to the strategy of slash and burn.

But what is done is done, and the important question now is what can be learned from this folly. How can we ensure that our public finances are never mismanaged so badly in the future? Part of the difficulty with Keynesian demand management is that during those times of economic boom a purely self-interested political party will run pro-cyclical policies. Irish economic history is littered with such examples. Instead of seeking to manage the economy with the long term interests of the country at heart the party in power is concerned with maximising the number of jobs and maximising growth levels at precisely the time of the next election regardless of the consequences. The long term health and sustainability of the economy is therefore sacrificed to ensure present day electoral success. As Irish economic history has shown, the party in power cannot be trusted not to abuse long term sustainability in this way.

To prevent history repeating itself, there is an argument for governments being deprived of the power to buy elections at the expense of the long term. One option for achieving this aim would be a Constitutional amendment.

The details of such a Constitutional amendment would be up for debate but one possibility would be to require the Government to run a minimum budget surplus equal to half the previous year’s rate of GNP growth. To ensure long term planning, the government would also be required to set out indicative budgets for the next three to five years. Finally, the Constitutional amendment would set up an independent group of experts with the power to veto the budget if the Government’s estimates of both revenue and expenditure are unrealistic or are heavily reliant on temporary phenomena such as asset price swings. Politicians would, of course, still have power to decide levels and composition of tax/expenditure.

These changes should ensure more long term economic planning and would guarantee that the option exists during times of recession to engage in demand management through massive capital expenditure increases. We would not be in the perverse position of needing to slash and burn at exactly the time when capital projects are likely to have their greatest economic net benefit. Instead of the current ‘There is No Alternative’ (TINA) strategy there could have been a strategy focused on job creation.

No one disputes that the budget does have to be balanced in the long term, but to ignore the jobs crisis will devastate a generation and compromise Ireland’s economic future by running down the national store of human capital. Addressing the jobs crisis will involve the up skilling of a whole generation of former construction workers. This will be expensive but it has to be done. The old jobs aren’t coming back and the alternative to up skilling is to condemn these cohorts to long term unemployment or emigration.

So where is future economic growth to come from? The Government’s strategy is evidently to place all of its hopes on export led growth. They hope that Ireland will grab a larger slice of the international market through improving competitiveness and that this improved competitiveness will be achieved primarily through downwards pressure on wages. One side effect of this downwards pressure will be to reduce consumption in the short term but the Government is hoping that the increase in net exports will outweigh this drop in consumption. Brian Lenihan has already signalled that we can expect a further €3billion in cuts this year in the form of a drop of 1€billion in capital investment and a drop of €2billion in current expenditure. So the vicious circle of economic contraction seems set to continue. Of course Brian Cowen is still claiming that the NAMA exercise will increase the flows of private credit in the economy. However the sad reality is that the International Monetary Fund is telling the Government that NAMA will not lead to a significant increase in lending by the banks. NAMA and underlying issues may end up impairing the economy for years to come.

So what is to be done? In an ideal world we would be in a position to engage in a stimulus to deal with the jobs crisis. The ESRI’s fiscal multipliers from last April and the Benetrix/Lane historical multipliers both show that investment can be effective in generating jobs and growth despite Ireland’s status as a small open economy. However the sheer seriousness of the fiscal position will make demand stimulation extraordinarily difficult to fund through borrowing. But the jobs crisis must now be given equal precedence with the fiscal crisis. The real question then becomes one of whether the potential damage to the fiscal position is outweighed by the benefits of a stimulus.

Targeted investment chosen on the basis of strict cost benefit criteria must now be pursued. Investment projects with long term productivity enhancing benefits can, by increasing growth and creating jobs, actually improve the public finances. With levels of private investment so low at the moment, the likelihood of crowding out is minimal. Also, as actual output in the economy is lower than potential output the likelihood of capital projects successfully increasing growth is higher than usual. The Government can begin to move in this direction by reversing its planned cut of 1€billion in the capital budget. However alternative sources of funding for job creation projects must also be pursued and dipping into the National Pension Reserve Fund must now seriously be considered as a source of funding for as long as the crisis continues. At the same time a commitment should be made to start repaying the money to the NPRF once the crisis has passed.

Finally there must be recognition that the goal of economic policy is not economic growth per se but sustainable improvements in the quality of life of citizens. With this understanding in mind, it becomes clear that a more holistic approach to budgeting is appropriate. Economic growth is one indicator of progress, but so too are equality, long term environmental sustainability, job creation, health, education and other life outcomes. In the long term the budget must be designed with a mind to the impact on these areas, and the budget must be designed within the constraints of prudent fiscal policy.
Tom McDonnell is Policy Analyst with TASC


Proposition Joe said...

They pursued counter-cyclical policies to remain in power, and now the taxpayer is left with the bill.

Surely you meant pro-cyclical?

The Keynesian prescription is counter-cyclical, i.e. acting against the boom by reining in demand via taxation and running a large budget surplus to fund future stimulus during the inevitable bust lying ahead.

The mistake made by McCreevy, Ahern and Cowen was to do the opposite and pursue pro-cyclical policies, throwing fuel on the fire of an already overheating economy.

Tom McDonnell said...

Edited. Thanks for the catch, Prop Joe. A typo on my part. The great shame is that almost no one spoke out about the dfangers of running a pro cyclical policy at the time. Sadly the damage is now done and the hole in the public finances has made pursuing standard demand management policies very difficult.

Mack said...

Tom -

The details of such a Constitutional amendment would be up for debate but one possibility would be to require the Government to run a minimum budget surplus equal to half the previous year’s rate of GNP growth

I think they did run surpluses during the bubble though, so this kind of rule wouldn't necessarily help under those kinds of conditions. I think they misinterpreted what was happening for sustainable growth generated, perhaps by economic 'maestros' - increased spending, tax cuts and still they got budget surpluses!

Budgeting and economic planning had become so dysfunctional under Brian Cowen and Charlie McCreevy that the country’s public finances had become reliant on a single commodity rising in price year-on-year

True. It was the growth in foreign borrowings by Irish banks that was fueling all this at the core - the rise in tax reciepts and the rise in house prices was an artifact of the increased amounts of foreign, borrowed money slushing around in our economy. We need to make sure that they can never gamble our future again.