Now that the economy is recovering, it is important to learn from past mistakes and pursue sustainable fiscal policies.
Concerns have been expressed by the Irish Fiscal Advisory Council (IFAC) and others about the wisdom of providing a moderate fiscal stimulus in the 2016 Budget.
But a possibly larger risk to the economy is the danger of overpromising during the coming election campaign. If Irish politicians had a track record of ignoring their election promises, then this would not be too serious.
However, over recent decades, governments have all too often sought to deliver on their promises, even when that put the economy at risk.
The IFAC, in its recent report*, looks in detail at the Department of Finance’s latest medium-term scenario for the public finances, published in April. The council is critical of the stylised numbers that are presented. The criticism is not that the scenario itself is fiscally unwise, but rather that it is wholly unrealistic.
In particular, the department’s scenario envisages a continuing fall in public expenditure as a share of GDP without any clear statement of the policies that would bring this about, and without adequate recognition of the pressures building up for increased expenditure.
The council is right; it would have been better if the department had, instead, spelt out the limits of what is reasonable or sensible for fiscal policy over the next five years. While this might have constrained the Government in what it could promise in the run-up to the election, it would also provide a benchmark against which to measure the promises by other parties. It was a missed opportunity to frame the debate on economic policy that will take place over the election.
Internally inconsistent
The IFAC also criticise the department’s publication because it is not internally consistent. The assumptions about the labour market, the economy, and the public finances do not fit well together. Instead, the council suggests that the department needs to use a model of the economy to ensure the consistency of their medium-term forecasts.
A second aspect of the IFAC report is that it demonstrates the complexity of European Union rules now governing the public finances. Though I spent much of my career as an economist analysing fiscal policy, I find the discussion of the fiscal rules in the report pretty impenetrable.
This is not any fault of the council, but a problem with the fiscal rules. As these rules are meant to guide policy as part of the normal democratic process, their complexity is a serious defect. When only a handful of experts understand what the rules mean, it is difficult for the people of Ireland to take them seriously.
This problem is not unique to Ireland, and the disconnect between opaque fiscal rules and normal democratic decision-making should be of concern to all EU members.
A third theme of the IFAC report is that the way potential output is calculated needs to be improved. Potential output measures how much the economy can produce in a sustainable way, and it is a key factor in determining whether a budget should put money into the economy or take money out of it.
Potential output
As the council discuss in detail, the EU’s definition of potential output is unsatisfactory, echoing comments made by a member of the
Austrian Fiscal Council
and in an ESRI paper I co-authored with Adele Bergin.**
In previous years, the IFAC appeared to accept the EU definition as a suitable benchmark guiding fiscal policy. However, in this report it concludes that, while the EU definition would suggest that the Irish economy is currently producing above potential, in reality the economy is producing below its potential.
Among the evidence for this conclusion are an absence of inflationary pressure in the economy; a large surplus on the current account of the balance of payments; and exceptionally high unemployment. If output in the economy was really above potential, then the 2016 Budget should be taking money out of the economy instead of providing a mild stimulus.
In framing its recommendations about the next Budget, the council highlights the fact that all forecasts are uncertain and that, while the economy may appear to be operating below potential today, unexpected future events could render such a judgement null and void.
Neutral stance
Hence, the IFAC takes a cautious view in suggesting that the Government should adopt a neutral stance in the 2016 Budget, rather than pumping €1.2 billion to €1.5 billion into the economy.
It is clear that this advice will unlikely be heeded. If things go well for the Irish economy, it could be the case that the planned Budget will not be unduly harmful. By contrast, should there be unpleasant economic surprises over the coming year, we could, as a result, find ourselves having to pursue a tougher budgetary strategy in 2017.
Still, fiscal policy over the next five years is likely to be determined by the shape of the commitments made in the forthcoming election. Possibilities of Grexit and Brexit show us how uncertain the economic environment up to 2020 may be for Ireland, so we won’t be able to afford any fiscal own goals.
And if the economy continues growing strongly, prudence requires the next government to take money out of the economy. Fiscal policy is always about making the right hard decisions.
* IFAC Fiscal Assessment Report, June 2015 http://iti.ms/1KeueYV
** http://iti.ms/1SMMIRK, session 4 and http://iti.ms/1Keunfc
