Budget 2020: Can we rely on the Government's plan?

Minister for Finance Paschal Donohoe signalled this week that the public finances would act as a shock absorber for the economy in the event of a no-deal Brexit.

What he means by this is that the Government will let the State finances swing from a surplus to a deficit if the UK crashes out of the EU without a deal.

Instead of running a planned budget surplus of 0.4 per cent next year the Government would run a deficit of up to 1.5 per cent, effectively pushing up to €4.5 billion back into the economy to counterbalance the fallout from a Brexit trade shock.

“Budgetary policy must lean against the wind, it must be counter-cyclical,” he said in the Summer Economic Statement.

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His twin-track approach to Brexit and his willingness to use the public purse as a buffer is being viewed as sensible in the circumstances. The problem, however, is one of credibility.

For decades Irish governments have driven a veritable coach and horses through their own budget plans, pulling last-minute budget day rabbits out of hats.

And budgetary policy has rarely leant against the wind; typically it tends to fly with it. Governments have spent lavishly during the booms only to be forced into swingeing cutbacks when the cyclical turns. So rather than smoothing the natural ups and downs of the economic cycle they have actively amplified them by pursuing pro-cyclical policies. The 2008 crash was a classic example.

In its latest assessment report the budgetary watchdog, the Irish Fiscal Advisory Council (Ifac), published a graph illustrating just how seldom fiscal policy here has been counter-cyclical.

In only four of the last 30 years have Irish governments maintained a clear-cut counter-cyclical stance. The graph charts a litany of budgetary mismanagement that stretches back to the 1980s.

"Ireland has a poor track record in terms of running a counter-cyclical fiscal policy," Ifac said. "Instead budgets have tended to follow the cycle: expanding in good times and contracting in bad times. This has stoked pressures in the economy at times when it is overheating and has exacerbated subsequent downturns."

Upward revisions

One way to gauge how pro-cyclical government spending has been in recent years is to compare the Government’s plans against what it actually ended up spending.

If we ignore interest costs, which are outside the Government’s control, annual spending for 2018 was meant to be in region of €63.7 billion, according to the budgetary framework. With various upward revisions to plans – both at budget time and within the year – spending last year turned out to be €76.8 billion.

And that extra €13 billion in spending is likely to be long-lasting and difficult to reverse. Much of the headline overruns relate to the health budget, which is again threatening to spill over this year on foot of increased payroll costs.

Fine Gael, and Donohoe in particular, like to present themselves as financially disciplined but in reality they have struggled to rein in spending. Even on a project by project basis the national children's hospital and the National Broadband Plan suggest cost-containment has become a major issue for Government.

Ifac says that, despite the favourable tailwinds behind the economy at the moment, the Government only managed to run a budget surplus this year for the first time in 11 years and even then largely by accident – on the back of surging corporation tax receipts.

It also noted that stronger tax revenues arising from the Republic’s rapid cyclical recovery – surging corporation tax receipts, and interest cost savings – have essentially been swallowed up by faster-than-planned increases in annual spending. And in 2018, the pace of spending growth accelerated.

Fiscal prudence

Pursuing counter-cyclical policies is a difficult sell politically – not least with a general election looming. When the economy is growing, people demand higher wages and looser credit conditions, railing against fiscal prudence. Governments, often focused on short-term electoral gain, frequently acquiesce for fear of being kicked out of office.

The Government says it cannot turn a “blind eye” to pressing needs in housing and health and is attempting to address these issues while maintaining fiscal probity – no easy task.

Donohoe defends the Government’s position by insisting that spending will only rise by 4 per cent in 2019. But that is from a different starting point than the Government had previously signalled – one that includes another €1.1 billion in last-minute unplanned spending last year.

If this is excluded spending this year is budgeted to rise by 6.5 per cent. The fiscal council claims this is unsustainable, and out of line with the long-run growth trajectory of the Irish economy, typically put at 3 per cent before inflation.

The Irish economy may soon face the problem of overheating thanks to the rapid turnaround in employment

And there are likely to be further increases in the health spend next year, while the 2019 Christmas bonus payment to welfare recipients has yet to be factored in, both of which could push the spending dial further.

KBC Bank economist Austin Hughes is less concerned with whether the Government’s budgetary stance is expansionary or contractionary, only whether it makes sense.

“Most of the time it’s last-minute, there isn’t fiscal policy planning, there isn’t the outline of a framework,” he says.

The days of pulling “budget day rabbits out of hats” must be done away with.

“The evidence of recent years is that a couple of weeks before the budget we see dramatic changes in fiscal space or spending,” he says. “The planned trajectory in spending over the past four or five years bears no relationship to the outturns. You need to have frameworks that are credible.”

Consumer spending

Hughes cites the Economic and Social Research Institute’s (ESRI) latest quarterly outlook which suggests Brexit is already weighing on consumer spending here, even with near-record low unemployment and rising wages.

“Perhaps part of the reason why consumers are so exercised about Brexit is that they fear we will have the same sort of calamitous public policy response that we saw in the financial crisis, where the government, rather than absorbing some of it, was forced to amplify the downturn because of the poor state of the public finances.”

He says if Brexit is disorderly we may have an economic crisis but there’s no reason for it to transform into a fiscal crisis similar to what happened in 2008 when badly managed public finances were overtaken by a global credit crunch.

“The fiscal stance is to be a shock absorber rather than a shock amplifier,” he says, echoing the Minister’s words.

If there is to be an orderly Brexit and the potential risk to trade from the UK's increasingly complex relationship with Europe recedes, the Irish economy may soon face the problem of overheating thanks to the rapid turnaround in employment and a marked pick-up in wages.

Unemployment hit a post-crash low of 4.4 per cent last month, a figure that most economists think is tantamount to full employment in the Irish context. When employers chase a shrinking pool of labour, wages get bid up. To pay for higher wages, firms must put up their prices, which in turn feeds back into further wage demands from workers in a sort of negative feedback loop.

When such a wage-price spiral develops it can be difficult to halt. While experts talk of capacity and output gaps, the real evidence for overheating can be found in wages and prices.

The ESRI suggests average hourly earnings grew by over 4 per cent last year and will grow by 4.5 per cent this year.

“That’s quite a pick-up from the 2-2.5 per cent rate we’ve seen in recent years,” the ESRI’s Kieran McQuinn says. “That’s obviously nominal earnings but, given that inflation has been quite low, you’re looking at fairly sizeable increases in real earnings as well.”

Overheating

The other side of the overheating equation is prices. While inflation, at barely 1 per cent, appears muted, McQuinn believes the weakness in sterling is anchoring it. If sterling was at a “normal” exchange rate with the euro inflation here could be much higher reflecting the high proportion of imports that come from the UK.

“So we’re importing a lot of cheaper goods and services from the UK than would normally be the case. So that’s helping to keep a lid on our inflation rate,” McQuinn says. “If sterling was to suddenly start climbing back up to a more historically normal rate, you could see costs building up quite significantly in the domestic economy.”

In such circumstances the ESRI recommends some sort of contractionary budget for next year, taking some money out of the economy overall, perhaps through non-distortionary taxes such as property tax or a carbon tax.

Sensible as this may be, both cause a ripple of fear in Government circles where the water charges fiasco remains a singular case study in how to lose votes.

Ironically a no-deal Brexit could cancel out the economy’s overheating issue, says McQuinn.

“A very disorderly Brexit would see a big, sharp economic shock for the domestic economy. While undesirable it would take care of any overheating issue,” McQuinn says.

He acknowledges that framing budgetary policy in such uncertain time is extremely difficult. The Department of Finance’s chief economist John McCarthy said as much at a recent conference, suggesting the economy here was on a knife-edge, poised between “overheating” and a major Brexit-related downturn.

He described the situation as “extraordinarily complex” and uncertain, saying it made forming budgetary policy extremely difficult.

Timing

One problem for the Government is timing.At the launch of the Summer Economic Statement this week, Donohoe said he would have to make an “informed judgement” as to whether there will be an orderly or crash-out Brexit in September, ahead of budget day on October 8th. It’s unclear what new insight he will have come September. He has also ruled out plans for an emergency post-Brexit budget should things go awry.

Fianna Fáil's Michael McGrath and Labour leader Brendan Howlin are among those who believe the Government shouldn't rule out such an option.

A further issue for the public finances is that framing the budget around Brexit takes the focus off other pressing issues like housing and health.

But, ultimately, using potentially temporary corporation tax receipts to paper over the cracks in its health budget is not a sustainable position and one that needs to be tackled head on.