Central Bank warns Donohoe to build buffers or risk more austerity in next downturn

The Governor of the Central Bank has urged the Government to set aside more financial resources while the economy is growing so strongly, which could then be used to cushion the economy from future downturns.

In his annual pre-budget advisory letter to the Minister for Finance, Paschal Donohoe, Philip Lane warned that "if fiscal buffers are not built up, there is a risk of repeating the historical patterns by which economic downturns have been amplified by pro-cyclical fiscal austerity".

The Government risked amplifying future downturns if the Government doesn’t put in place sufficient “fiscal buffers” now, he said.

Having orginally pledged to run a budgetary surplus in 2018, the Government is still running budget deficits (spending more than it raises in revenues), a situation that is not expected to change until 2020.

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Mr Lane cited three reasons to set “ambitious” fiscal targets in the current positive economic environment.

He said the recent surge in corporation tax revenues to more than €8 billion a year could be “temporary”, arguing that some elements of the returns should be seen as a “windfall”.

“Second, to the extent that the current low interest rate environment is not expected to persist indefinitely, a tighter non-interest budget balance offers protection against future increases in debt servicing costs,” he added.

The governor also cautioned that the Republic’s legacy of high public and private debt levels meant the State was “relatively more vulnerable to reversals” compared with other countries with less-leveraged balance sheets.

Cooling measures

In terms of measures that might be taken to help cool the economy, Mr Lane said raising the VAT rate on labour-intensive activities would be a proxy for the stabilising role of exchange rate appreciation, while raising taxes on investment and consumption during phases of strong growth “substitutes for the cyclical role played by an interest rate hike in an independent monetary regime”.

He said these taxes could be lowered in the event of a future downturn to “provide similar support that would be provided by currency devaluation and interest rate reductions under an independent currency”.

Mr Lane said that while the State’s current strong economic performance was welcome, it was “important to be proactive” in building up buffers to “limit the costs of future downturns”.