John FitzGerald: Economy may overcome Covid by late 2022

Economic crises can have long-lasting effects as they put the brakes on investment in both physical and human capital (through education and training). As a result, future economic activity may be impacted many years after the economy recovers from a recession. While this was the outcome of the financial crisis of the 2008-2012 period, it looks likely to be different with the pandemic-related depression, from which we are now emerging.

While the Omicron variant is casting a pall of gloom coming up to Christmas, what remains surprising is how limited the effects of the pandemic have been on much of the economy. Some sectors of the economy, like arts, entertainment and tourism, have, of course, been very seriously affected.

As always with the Irish economy, the Central Statistics Office’s runes are difficult to interpret, but one does not need to consult the oracle of Delphi to know that many sectors of the economy have undergone a vigorous recovery this autumn. The Economic and Social Research Institute on Thursday produced a fairly upbeat forecast for the new year, with a return to full employment expected by the end of 2022, and very rapid growth in domestic demand.

By the end of next year, give or take Omicron, and possible future variants, the economy should be fairly close to where it would have been without Covid. However, the composition of that output may be different, reflecting changes that the pandemic has wrought in our patterns of behaviour.

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IT and pharmaceuticals

An important reason why the Irish economy has outperformed other EU economies has been that we have specialised into producing goods and services where demand rises rapidly with increasing incomes. Thus, the demand for IT services has continued to boom and the pandemic also gave a further boost to production of pharmaceuticals. These factors have sustained high-paid employment, and related revenue from corporation and income taxes.

Probably the biggest economic surprise is how strong the public finances have proved in the face of the huge fall in output in 2020 and early 2021. This is partly because the booming high-tech sectors pay a lot of corporation and income tax. However, the recovery in VAT revenues reflects the fact the very high savings rate due to lockdowns is now beginning to return to more normal levels, and with this readjustment consumption has surged since the summer.

As a result, it now looks likely that government borrowing for the year will be less than 3 per cent of national income, whereas in the budget in October the Department of Finance was forecasting a deficit of almost twice that size.

On its own, the rise this year in corporation tax paid by foreign firms will add about 1 per cent to national output. Over the period since 2013, it has added about 0.4 per cent each year to the growth in real national income. While the revenue from corporation tax is not at any immediate risk, much of it is vulnerable to forces outside our control. Thus, the revenue from this tax should be viewed in the same way as Norway has viewed its bonanza from oil – as a potentially exhaustible resource. What Norway has done is save much of this “temporary” revenue, and Ireland should be doing the same with some of the unexpected corporation tax dividend.

Vagaries of virus

With the economy returning to full employment by the end of next year, output will also be close to capacity. In turn, the Government’s budget should be close to balance. If this favourable outcome is not disrupted by the vagaries of the Covid virus, it will pose very different challenges for the Government for 2023 and subsequent years.

As in the early 2000s, once the economy reaches capacity, the Government’s job will be to keep the lid on demand. Failure to do so could see exceptional domestic inflationary pressures, especially in areas such as construction where imported goods cannot substitute for domestic production. The way the Government must do this is through running an increasing budget surplus while rapid growth continues.

At the same time, the Government will face major demands for more expenditure to tackle services related to ageing, the housing crisis and climate change, and improve health and social care services. With a fully employed economy, financing this expenditure must be done through increasing taxation to redirect the necessary scarce domestic production to where it is most needed. This reflects the fact that most of these new demands cannot be met from imports – the goods and services have to be produced locally. Under these circumstances, reliance on borrowing would just add to inflationary pressures, not add to our wellbeing.