ECONOMICS: The Government must strike a balance between deteriorating public finances and deflation
IN MODERN industrial economies, there are what are known as “automatic adjustment mechanisms” which help to keep the economy near its long-term growth trajectory. If the economy is overheating, as in the Celtic Tiger period, the mechanisms start to slow down the economy. Equally, in times of recession, the mechanisms act to speed up the economy.
The Irish economy is now in an unprecedented recession. The Central Bank is forecasting, perhaps optimistically, a real economic contraction of 4.6 per cent and unemployment of 10 per cent for 2009. Are there any automatic mechanisms at play that could at least stabilise, if not reverse, the current economic downturn?
No respite can be expected, in the short term, from external developments as the global economy remains firmly in the doldrums. All our main trading partners are forecasting negative economic growth for 2009. The outlook for 2010 is perhaps a little more favourable but depends on the effectiveness of stimulus packages being implemented in the US and EU.
The most significant development on the domestic front is the fall in inflation from 4.9 per cent in 2007 to a forecast deflation of 1.9 per cent in 2009. This Central Bank deflation forecast could prove to be an underestimate. Based on current trends, deflation of 5 per cent is a distinct possibility for 2009.
Deflation is the key to igniting a number of adjustment mechanisms within the economy. In the foreign exchange market, Irish deflation – to the extent that it exceeds that in our trading partners – will improve our price competitiveness and help moderate the recession.
However, deflation also increases both real interest rates and real wages. Both of these effects will constrain or prevent recovery. We thus have a situation where a recovery mechanism in the foreign exchange market is constrained by developments in the money and labour markets.
Fortunately, the money market constraint has eased as the European Central Bank (ECB) cut interest rates to 1.5 per cent in early March. This will reduce the real interest rate and facilitate the gain in competitiveness. But even at zero interest rates – and the ECB seems reluctant to imitate the Bank of England and the Federal Reserve by moving their borrowing rate to zero – real interest rates would remain positive as long as the price level is falling.
Moreover, the labour market is only adjusting slowly to deflation. Wage cuts are being resisted with growing ferocity in the public sector and may not be as widespread in the private sector as we are led to believe – although there are signs that, in the private sector, workers given a choice of losing their jobs or taking a sizeable pay cut are choosing the latter.
The same cannot be said of the public sector. When the social partners agreed, in autumn 2008, to a pay freeze for the public sector in 2009 it was based on an inflation forecast of 1.5 per cent. Deflation of 5 per cent would constitute a significant increase in real earnings for public sector workers in 2009.
The recently-introduced “pension levy” on public sector pay (which strangely does not apply to pensions!) is equivalent, in some respects, to a pay cut. However, there is an important difference. This levy is perceived to be a tax designed to reduce the Government’s budget deficit. This is entirely different from an inflation or competitiveness policy that ensures that nominal earnings move in line with deflation.
However, wage flexibility is not in itself a solution to the crisis. Some form of demand-side stimulus, in addition to the rather weak in-built mechanisms outlined above, will have to come from somewhere if a prolonged recession is to be avoided.
In large economies that are less open to international trade than Ireland, the standard policy recipe during a recession is for the government to implement some form of fiscal stimulus, as is now happening in the US and EU.
This stimulus package can be some mix of more public spending and lower taxes. However, the Irish Government is implementing a severe deflationary fiscal policy in a time of recession. The almost inevitable consequence of this will be to deepen the recession and prolong the downturn. There is some hope that a sudden, sharp correction to the public finances would restore national and international confidence in the battered Irish economy, leaving us in a better position to benefit from the international upturn when it comes. In the short and even medium term, as unemployment rises, social welfare spending will increase and tax revenues fall, leading to a further deterioration in the budgetary position.
The housing and construction sector will come under even greater downward pressure.
The official stance is that the government has no choice but to introduce a deflationary fiscal policy. Predicted government deficits of 10 per cent of GDP per annum would soon result in a debt/GDP ratio of 100 per cent. We are reminded of the lessons of the 1980s. However, this is not the 1980s. The Irish pound does not exist and there is no risk of the type of currency crisis recently experienced in Iceland. Most important interest rates are 1.5 per cent not 20 per cent.
A downsizing of the bloated public sector is inevitable and desirable, especially by ensuring nominal wages adjust to the new deflation. Some commentators have called for the cancellation of projects contained in the National Development Plan. Is this not a time to do the opposite?
Labour intensive capital projects, partly funded by the EU, and financed at low interest rates seem to be a sensible option provided they represent value for money as judged by objective cost-benefit evaluations.
The critical issue is to strike a balance between the continuing deterioration in the public finances – including the need to restore international confidence in our economic governance – and the deflationary implications of major tax increases/expenditure cuts. So far, the Governments reaction to the economic crisis is leading only one direction and that is down the road to economic ruin. There is a better way.
Dr Anthony Leddin is head of the Department of Economics at the University of Limerick
