The Government is being praised for its harsh cuts but in many cases the basis for its policies are unsupportable. Is the Minister getting the full picture?

WE KNOW THAT government policies during the last 10 years of the boom were badly designed. The question is whether policies in the present recession are fit for purpose.

The two recent reports by Honohan, and by Regling and Watson, were critical of Government policy during the good years. Government is blamed for inflating the property bubble by tax incentives, overheating the economy by lax fiscal policy, ignoring the fragile state of the Exchequer – given its excessive dependence on property-related taxes – and for allowing the economy to lose competitiveness, knowing that devaluing the exchange rate was no longer an option.

There is no doubt that the Government took excessive risks during the boom. Many commentators had warned that virtuous economic circles tend to turn quickly into vicious ones and that we were all living in a fool’s paradise. In other words, we faced a hard landing, for which there were many international precedents. The most serious one, Japan, gave rise to the “bicycle theory”: If you slow down, you fall off.

The Irish government did not have the analytical apparatus to examine different economic scenarios or to undertake policy simulations. It is unlikely that anyone bothered to examine what might happen to Government revenue if the economy slowed down, or more particularly, if construction activity contracted. Consequently there was no planning for contingencies.

There is another aspect the Government must take responsibility for – incessant hype and spin. Form dominated substance. The belief was that if you continued talking up the economy it would be a self-fulfilling prophesy. Hype became more important than policy. This encouraged people to spend more than they could afford, often on the basis of borrowing from banks. In turn, this made the recession far more onerous for many people who believed the official line.

Is the Government finally doing the right thing? Once the economy and banking system hit the wall the Government believed it had no option but to cut spending and public sector pay, and raise taxes in an attempt to reach the EU deficit norm (3 per cent of GDP) by 2014. As well as this, the banks were allowed to increase their interest rate margins, thus tightening monetary policy.

Whether most economists are Keynesian or not, they would tend to agree that policy should be counter-cyclical. Thus, when the economy is in serious recession, policy should be expansionary. (There can be exceptions to this rule but it has never been adequately demonstrated that Ireland is such an exception.) That is why the Government has been criticised for a pro-cyclical policy in the past. But at present not only is the stance of policy not expansionary or even neutral; it is unambiguously restrictive.

Economics laureate, Paul Krugman, would say that we are mad. But there were no Paul Krugmans advising the Government. In fact, if we pause to reflect, it becomes apparent that virtually all of the advice given to Government would have been of the deflationary kind. The main sources of advice were the Department of Finance, Central Bank, ESRI, the EU Commission, OECD, the NTMA and the European Central Bank. It is also abundantly clear that the powerful international markets would favour the deflationary course.

It is a matter of concern that virtually all of the advice would have downplayed the possible adverse effects of deflationary policies. These may not have been explained to the Minister for Finance at all. He, and the Taoiseach, often refer to their policies as ones which will stimulate growth and employment in the economy, even in the short term. Such claims are unsupportable.

He may have been told that fiscal consolidation in the mid-1980s did not inhibit growth or job creation. But was he told that the situation was completely different back then. We had the benefit of strong international growth, reasonable competitiveness, and two additional policy levers (interest rates and the exchange rate) which are no longer available to us. Moreover, the banks were not in a zombie state and were lending at a rapid rate in the mid 1980s.

It is possible that our present deflationary stance could prolong the recession and keep unemployment at about 12 per cent. In turn, this could mean that the Government will miss its fiscal targets because slow growth means a poor flow of revenue.

International financial markets do not care about this. All they care about is the risk of default. If a government shows that it can tax its people and cut their pay, this is music to the ears of international markets because it demonstrates that the government in question will be able to reduce its borrowing over time and will also be able to service existing debt by raising money from ordinary people.

If, in addition, the people are docile and do not take to the streets like the Greeks, then this is a handsome bonus. In this context the Croke Park agreement is good news because union leaders are prepared to accept the pay cuts and will control their rank and file members. The markets and rating agencies will give us good marks for this, and our bond yields are likely to fall well below those of Spain.

The markets, of course, are also impressed by Nama and the original blanket guarantee to the banks, especially the safety net provided for holders of subordinated debt. The latter is a gift from ordinary people to market participants who are supposed to be risk-takers.

Not surprisingly, the Wall Street Journal(June 2nd) praised Ireland's fiscal adjustment, including the taxation of the lower-paid. By dancing to the tune of the markets, the Government got a pat on the head. (Isn't it ironic that the markets, having ruined the international economy are now ruling the roost again?) Let us hope that this praise will not go to the heads of Ministers who might be tempted to go on the international circuit, lecturing Greece, Italy, Spain and Portugal, on how to adjust their budgets and impress the markets.

Perhaps the Government is aware of the deflationary risks but believe that there is no alternative. Unlike the early 1980s when the world was flooded with petro-dollars and any country could borrow to its heart’s content, the situation is much more difficult now because of scarce international liquidity.

So, excessive reliance on borrowing is not the answer for Ireland. However, it would be far better to grasp the nettle of public sector reform where the elimination of waste, inefficiency, and social welfare fraud could save the Exchequer €4-5 billion on a once-off basis with considerable savings accruing over future years. Action on this front would address the Exchequer’s difficulties in a much less deflationary manner. It is well known that from a political perspective it is easier to cut capital spending than current spending. Thus, it is likely that over the next few years our infrastructure will be neglected  yet again and job creation will be inadequate.

The audience we most need to impress is the US multinationals. It is possible that they, like the Wall Street Journal, will be heartened by our fiscal adjustment to date. But that is not a decisive factor for them, compared with the favourable corporation profit tax rate and the supply of skilled workers. The budget cuts may not, however, be consistent with the provision of skilled workers. Cuts in the education budget, and lack of reform in the education sector, could prove to be very costly. Even if we can avoid civil unrest, there is still the problem of the middle class which tends not to demonstrate in the streets but, nevertheless, votes with its feet. This can take the form of the export of capital and the emigration of highly educated young people.

The Government should not be too impressed by the Wall Street Journaland should keep a sharp eye on deflationary effects and other adverse effects, such as a brain drain and a more serious infrastructural deficit. Talking of people voting with their feet, what will the Wall Street Journaland the rating agencies make of the recent poll which shows a massive and unprecedented swing to Labour? Despite the plaudits of the markets, Ireland's policies to cope with recession are open to challenge. History will be the final arbiter.

Michael Casey is former chief economist at the Central Bank and board member of the International Monetary Fund.