ECONOMICS:Now is a good time to consider a new approach to the conduct of fiscal policy, writes PHILIP LANE
DURING THE current economic crisis, the Government has been compelled to undertake a sizeable budget correction in the midst of a severe recession. While this route may well have been the best option given the situation we faced, it begs the question of whether a different path for fiscal policy during the pre-crisis period may have permitted a less onerous fiscal response in the last couple of budgets.
This question is also relevant for other economies that must undertake sizeable fiscal corrections, such as Greece and Britain. Debate about how fiscal policy is conducted through the economic cycle is especially important in view of Ireland’s membership of the economic and monetary union (EMU), since fiscal policy is the main tool available to deal with country-specific shocks.
Accordingly, it is timely to consider a new approach to the conduct of fiscal policy in Ireland. If a new fiscal framework could enhance macroeconomic stability for Ireland, it would improve the policy coherence of EMU membership.
Moreover, by improving the prospects for long-term fiscal sustainability, it should also improve Ireland’s reputation in international debt markets, helping to reduce the high spreads on Irish sovereign debt.
International research evidence indicates that the political distortions that may prevent the accumulation of sufficiently large surpluses during the good times can be mitigated by the introduction of effective fiscal rules and an independent fiscal policy council.
The overriding principle in designing fiscal rules for Ireland should be to preserve medium-term fiscal sustainability. To this end, it is appropriate to target an annual surplus in the structural fiscal balance – the budget balance after allowance is made for the ups and downs of the economic cycle – for several reasons.
First, Ireland faces the prospect of higher future public spending needs on healthcare and pensions due to the ageing of the population. Second, public debt will be quite substantial by the end of the current fiscal adjustment process: returning the level of public debt to below the 60 per cent ceiling specified in the EU Stability and Growth Pact will require a sustained period of structural surpluses. Third, it is appropriate to target a structural surplus during normal times to provide a buffer against a major negative macroeconomic shock, such as we are now experiencing.
In tandem with the last point, the structural balance fiscal rule should contain an escape clause by which a structural fiscal deficit is permitted in the event of a sufficiently large macroeconomic shock. Such an escape clause provides the flexibility to address major recessions or (in the other direction) episodes of overheating, which may require extra fiscal measures beyond the automatic stabilisers that are part of the passive cyclical component of the budget.
Fiscal rules are more effective if the setting of policy incorporates a role for an independent fiscal policy council. The establishment of such a council in Ireland would offer many potential benefits.
Such a council could play a role in identifying the cyclical state of the economy and the distribution of macroeconomic risk factors. Given the macroeconomic environment, it could make recommendations concerning the overall budgetary stance that would be consistent with medium-term fiscal sustainability. It could also monitor compliance with the specified fiscal rules and make recommendations concerning the appropriate adjustment path in the event of non-compliance. In related fashion, it could make an ex-post evaluation of the conduct of fiscal policy over the preceding year.
In addition to these direct budgetary roles, an independent fiscal council could contribute to the transparency of the fiscal process by acting as an independent monitor of the quality and availability of the fiscal data. It could also promote public debate about fiscal policy through engagement with Oireachtas committees and the media and the organisation of policy workshops.
In terms of scale, the Swedish Fiscal Policy Council provides a model. Moreover, it would be desirable to match the Swedish practice by including some non-Irish members in the council, since this expands the range of potential members and provides a mechanism for Ireland to learn from the experience of other countries.
It is important that the fiscal policy council is an independent institution, for the same reasons that justify the independence of central banks. But it is also vital that the council is accountable.
Accountability can be made effective by a two-track process. Council members should testify before the relevant Oireachtas committees on a regular basis and explain any errors in projections made by the council. Also, the technical quality of the work produced by the council should be audited in regular reviews by an international expert group.
It is plausible that the difficulties faced by the EU in handling the Greek crisis may lead to initiatives to encourage the formation of fiscal frameworks that combine a set of fiscal rules and a formal role for an independent fiscal council in each member state. As an early adopter of a new fiscal regime, Ireland could establish itself as a leader in European fiscal reform.
Philip R Lane is professor of international macroeconomics at Trinity College Dublin
