OPINION:What should the budget try to do? Brian Lenihan should slash public spending on items that don't help the economy and people's welfare; should not increase taxes; and should not try to stimulate either construction or the property market - because that will only make matters worse
A N IMPORTANT feature of the international experience of house price booms and busts is that the public finances always deteriorate significantly in the aftermath of the downturn in house prices. Studies of these episodes find that the budget deficit typically continues to widen for four years after the peak in prices.
The worsening of the State's finances in this country over the past 18 months has been dramatic. This has happened not only because Government revenues had become so heavily dependent on property-related receipts (such as VAT, stamp duty and capital gains tax), but also because housing activity accounted for such a large share of the economy. Housing activity typically stalls during a property bust, depressing government revenues.
It follows that in the budget on October 14th, the Government's first priority must be to curb further deterioration in the public finances. This will require Minister for Finance Brian Lenihan to take a knife to Government spending. The crucial task will be to identify spending that contributes little to the economy's productive capacity or citizens' welfare. Such spending needs to be slashed.
Studies of fiscal consolidation efforts in European countries over the past few decades suggest that consolidation is unlikely to be successful if it relies on reductions in productive capital spending. The international evidence underscores the importance of choosing a growth-oriented strategy for fiscal consolidation. Too often, governments under pressure have resorted to quick fixes for deficits, overlooking the medium-term effect of such policies on economic growth.
Addressing the challenges facing the State's finances will require that the Government show commitment and stamina. Commitment is crucial, because politically sensitive spending items such as public sector pay will need to be tackled. Fiscal consolidations in other countries have often faltered in the face of pressure from interest groups. Stamina is required because the Government's fiscal plan must be carried through fully over the next several years in order to bear fruit.
Maintaining spending on productive capital projects should not be confused with fully funding the National Development Plan (NDP). The social returns on many investment projects in the NDP have never been identified or quantified. Investments that can be justified on the basis of rigorous cost-benefit analysis and the expected effects of such spending on the economy's medium-term competitiveness should be given priority.
Financing productive capital spending by borrowing, which is perfectly reasonable, will imply a budget deficit more than 3 per cent of GDP.
Some commentators mistakenly believe that running a large deficit will mean that Ireland will be in violation of the EU's Stability and Growth Pact (SGP) rules. In fact, reforms to the SGP rules introduced in 2005 mean that no excessive deficit procedure will be launched against a member state experiencing negative growth.
Moreover, member states that record deficits more than (but close to) 3 per cent are able to refer to a series of "relevant factors" to avoid penalties. These factors include the economic cycle.
Trying to stay inside the 3 per cent guidelines by increasing income tax or taxes on businesses would be a mistake. Any increases in the tax burden on labour or business income would further depress economic activity. The bubble-financed tax cuts of recent years will have to be reversed at some stage to put the public finances on a sustainable footing, but only when the recovery takes hold.
As well as planning for public spending and revenues, the Government must decide whether or not to provide incentives in the budget to try to affect decisions that will be made by households and businesses. Unfortunately, previous incentive schemes in some areas over the past decade have had undesirable effects. Nowhere is this more evident than in the property market, where tax incentives contributed to the overheating of property prices and construction.
Much media speculation over recent days has focused on what the Government might do, if anything, in the budget to stimulate the housing market. To determine whether stimulus measures are needed, a good place to start is to consider how the size of our current housing stock compares with housing needs.
Over the past five years, new homebuilding surged to levels well above estimates of medium-term housing needs. Assuming a sustainable level of residential investment of about 10 per cent of GNP, the rate of investment in housing since 2002 has generated an excess stock of residential capital equivalent to about 25 per cent of GNP. Working off this surplus will mean that new homebuilding will have to drop to about 25,000 units next year and remain at those levels for roughly a decade.
The simple fact is that the construction sector must shrink. Our economy over the next decade will rely on other sectors for growth. It is clear, therefore, that measures that artificially stimulate new homebuilding will likely worsen the inventory overhang problem and prolong the adjustment process.
There is a case for subsidies to energy efficient investments in houses. As I have argued in the past, insulation investments in houses have long been recognised as an economically attractive way to reduce carbon dioxide emissions. Subsidies for such insulations might give rise to a double dividend of environmental benefits plus a cushioning of the necessary but painful contraction of the construction sector. The Home Energy Saving Scheme announced in April could be used as a model.
A separate issue is whether the Government should do anything to try to revive transactions in the housing market. The answer is almost certainly no. Sales will recover when the house price bubble has fully deflated.
Like the common cold, the unwinding of the bubble must run its course. The sooner sellers face the reality that housing has undergone an enormous revaluation, the better. Measures to help first-time buyers are not necessary, since these people are the unambiguous winners from the drop in house prices.
The supposed problem of banks now requiring 15-20 per cent deposits from homebuyers simply reflects a welcome shift away from the imprudent banking practices of the bubble years and lenders' own expectations that prices will continue to decline.
Of course, falling house prices have created a legacy problem. Having borrowed enormous sums to buy overpriced development land, some developers are now de facto insolvent. Banks face difficult decisions about how to deal with troubled borrowers, but the Japanese experience in the 1990s cautions that excessive forbearance can be disastrous for both lenders and the economy.
Instead of calling in loans, Japanese banks spent a decade protecting their meagre capital and managing bad debts instead of contributing to economic growth by financing new projects. These poor banking practices turned a temporary property downturn into a prolonged economic depression.
Irish banks need to face the reality of bad debts and doing so will have implications for banks' balance sheets. If banks do not have sufficient capital to take the hit, then they will need to raise new capital to plug the hole. Depending on conditions, this may require public money.
These significant contingent demands on the public purse make it all the more important that the upcoming budget positions the State's finances for the challenges ahead.
• Alan Ahearne lectures in economics and is vice dean for research at NUI Galway; he has advised Minister for Finance Brian Lenihan on his forthcoming budget