The publication of the Medium- Term Review earlier this week by the Economic and Social Research Institute is welcome. It provides an analysis of possible economic scenarios and policy options over the remainder of this decade. The review also draws attention to the many uncertainties and risks in regards to both international and local developments and their impact on economic growth and public finances.

There has been some focus on just one of its policy recommendations, namely, that the Government should proceed with a “fiscal consolidation” of €3.1 billion in tax rises/spending cuts in budget 2014 which had been signalled before last February. Arising from the replacement of the former Anglo-Irish promissory notes with long-term government bonds payable in the future there is likely to be some fiscal space in budgets 2014 and 2015 within the deficit reduction targets agreed with the EU-IMF-ECB troika.

The deal on the promissory notes means that the Government will have approximately €1 billion less to pay on interest as recorded in the public finances in 2014, giving some leeway for it to aim for a deficit of 3 per cent in 2015 while not raising taxes or cutting spending as much as had been previously signalled.

In the initial reaction to the deal announced on February 7th, it looked somewhat likely that fiscal easing was on the table for the coming two budgets. After all, the political pressure to secure a deal on the odious debt of the former Anglo- Irish Bank was aimed at securing some relief for Irish taxpayers in respect of the promissory notes written in 2010.

Since then, mixed messages have emerged including a “purely technical assumption” contained in the most recent Irish Stability Programme Update of last April to the effect that the benefit of a lower total interest bill on Government debt, in 2014 and 2015, would be used entirely to reduce the Government deficit as a proportion of GDP more quickly than had been previously projected (from 2.9 per cent of GDP in 2015, according to previous plans, to 2.2 per cent in the most recent programme update).

The ESRI Medium-Term Review has added weight to the calls for the fiscal breathing space to be used to write down debt or reduce the deficit to 2.2 per cent (comfortably below the target of 3 per cent in 2015).

The main rationale given is that the Government needs to minimise the risk of overshooting its 3 per cent deficit target if growth falls significantly below its expected level (something that is not unlikely as evidence is emerging that a European recovery is further away than previously hoped).

In short, the review urges what they view as a precautionary approach of cutting more sooner ‘just in case’ economic growth falls significantly short of expectations. This approach, it is argued, would give the Government some leeway, perhaps, to avoid fiscal consolidation measures in budget 2015 if growth turned out to be better than expected.

The principal difficulty with a full consolidation of €3.1 billion in the coming budget is that it risks prolonging domestic recession unnecessarily at a time when the economic signals are not positive.

A combination of slowing growth or recession in many of our European trading partners together with the overhang of private household debt and continuing fiscal austerity measures means that the domestic economy has little or no space to recover.

Personal consumption

Consumer expenditure, investment and public consumption are stagnating or declining, as indicated by trends since mid-2012. Measures to increase personal income tax (through withdrawal of the PRSI tax credit earlier this year) as well as increased local property taxes and other charges may be partly linked to the fall in personal consumption in the first quarter of this year.

Paradoxically, more austerity risks prolonging recession with an adverse impact on the Government deficit as spending related to unemployment and associated income support measures and health spending exceed planned levels.

Over the coming two months, the Government will need to carefully assess the balance of risk in relation to the size, composition and timing of fiscal consolidation over the coming two budgets. A prudent course of action would be to cut some slack in the scale of consolidation to allow more breathing space.

The very risk of lower growth cited by those arguing for maximum consolidation “just in case” may very well be fulfilled if a €3 billion shock is administered to an economy on the floor. However, fiscal easing is not sufficient, of itself, to generate sufficient recovery. It needs to be complemented by an accelerated programme of investment, building on those decisions already taken or signalled in relation to the National Pension Reserve Fund.

If an accelerated programme of European, private and public investment were brought forward over the coming two years, together with a smaller consolidation effort in the region of €2 billion in 2014 and €1 billion in 2015 (instead of €3.1 billion and €2 billion respectively), there is a good prospect that Government could attain its deficit target of 3 per cent in 2015 (as projected recently by the Nevin Economic Research Institute in its Quarterly Economic Observer).

Pressing on the brakes as the car is skidding off forecast growth may worsen the skid. Each €1 billion of tax increases or spending cuts lowers growth in GDP by up to 0.5 per cent per annum based on Department of Finance estimates.

Much of the progress towards lower deficits has been slow, painful and economically disruptive. A quicker way towards deficit reduction is through investment and fiscal correction that causes the least damage to domestic consumption.

However, such a course of action would require difficult and possibly unpalatable political choices to raise the low average levels of effective corporate, employer and high-income taxation.

The Government has more than one way of reaching its stated fiscal targets. Risking prolonged recession through an adjustment of €3 billion this autumn is not the most prudent or economically sound way to proceed at this time of heightened uncertainty.

Dr Tom Healy is director of the Nevin Economic Research Institute.
See www.NERInstitute.net