This is an expanded and updated version of a column published in the Irish Examiner
With the passing of the fiscal compact the government now find themselves in a position t once easy and difficult. It is easy in that the parameters of fiscal policy for the next number of years are set out, if not for the next decade. It is hard in that the implementation of these policies is going to result in wrenching adjustments to all aspects of irish life. In 2013-15 expenditure will fall by €2.25b, €2.0b and €1.0b, while tax increases (and these will be coming from an anemic economy) will 1.25b, 1,1b and 0.7b. Despite the ULA and related calling the referendum an austerity referendum, such terminology disguises the fact that there are at least in principle two different kind of adjustments to be made. First, we are still running a primary deficit, defined as government spending less interest payments still being more than government income. Bringing this into broad balance is going to be a sine qua non for accessing regular market bond financing. Second, and only then, we need to consider the issues facing us from the fiscal compact. As has been explained in great detail over the last number of months so long as any nominal growth emerges and so long as government net spending does not run out of control the parameters of the compact can be met
In recent months there has been a slight glimmer of good news for the government in terms of taxation. Income tax has shown strong growth, up 12% over the year (although that figure is somewhat distorted by changes in the way various taxes are allocated to headings). What is problematic is that expenditure is still rising, but this is largely driven by health and social welfare. In a deep recession it is unrealistic to expect these government functions to shrink. Nor might we want to cut too deep. We are not good in this country at realising the essential nonlinearity of much of the relationship between government expenditure and output. Put simply we have a pretty decent health and education system. Small, or even medium increases in expenditure are inherently unlikely to result in a proportional increase in output. The same cannot necessarily be said on the downside – a quality system requires constant high levels of quality inputs, and it is easy for the system to begin to fail with slight reductions in the quality or quantity of inputs. And the pressure will be to shrink. Despite the tax take rising unemployment remains stubbornly high, and the domestic economy has flatlined, as is evident from retail sales and the labour force both shrinking. Any measured growth in the economy for the next few years will only come from the high-tech low-job export sector.
The future of Ireland therefore is crucially dependent on the future of the European economy, both the eurozone and others. this future is now clearly resting on the shoulders of the ECB, shoulders that are being shrugged as if the crisis was nothing to do with it. Right now the epicentre of the crisis has moved to spain. Although spain has a reasonable debt-gdp level of about 80%, there are concerns about its banking system. In particular, there is grave uncertainty about the level of losses in its banks. It is the uncertainty about the level combined with the near certainty that the Spanish taxpayer will end up footing the bill that has spooked the markets. Spanish banks may be broke, but the ECB will not allow them to fail. Nor will they allow bondholders to be burned. A promissory note a la Anglo solution would allow Spanish banks to ease their liquidity problems, as might any euro area lending solution. It would not solve their solvency. So long as the ECB continues to (even with euro inflation low) to obsess about inflation it will not allow monetization via promissory notes. The ECB’s most recent meeting showed how it is now paralyzed by irrational fears of inflation, where they refused to cut interest rates. Paul Krugman has recently echoed the fears of many, that the ECB are repeating the mistakes of the 1930’s. History we are told repeats itself twice : it is our misfortune to be in the first such repetition, which we recall is tragedy.
To solve the euro crisis and the irish crisis will require coordinated movements. Banks must be allowed to fail, and senior bondholders must be forced to take losses. The disruption to financial markets that that will cause is less than will be caused if the euro breaks and in any case the ECB’s insistence on a sovereign-bank linkage has caused untold damage. That will assist in cleaning the Spanish quagmire. Existing bank recapitalisation in Ireland and the bulk of greek debt should be converted to a longterm low interest rate loan, on condition that we adhere to good governance standards. But most of all Europe needs leadership from a patently unwilling germany. Germany is an export led economy, and by definition therefore requires a strong market for its products. The shortterm political win of truculent arrogance will result in a longterm loss of incalculable dimensions. European leaders must make it clear to germany, which is now beginning to show signs of deterioration in its economic state, that mutual adjustment in the eurozone requires both sides to move. This is no longer economics, it is high international politics, a game in which we Irish have little experience or evident competence.