Professor of International Business and Development, Trinity College Dublin
To what extent is Europe the answer to Ireland’s economic problems? The question reminds me of the great anarchist slogan that I used to see painted on London walls: “if society is the answer, you’ve asked the wrong question”. Not many people in Ireland appreciate as yet how much of the current recession is of our own making. Our recession is one of the deepest by far in Europe. It was caused by a series of policy errors, many of which date from Charlie McCreevy’s stint as Minister of Finance, though the political roots of the problem stretch much further back. Business people a few years ago voted McCreevy the best Irish finance minister in history. Few economists would agree.
“When I have the money, I spend it”, McCreevy said; “when I don’t, I don’t.” Spoken like a true accountant! But even the most basic macroeconomics course points out the flaws in this way of thinking. Government fiscal policy should be counter-cyclical. When the private sector economy is in a downturn, the state, if it has the fiscal resources, should use them to offset the recession by increasing spending or reducing taxes. Irish fiscal policy, by contrast, has been pro-cyclical since at least the mid-1960s, and stands out among European countries in this respect.
Irish governments, especially Fianna Fáil-led ones, mishandled the tax revenues that the long economic boom generated. We should have been running much larger budget surpluses in the good times so that we would not now be forced to slash expenditure. The Stability and Growth Pact adopted in 1997 was meant to enforce this outcome. However when Ireland became the first member state to be rebuked by ECOFIN in 2001 for its overly expansionary budget, the Finance Minister strongly rejected the criticism and refused to change course. Indeed the hugely generous SSIA scheme was introduced later that year and the government continued to cut income tax. Such tax reductions had been expansionary in the earlier years of social partnership as they helped to keep the lid on wage demands. As house prices rose and unemployment disappeared and the participation of married women in the labour force reached Continental levels, labour supply became increasingly inelastic and the consequent impact of tax reductions fell on aggregate demand rather than aggregate supply. All of these points were widely recognised within the economics community, as evidenced by a paper that the ESRI’s John Fitzgerald and I published that year, but were of course ignored by government. Fiscal policy continued to be overly expansionary throughout the boom.
Further policy errors over the period included the response to the house-price bubble, the failure to reform the tax system, Ireland’s laid-back financial sector regulation and the first round of public-sector benchmarking awards. Even as house price inflation continued at double-digit levels, the kinds of tax breaks that have made areas such as Achill and Clifden look like suburban Dublin remained in place. The measures taken on foot of the “Bacon reports”, which were supposed to take the steam out of the housing market, were conservative in the extreme. The problem lies in Fianna Fáil’s continuing entanglement with property developer interests. The only way I can see out of this is a wholesale reform of how political parties are funded. Try getting that through the Dáil!
The housing boom was compounded by Ireland’s joining the euro, even though it was clear to all analysts that Ireland was “asymmetric”: its business cycle was out of sync with the rest of the Eurozone and Ireland was much more highly exposed to fluctuations in sterling and the dollar than other Eurozone member states. The house-price consequences of the very much lower interest rates that Eurozone membership brought could have been offset by targeted measures but such actions were not taken.
The debate among economists on whether or not to join the Eurozone brought all these issues to light. Were Ireland not now in the Eurozone we would not have the protection that Iceland must dearly have wished for in recent times, but the current weakness of sterling compounds the effects of the recession on those very substantial segments of Irish-owned industry that either export to the UK or compete with sterling-denominated products on Irish and other markets.
The spectacularly generous first-round benchmarking awards made to the public service were related to the house-price boom, as public-sector groups such as Gardaí and nurses found themselves increasingly priced out of the housing market. The generosity of public-sector pensions and the permanency of public-sector employment were not taken into account however. The most recent research shows that public service salaries are some 20 percent higher than private sector salaries when comparing like-with-like in terms of education, experience etc.
The real benefits or otherwise of social partnership will become apparent in the near future. Supporters of partnership such as Paddy Teahon, secretary general of the Department of the Taoiseach when the process was established, have argued that partnership has promoted a shared understanding among unions, employers and the government of the key mechanisms and relationships that drive the economy. Other analysts viewed it simply as a mechanism to deliver wage moderation in exchange for income tax cuts. The Teahon view will be proved accurate if the unions now agree to some mechanism to reduce public-sector pay until the current crisis is overcome. The only politically viable option that could deliver this however would require that other more advantaged groups such as hospital consultants and the legal profession that earn much of their remuneration from public-service work are also faced with similar or larger reductions.
One of the outcomes of partnership has been to shift the burden of taxation away from income tax and onto much more cyclically-sensitive and property-sensitive forms of taxation such as Stamp Duty, Capital Gains Tax and Value-Added Tax. Again, the dangers of this should have been foreseen, and the tax system reformed, before the slump hit.
Europe was not a factor in any of these policy errors. Only in the area of bank regulation is a European-wide initiative likely to emerge. If other European countries facing less severe fiscal conditions can take steps to expand aggregate demand, however, the Irish economy can ride on their coat tails.