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Speech to Dublin Economic Workshop: Robert Watt, Secretary General, Department of Public Expenditure and Reform

Published: 13 September 2019
From: Department of Public Expenditure and Reform

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Ireland has achieved an incredible convergence to the living standards of the advanced economies over the last 50 years. 

In 1960, Irish living standards were 66 per cent of the EU 12 average of the time. This coincided with increases in population after a longer-term decline. In the 1961 census Ireland’s population reached a low of 2.8 million and is now at 4.9 million. Employment increased over this period and is now at an all-time high of just over 2.3 million people. 

This was achieved through a remarkable transformation from a mostly agricultural economy to an advanced capitalist economy with strong traded exports in both goods and services. 

Economic policy over this period has been broadly consistent and can be characterised by:

  • A commitment to the European Union
  • An externally oriented investment policy;
  • A belief in a competitive market economy;
  • Investment in public goods with education as a priority;
  • Co-operative approaches to wage setting;
  • Tax policy and the broader regulatory environment supporting a dynamic market economy; and
  • A legal system which is seen as fair and balanced

This is what is good about our economic policy performance.

Economic and social progress never runs smoothly but on two occasions peaks were followed by extraordinary downturns. In the 1980s and more recently the 2000s we made chronic mistakes and paid a heavy price.

This could be described as the bad. 

The unsustainable boom periods preceding each of these recessions have some similarities and, of course, many differences. Critically, they have elements in common where lessons were not learned and a prudent approach to policy was ignored. 

Thus, the question posed is what have we really learned from these experiences?

How are we managing this period of exceptional economic expansion which has been running since the first quarter of 2013? 

Specifically, are we prepared for the next inevitable downturn? Financial and economic shocks are frequent. Is the economy better balanced, both internally and externally, and less vulnerable to these shocks? Are the balance sheets of banks, households and the State prepared for weaker growth? 

A tale of two crashes

In comparing the two crashes of the 1970s and the 2000s, the similarities between both periods are interesting. Both were triggered by external factors but made much worse by domestic policy failure. In both cases, the economy became highly imbalanced with large external deficits. 

In the 1970s, overly expansionary fiscal policies in the later part of the decade left us vulnerable to the subsequent external shock. This “pump-priming” was tried at a time when the economy was recovering from the first oil shock and approaching full employment. By the beginning of the global recession in the 1980s our debt as a percentage of GDP was 130% and the current account deficit had reached 15% of GDP. The rationale for this misguided Keynesian approach was that more public spending and higher deficits would reduce unemployment. 

The intellectual errors were twofold: overestimating potential output by overstating the sustainable rate of full employment. And failing to appreciate the limitations of these expansionary policies for a Small Open Economy. 

It is clear that the crisis of the 2000s contained uniquely banking features. It was caused by excessive private spending, excessive leverage, unsustainable construction activity and a remarkable asset price bubble enabled by easy credit conditions. Bank balance sheets were allowed to expand to an incredible extent. Once again a large balance of payments deficit emerged by the time the tide turned. 

Weak external supervision, the incomplete design of the Euro and the weak initial response of our Partners didn’t help– but this crisis was home grown. This is a central lesson from this period. This crisis was not caused by our adoption of the Euro, by the Troika or by other real or imagined villains. Ultimately, it was caused by the pursuit of domestic financial, banking and fiscal policies that were inappropriate irrespective of the currency regime in place. When the shock came we were badly prepared for the second time in 30 years. 

Fiscal policy was not the primary cause of these imbalances, but large increases in public spending and tax cuts made things worse. Permanent commitments were based on unsustainable revenue sources - policies were pursued based on an overly optimistic view that improvements in output were permanent.

The intellectual errors involved failing to appreciate the impact of “financialisaton” on the sustainability of growth. Moreover, large external funding of the banking system and the related external deficit failed to raise the alarm. It was felt that such imbalances were not a cause for concern in a multi-country currency zone, mistakenly believing that such countries faced the same risks as countries or States in a full monetary union. We allowed the economy to expand on an unsustainable course without regard to the discipline required to prosper in a multi-country currency zone. 

Lessons can be learned if we correctly identify the causes. A simple view is to blame the greed of bankers and/or incompetence of relevant regulators and officials and the politicians for their support for easy credit and pro-cyclical fiscal policies. 

But economics is also to blame. In the late 1970s economists were universally critical of the policy stance. But, during the 2000s there was not a widespread chorus from more neutral, non-political observers advising caution. Much revisionism now claims that “we saw it coming”. This is not credible. Some economists and commentators – the ESRI most notably -issued warnings. However, the vast majority of the commentariat took a more sanguine view. 

There is much rewriting of history. 

Wider societal failings are also relevant. As a society we allowed optimism bias and Groupthink to take hold. 

Lessons to take forward

Interests and Ideology

More specifically, we failed to manage the impact of interests and ideology on the policy formation process. 

In the lead up to the financial crisis of the 2000s, bankers, the wider finance community, the construction sector and many related interest groups dominated the public discourse to the advancement of their own interests. Much of the media and many vested interests were cheerleaders too.

For example, the funding by the construction industry of the electoral system was critical. Similarly, vested interests took over the policy space. 

The social partnership model also gave too much influence to buying off interest groups rather than considering the wider public interest. Hopefully, various reforms to the funding of political parties, lobbying legislation and Freedom of Information Acts should help in constraining excessive influences in future – we shall see. 

The lack of academic economists engaged in applied Irish macroeconomic policy was striking and – despite the interest generated by our misfortune – is low again. Once again I think there are not enough independent voices.

Institutions matter

Of course, strong institutions are meant to confront these biases and interests - and these institutions failed. The Central Bank has a specific critical mandate in relation to banking matters and financial stability. In many ways the Governor of the Central Bank of Ireland has a unique role as a public servant who is independent of politics and has a platform to influence policy formation.

The role played by the Central Bank during the 2000s has received much criticism and much of it is valid. 

The role of the Department of Finance should be highlighted too. Fiscal policy choices that promoted large increases in public spending and tax cuts in the lead-up to the financial crisis certainly exacerbated the boom. 

In my opinion, the Department of Finance became too close to the political leadership of the day and lost its role as an essential bulwark in the system. At a critical juncture these institutions lacked the competence and/or platform to confront these interests and ideology. 

External supervision

Beyond the political system, macroeconomic policy decisions are also shaped by the role of external supervisors– the European Commission, the IMF and the OECD. 

Ireland was highly compliant with budgetary surveillance in the lead up to the financial crisis. However, the focus on budgetary discipline demonstrates the weakness of European based fiscal policy surveillance in the first decade of this century. Some reports noting the downside macroeconomic risks to the public finance position associated with Ireland’s exposure to the international economic climate and a downturn in construction activity were not sufficiently highlighted. External supervision was too sanguine and provided domestic cover for mistakes. 

Policy response

This crisis offered an opportunity for the State to put in place reforms that were missing a decade ago. How well have we done? 

New fiscal framework

A key element of the overall set of reforms was a revised fiscal framework. 

The reforms to the revised fiscal framework in Ireland have been significant and include:

  • The introduction of fiscal rules through the Stability and Growth Pact and Multi-annual Exchequer Voted expenditure ceilings;
  • Mechanisms to ensure greater engagement with the Houses of the Oireachtas, including the establishment of the Budget Oversight Committee and the Parliamentary Budget Office;
  • The development of a ‘whole-of-year’ budgetary framework, including the publication of the *Mid-Year Expenditure Report, Tax Strategy Papers, Spending Review Papers, the Public Service Performance Report and the annual Summer Economic Statement;
  • The establishment of the Irish Fiscal Advisory Council;
  • The introduction of the Irish Government Economic and Evaluation Service (IGEES); and
  • The development of frameworks to enhance policy appraisal and evaluation, such as the Public Spending Code and the Spending Review. 

The broad parameters for an upcoming budget are now flagged well in advance of the October Budget Day each year. This has enhanced the potential for better debates about fiscal choices. 

We also have enhanced resources within the system to analyse data, evaluate expenditure and appraise policy options through the establishment of IGEES across all Government Departments. 

Multi-annual Exchequer Voted expenditure ceilings were introduced in 2013. The rationale behind introducing these ceilings was to anchor expenditure projections to a fiscal target and provide more budget certainty. The medium term expenditure budgeting has not worked as envisaged and we need to look at it again. 

It is fair to conclude that much has changed. The movement to a ‘whole-of --year’ budgetary cycle has encouraged greater transparency with regard to fiscal policy decisions. There is more commentary from the Fiscal Council and the PBO and others. This is to be welcomed. Further to this, via the Spending Review process and the creation of IGEES, there is more evaluation of expenditure taking place throughout the year. This is also to be welcomed. However, it is not clear that these changes have improved the quality of the decision-making process even though there is more evidence to assist decision makers. 

Changes to the fiscal rules were a significant reform. These rules helped to support the necessary fiscal consolidation to 2014 and our move to a balanced Budget. The consolidation was a remarkable achievement and the politicians of the day don’t get the credit they deserve. However, it is questionable whether these rules are appropriate in managing demand at this stage in our economic cycle. 

As this audience knows, estimates of the structural balance are non-observable and the rules are too complex and too easily gamed. Moreover, our analysis has indicated that they can produce pro-cyclical outcomes as countries can expand spending too rapidly when they meet their Medium Term Objectives. Also, they are not flexible enough to deal with country specific circumstances – in our case severe measurement challenges and volatile corporation tax receipts. 

There is now a wider European debate about these rules with an emerging view that the rules are too lax in good times and too inflexible to deal with weak demand conditions. This accords with our views. Better rules are required – either through revisions at EU level or new domestic rules that Dáil Éireann could adopt. 

Banking reforms

The most important reforms overall relate to the banking system. Banking is, by nature, inherently risky, as loans are less liquid than their liabilities. Reforms have responded to the risks exposed by the crisis. There are now revised minimum capital requirements for banks, better rules for managing failing banks and improved deposit guarantee schemes. Together, these represent efforts to reduce the risks of excessive credit growth. 

In contrast to the pre-crisis period, regulated financial services firms in the State are now required to have sufficient financial resources and sustainable business models while being well governed and able to recover if they get into difficulty. In addition we have the much debated macro-prudential policy rules. 

Is this time different?

The current period of economic expansion began in 2013 and has resulted in a robust recovery. Over this period the economy, as represented in GNI*, grew by 40.4 per cent. Unemployment rates, which reached a crisis peak of over 15 per cent in 2012, have fallen sharply and stood at 5.3% in July 2019. The number of people in employment passed 2.3 million in July 2019, an annual increase of 45,000. Significant population growth, driven by increased migration, has also returned, with the population of the State increasing by roughly 130,000 in the two years to April 2019. 

The key goal for policy-makers is to sustain these gains. We know that economies are prone to financial and other shocks. This is an inevitable part of the business cycle which needs to be reflected in good policy making. 

Financial and economic indicators

I would argue that there have been notable improvements in policy sustainability. 

Firstly, the balance sheets of domestic Irish retail banks are in a much stronger position and are less vulnerable to either a global or domestic economic shock. The capital ratios of the banks are significantly higher and we are not experiencing a credit boom. Indeed there has been a consistent year-on-year deleveraging of overall credit outstanding in the Irish economy. At the end of 2008, this amount was fast approaching €400 billion. By the end of 2018, the outstanding liability of credit advanced to the Irish private sector, inclusive of households, was less than half this amount. 

Household indebtedness has also declined and was estimated by the Central Bank to be at 126 per cent of disposable household income in 2017. This compares with an estimated 212 per cent in 2009. 

Investment growth has been significant during this expansion, with fixed capital formation growing strongly. This investment has not been funded by a credit boom or a growing balance of payments deficit. Critically, the modified balance of payments shows an adjusted surplus indicating that the economy is more externally balanced. 

Costs are accelerating as we reach full employment. These will need to be carefully managed if growth continues. The real effect of the exchange rate is a critical measure of potential pressures. 

This expansion is different – and looks more sustainable but that is not to say there are not vulnerabilities. Of course there are.

Fiscal policy

Are we getting better at managing fiscal policy? 

Fiscal consolidation ended in 2013 and by 2014, as the deficit fell towards the 3 per cent limit, expenditure started to increase once again. Policy started to move beyond the contractionary phase into managing a recovery phase. The question is ‘Has policy been sufficiently prudent post 2014 by building up larger fiscal buffers and seeking to constrain demand?’ 

An indicator of particular relevance when we think about sustainability is public debt. In 2018 gross debt stood at 107.3 per cent of GNI. While interest payments are low, and servicing costs falling, this is a large debt which leaves the economy exposed in the event of a weaker economic outlook. 

While the State finances, as measured through the headline deficit, show a significant improvement it is also evident that there have only been modest improvements in the primary balance since returning to a surplus in 2014. 

Measures of the structural balance are benign – but show no real signs of tightening. Policy, on this basis, has been broadly neutral without having regard to the sustainability of corporation tax receipts.

However, as we are all aware, estimates of the potential of the Irish economy are uncertain. Ex-ante assessments of fiscal policy have been subject to comparatively large revisions in the past, making the assessment of budgetary policy more complex. 

It is useful to dwell for a moment on some of the detail behind these aggregate numbers. Since 2014 gross voted current expenditure grew by 17.4 per cent. 

This is markedly slower than during the previous expansion. For example, between 2004 and 2009, gross voted current expenditure grew by almost 57 per cent. 

The growth in day-to-day expenditure in the last five years is far more moderate than that seen in the pre-crisis period. 

Furthermore, the scale of tax packages over the last number of years has also been modest compared with the pre-crisis period. Comparing the two periods, taxation measures introduced by Government cost approximately €3 billion less in foregone revenues between 2015 and 2019 compared to the 2004 to 2008 period. 

Clearly, assessing the stance of policy depends on judgement and is a contested space – and highly political – so I will say no more. 

Concluding remarks

This recovery has been highly impressive – and better balanced/and more sustainable. Policy should be firmly focused on stability and sustaining those gains. 

What do I think are the central lessons from our successes and failures over this period? 

Continuing success requires on-going commitment to openness and trade – and policies in education and the provision of public goods. Delivering on the ambitions in the National Planning Framework and Project Ireland 2040 are essential to the development of proper functioning communities that can sustain growth. NIMBYISM and poor land use management are the greatest risks to this. 

To avoid domestic macroeconomic mistakes I think the message is simple - rules and institutions matter. 

We have better rules governing our banking and financial system. This is a critical reform legacy – and it is having an impact on this period of expansion. And I think in an overwhelmingly positive way. 

Changes to the fiscal framework have improved openness, transparency and engagement. But we need better fiscal rules – at EU level or domestically which reflect our unique circumstances, particularly regarding corporation tax receipts. 

Critical institutions are in a better place – but there are no grounds for complacency as we don’t yet know the challenges we we might face in the future. 

Finally, Groupthink is the enemy - more debate and challenge and thought is needed – and more weekends like this.