Global Economic Developments – Implications for Budgetary Policy in Ireland
Check Against Delivery
Good afternoon and let me begin by thanking the Institute for the invitation to speak here today.
The financial crisis of a decade ago – sometimes called the ‘Great Financial Crisis’ – has fundamentally changed the political and economic landscape and, indeed, society more generally in many advanced countries.
The forces at work are, of course, larger than just ‘Brexit’. The international landscape is changing rapidly:
Trade tensions are elevated and many are questioning whether we have reached, or even passed, ‘peak globalisation’;
International tax reform is approaching and Ireland will be at the frontline of any changes;
Slower growth in our main export markets looks like becoming the new normal;
Central bank balance sheets have expanded exponentially with the notion of ‘lower-for-longer’ interest rates and the accompanying ‘hunt for yield’ now commonplace.
In my remarks today I will discuss the key global structural changes, and outline how these could affect the Irish economy, both now and in the future.
In doing so, I will also outline what I see as the most appropriate way that we in Ireland can respond to these emerging challenges. Our objective at all times must be the preservation of sustainable living standards: to give people the opportunity to have a home they can call their own; offer timely and effective healthcare and provide world-class education.
Achieving this will require measures to boost the resilience of our economy and to safeguard the public finances.
Macro-economic stabilisation: a difficult journey
Before proceeding, I think it’s important to take stock — to remind ourselves just how far we have come. While date-stamping the low-point of the crisis is not an exact science, given the nature of Irish macro-data, I place greatest emphasis on the labour market as an indicator. I do so because employment is the foundation upon which we build so much in both our economy and society.
The unemployment rate peaked at 16.0 per cent in 2012. Today it is 4.8 per cent.
That same year, our Budget deficit was 8.1 per cent of GDP – a figure which had nothing to do with supporting the banking sector. Last year, a modest surplus was recorded; the first since 2007. Budget 2020 outlined a surplus of around 0.2 per cent of GDP, or €700 million for this year.
That year (2012) involved a painful, but necessary, fiscal contraction of 1.6 per cent of GDP. This year — despite the uncertainties around Brexit — I was happy to present the sixth successive budget in which investment and spending on our public services was increased.
Back in 2012, public indebtedness as a share of income was on a rising trajectory. It is now on a downward trajectory although, as I will outline later, much more needs to be done.
Crucially, our economy today is much more balanced than it was during the pre-crisis period. On the eve of the crisis, the construction sector accounted for around 10 per cent of all economic activity. At the time, one in 10 workers was directly employed in this sector, and that is not counting those employed in downstream activities, such as in conveyancing and real estate activities. Today the figure is 1 in 16.
Similarly, the recent improvements in living standards have been achieved without a credit boom. Last year, we had an underlying current account surplus of €13 billion — 6½ per cent of national income. This means we are very much paying our way in the world.
In summary, although many people are still experiencing difficulties, the economy is now in much better shape. Quite simply, this would not have been possible without the restructuring of the banking system and the repair of the public finances. Difficult decisions were taken but these laid the foundations for the subsequent recovery.
Having said that, I am acutely aware that economic recovery has not been uniform. Crisis legacies remain, not least in the form of an inadequate supply of housing and healthcare, as well as rental and childcare costs. So my job, as Minister for Finance, boils down to ensuring:
Firstly, that economic progress is maintained; and
Secondly, that resources are available on a sustainable basis to meet the needs and realise the opportunities of Irish society.
I need to do both, because ultimately, I am the Minister for an economy within a democracy, not a democracy within an economy.
Mounting external challenges
While recognising the huge progress made in recent years, it is crystal clear that this is no time for complacency. New challenges are emerging, with the potential to shape Irish economic prospects for years to come.
So I would now like to highlight some of these, focussing today on the external challenges. In my remarks, I will be brief as, I’m sure you will agree, I could devote a full speech to discussing each individually.
(i) UK exit from the European Union
Firstly, there is the issue of Brexit.
The risk of the UK departing the EU without a deal this year has been averted for now. However, the ultimate outcome remains highly uncertain and a disorderly exit – either without ratification of the revised Withdrawal Agreement or at the end of the transition period in 2020 – remains a distinct possibility in the not-too-distant future.
It goes almost without saying that our hope is that the UK’s withdrawal will take place on the basis of the deal agreed between the UK and EU at the European Council last October, while also awaiting the outcome of the UK’s General Election.
But even this is sub-optimal: there is no good UK exit for Ireland. Anything that disrupts free and easy trade between Ireland and the UK, however minimal or non-intrusive, is bad for Irish business, bad for our economy and bad for our common bonds. And the loss of a large Member State – one that has actively promoted free trade and liberal values – comes at a considerable cost to a small country like Ireland, where free and open trade has been the driving force behind the convergence of living standards to EU norms.
But we must be realistic. Brexit, in whatever form it takes, will soon be a reality and our economy must adapt. The Government can, and will, help to ease the transition but our economy will have to adjust to a new normal.
(ii) ‘Peak’ globalisation
The rise in protectionism and the associated trend towards ‘de-globalisation’ and what the Irish political economist, Henry Farrell, has called ‘weaponised interdependence’ – that is, the unravelling of global supply chains and their leverage for geopolitical advantage – are worrying from an Irish perspective. Our economic model is based on integrating Irish production into global value chains and, over time, shifting this production further and further up the value chain.
Following three decades of growth, world trade as a percentage of global GDP has been declining in recent years. This trend pre-dates the current deterioration in trade relations between the US and China.
(iii) International corporate tax reform
Turning now to the issue of corporate taxation, it is fair to say that there is a broad consensus that further international tax reform efforts are needed in order to address the tax challenges arising from the digitalisation of the economy. The corporate tax system that is in place in most jurisdictions was developed around a century ago, with very little change in the meantime. Meanwhile, the digitalisation of the global economy has proceeded apace, especially in the past two decades.
This has led to a mismatch between the global corporate tax code and global economic activity, and addressing this mismatch is now a priority for many. I have always supported the OECD as the most effective organisation through which these challenges can be addressed.
I have consistently argued that tax competition is a legitimate form of competition between countries looking to attract investment to their shores. This is especially the case for geographically disadvantaged countries, such as Ireland. I will continue to argue that point within the OECD framework.
But I want to be clear. The precise form and timing of these changes may be up for debate, but their introduction is not. Change is coming and changes will have an impact on both our economic model – our ability to attract inward investment – and on our revenue stream.
In terms of the latter, we have seen a large increase in corporation tax receipts since the mid-part of this decade: these now account for nearly a fifth of total receipts. Later today, my Department will publish figures that show taxes paid by the corporate sector in November – the single most important month – were €0.7 billion ahead of expectations. In the year as a whole, overall tax receipts are likely to be €600 million higher than we thought in October.
On foot of today’s figures, I now believe a surplus of 0.4 per cent of GDP is in prospect for this year. In cash terms, this represents a surplus of around €1.4 billion.
It is by running surpluses that we can reduce our vulnerability to a reduction in corporate tax receipts. As I’ve said previously, receipts at this level will not last forever. A further increase for next year is likely but, subsequently, I expect these receipts to begin to fall. Building up our surplus is the best way of addressing the decline in corporate tax revenue that looks increasingly inevitable. This is now well underway. The implementation of Budget 2020 will be the next step in this process of reducing that reliance.
(iv) ‘Secular stagnation’
One factor behind the trend towards lower interest rates is the very real possibility that the potential growth rate of advanced economies is slowing. Put simply, a combination of ageing populations and weakening productivity growth mean that future growth rates will be lower than in the past. The US economist, Larry Summers, has re-introduced the concept of ‘secular stagnation’ to describe this phenomenon.
With regard to the change to the political economy landscape over recent yearsthis change, which in very broad terms can be described as a shift towards increased government spending — including deficit-financed spending — is evident in the UK and the US, and is increasingly informing debate at a European level.
The US is an interesting example. Last year, under President Trump, the Republican Party voted through a series of tax cuts that are estimated to result in successive federal deficits out to 2022. The package will add over $1 trillion to the federal debt per annum. The fact that the narrative in the US appears to have changed to one of ‘deficits don’t matter’ is hugely significant.
In the UK too, the current election campaign is interesting for the fiscal position of the two main parties. Both Labour and the Conservatives are committed to increasing public spending — particularly on capital infrastructure — in a way not seen in many years. The Conservatives, in particular, have deferred their commitment to a balanced budget beyond 2024.
In a speech at the European Banking Conference a number of weeks ago, the new ECB President, Christine Lagarde, spoke of the importance of investment in boosting domestic demand and countering some of today’s economic challenges. Her comments are indicative of a discussion occurring within Europe on the appropriate role for fiscal policy. The Commission’s recent call for a ‘pre-emptive’ rather than ‘reactive’ approach to fiscal policy, in which infrastructure investment is used to boost long term growth prospects, echoes the view of many Member States.
The political momentum behind a more pro-active fiscal stance has fed into recent discussions around the appropriateness of the fiscal rules. I have long highlighted their limitations in relation to Ireland, but would caution against diluting the principles upon which they are based.
In my opinion, there are a number of key drivers of this fundamental shift.
Firstly, in relation to the US, the UK and other countries, wages have been stagnant over recent decades. In the US, real wages have barely increased in over 40 years. A situation unimaginable in an Irish context. In the UK, Italy and Spain, large wealthy European countries, real wage increases have been sluggish.
In democracies, people who feel they are not benefitting from the prevailing economic orthodoxy demand change.
Politicians, or at least those who wish to be elected, respond.
The macroeconomic data are instructive in this regard. Manufacturing as a share of economic activity is falling in many advanced economies and, with it, the loss of high-paying employment. At the same time, the macro data show that the trend of rapidly expanding world trade – in evidence since the 1980s – has now gone into reverse.
Moreover, the share of the economic pie that goes to workers – the so-called labour share of national income – has fallen in many countries, with adverse distributional issues. As the labour share has declined, returns to capital have increased. The rise of capital at the expense of labour is placing strains on the social contract that underpins global capitalism.
Our progressive tax regime, as well as our comprehensive social welfare system helps us to mitigate against these forces.
Secondly, at a time when demographic pressures mean that developed economies increasingly rely on productivity increases for economic growth, it has flat-lined. Paradoxically occurring at a time of immense technological advancement, the ‘productivity conundrum’ depresses wages and reduces standards of living.
The public and private sectors not increasing investment in line with economic growth is, in my opinion, a major cause of the paradigm shift we are now seeing.
Private sector investment has fallen over recent years. Some large corporations, many of which are multi-billion dollar companies operating at the technological frontier, are choosing to spend their excess cash on share buy-back schemes, rather than on investment. The ‘financialisation’ of many of the world’s industrial and technological giants will make it harder to achieve long-term productivity gains.
Although in Ireland we have seen huge inflows of foreign direct investment, globally, with a relative dearth of investment, it is natural that there are increased demands for public investment.
Thirdly, adding to such demands is the need for investment in climate-related infrastructure. Almost unprecedented levels of investment are needed across the world to aid the transition to low or zero emission economies. As societies increasingly recognise the importance of adopting such changes, demands for public investment are increasing.
But again the private sector must play its part. The primary role of the public sector is to provide the legal and administrative framework within which private investment can flourish. Private investment in low carbon technologies and processes will need to do a large proportion of the ‘heavy lifting’ if we are to make the necessary transition.
Finally, in many advanced economies, policy interest rates are now effectively at zero – what economists call the ‘zero lower bound’. Many central banks have followed the example of the Japanese central bank, resorting to ‘non-standard’ policies, such as expanding their balance sheets in order to reduce longer-term rates.
But there is a shared view that monetary policy has borne too much of the burden; that it has reached its limitations, particularly with regard to its effectiveness. Because of this, there is a growing – though not complete – consensus that fiscal policy has a complementary role to play at the ‘zero lower bound’. The low interest environment means that financial markets access is no longer the constraint it once was for many countries. This creates both opportunities for greater fiscal activism, but also dangers of overreach.
The intellectual backdrop to this can be traced to Olivier Blanchard’s speech to the American Economic Association earlier this year, which kick-started much of the discussion. He highlighted that when the growth rate of the economy is higher than the average rate of interest on public debt then, all things being equal, the debt ratio will fall.
Using this truism he argued that there is more scope for fiscal policy to smooth the economic cycle in many advanced economies, as long as interest rates remain low.
But as we know, all things never are truly equal in a small open economy like ours.
In articulating my view of this paradigm change in political economy, let me make a couple of points.
Firstly, I broadly agree with the view that with monetary policy increasingly constrained, fiscal policy has a key role to play in stabilising the cycle. But it must be accompanied by structural reforms that boost the supply-side: reforms that raise growth through boosting productivity and labour supply.
In Ireland, the Government has been using fiscal policy proactively, successively increasing capital spending since 2013. That year, capital spending was €3.4 billion, this year is will be €7.4 billion, more than a twofold increase. In 2019, capital spending will be 24 per cent higher than 2018. The investment has been made at a time when the public finances were in deficit. We borrowed to make capital investments and boost the productive capacity of our economy.
I am sometimes asked why we are not running larger surpluses at this stage of the economic cycle. The answer is simple: if capital expenditure had not been increased in the way it was, Ireland would have a fiscal surplus of over 1½ per cent this year. Which is the better approach? I think that is clear – borrowing to invest in capital infrastructure was the correct approach to take and is consistent with some of the arguments for looser fiscal policy today.
Maintaining control of current expenditure will allow us to continue to invest in the productive capacity of our economy.
Budget 2020 included increases in capital expenditure at an average annual rate of 5.8 per cent out to 2024. In 2020, we will invest 4.4 per cent of GNI* in public infrastructure. Crucially, we will continue to invest at a steady rate. Investment as a share of GNI* will be maintained at an average rate of 4.3 per cent over the medium term. Investing in this way ensures our productive capacity does not fall behind, as it did in the aftermath of the financial crises.
Secondly, let me address some of those who think we should take a similar approach to current spending. As a small open economy, Ireland is particularly vulnerable to the global economic environment. We do not have the luxury of a large domestic market. We do not have our own currency and the independent monetary policy that it entails. For economies such as ours, it is important that fiscal policy ‘leans against the wind’ and does not become pro-cyclical by inflating booms and exacerbating downturns. We need to ensure that when times are good we hold back resources to allow us to spend during the inevitable downturn.
Thirdly, given the issues I have already outlined in relation to corporation tax, Ireland has particular vulnerabilities that require a specific set of responses. Government deficits were needed in recent years to address infrastructural deficits. That level of investment will be maintained. But we cannot ignore the clear and present danger of a fall-off in corporation tax receipts.
The political economy zeitgeist may be changing, but the fundamental duty of any Government to protect the public finances against risks — including those posed by potentially transient corporation tax revenues — has not.
Finally, despite the progress made over recent years we remain a highly indebted country. The ratio of debt-to-income is around 100 per cent. On a per capita basis, public indebtedness increased last year to over €42,000 a figure which is amongst the highest among OECD countries.
Because of the high level of public debt, my Department publishes an in-depth analysis of debt each year. The latest piece of work – published in August – shows that while the debt ratio is expected to decline over the coming years, its trajectory is threatened by numerous risks. These vary from short-term risks on the immediate horizon, such as the impact of Brexit, to more medium-to long-term risks, such as the challenges associated with population ageing.
Recognition of these key points — the use of deficit-financed fiscal policy to increase capital spending over recent years; the open and sometimes volatile nature of our economy; the risk of a reduction in corporation tax receipts; and the existing level of public debt — inform the policy response I am now proposing.
Building Up Fiscal Buffers
Firstly, I’d like to briefly discuss the fiscal rules. The rules, as enshrined in the Stability and Growth Pact, are intended to institutionalise counter-cyclical fiscal policy and to ensure sustainable public finances.
However, compliance with the “one-size-fits-all” EU fiscal rules may not be sufficient to achieve that objective in Ireland. I have previously outlined the limitations of the rules in an Irish context. For example, the use of GDP as the key metric by which our national debt is calculated is problematic, misrepresenting the true size of our debt burden.
In recognition of this fact, today I am announcing a new target, namely that the ratio of debt-to-GNI* be brought down to 60 per cent at a suitable pace. I am also setting an interim target: We are aiming to reduce the debt-to-GNI* ratio to around 85 per cent by 2025.
The targets are, of course, predicated on a continuation of the positive economic growth seen in recent years. Nominal annual growth of around 3.5 to 4 per cent of GNI* should allow us to meet these targets.
Under a disorderly Brexit scenario, in which significant economic challenges will emerge, the target will be to reduce debt to between 90 and 95 per cent of GNI* by 2025.
I have asked my Department to continue to monitor debt dynamics closely and to report to Government on progress towards meeting these goals in its Annual Debt Report.
Smoothing the Economic Cycle
A key objective of budgetary policy must be to smooth the economic cycle. The pro-cyclical behaviour of the past – ‘when I have it I spend it’ – must be avoided. The economy is at, or close to, full employment at present. This calls for prudence in framing policy.
Given the economic risks I have outlined here this afternoon, not least by the expected reduction in corporate tax receipts, the appropriate policy is to increase this surplus in successive budgets. This is how we can enhance the resilience of the economy.
Therefore, today I am announcing that, assuming continued economic growth, the Government will target annual increases in the budgetary surplus over the coming years. Overall, we are aiming to achieve a surplus of at least 1 per cent of GDP by 2022, and crucially, will maintain and improve that level over the medium term, subject to economic trends.
In GNI* terms — a better gauge of the size of our economy — the surplus will be 1.7 per cent, or around €3.8 billion.
Building upon our performance in 2019, running surpluses is the best way of addressing the vulnerabilities associated with our exposure to corporate tax, including international policy changes in this area.
This approach is, of course, contingent upon the avoidance of economic shocks. The main – though not the only – threat to short-term economic growth prospects relates to a disorderly exit of the UK from the European Union.
Should a disorderly Brexit occur, we would follow the same approach taken at Budget 2020. That is to say we would allow the automatic stabilisers play a counter-cyclical role and introduce timely, temporary and targeted supports for the most effected sectors. These supports would be funded through deficit spending, if necessary. Under such a scenario, the deficit in 2020 will be around €2 billion. On this basis, we would expect the budgetary accounts to return to balance by around 2023.
I want to make clear that achieving budgetary surpluses can be achieved at the same time as improving public services, which is a key commitment of the Government. The days of austerity are over, but so are the days of pro-cyclical budgets. To safeguard public services in the long term, current expenditure increases need to be sustainable. We cannot return to the boom-bust days of the past.
Public investment has increased dramatically over recent years, but there is a limit any economy can take before additional investment only serves to increase prices and erode value for money. Given capacity constraints in the construction sector and more generally, it would not be appropriate to increase capital expenditure beyond this very high level.
Instead, there is a role for the construction sector itself in helping to address some of the constraints now becoming evident. To do this the sector must become more productive.
A recent report by the Department of Public Expenditure and Reform showed that the industry in Ireland lags its European peers in productivity. In fact, productivity remains over 10 per cent below the level achieved in 2010. This has to change.
Of course, the need to boost productivity applies to all sectors. Productivity is, in many ways, the economic ‘holy grail’. It is how living standards are improved – think of Denmark or Sweden, countries where wages are high but still competitive. Higher wage levels and competitiveness coexist because workers in these countries are so productive; this is an important lesson.
Given the importance of productivity – especially at full employment – my Department has conducted a considerable volume of research on this issue.
Perhaps the most important finding is that while productivity levels are very high in Ireland, this is mainly accounted for by exceptionally high levels in a small number of multinational-dominated sectors. Elsewhere, productivity levels are lower and, I believe, there is scope to improve this.
The Government is playing its role. Pillar 2 of the Government’s ‘Future Jobs’ strategy aims to increase productivity in the domestic sector by 1 per cent per year by 2025.
This will be achieved by increasing the role and impact of State supports available through Local Enterprise Offices and Enterprise Ireland, strengthening the National Competitiveness Council and deepening the linkages between Irish and foreign owned companies.
Future of Europe
Access to European markets and, especially, the Single European Market has allowed Ireland to prosper. We have received incalculable benefits; from access to European markets, inward migration and free trade. Ensuring the fruits of this success are felt as widely as possible is crucial if we are to avoid the emergence of some of the politics we now see in other countries.
A key part of my job, is to help make this happen. That is why, in successive Budgets, this Government has invested heavily in public services, such as housing and health.
The loss of the UK from the European table presents many challenges. Were the UK to pursue a policy of regulatory divergence from the EU, there are very profound implications for the protection of the Single Market on this island, which constitutes the UK’s sole land border with the EU.
For Ireland, our future is with the European Union. We must recognise the reality that in our global era, where the separate regulatory superpowers of the US, the EU and China co-create global rules, our place is firmly within the European project. This is how we will prosper. It is a market of 440 million. It is how we negotiate with the rest of the world – as part of a large trading bloc that carries significant weight. It is how we have a voice on the global stage.
But the Union is not perfect – nobody ever said it was. Jurgen Klopp put it very well recently when he said (and I paraphrase): the EU has never been perfect, it is not perfect now, and it never will be. But I have yet to hear anybody come up with anything better.
However, we should be very clear that the EU without the UK will have a different character. Agendas on European security, economic sovereignty and competition will move ahead at greater pace. We need to be ready for this change in direction and respond to it strategically.
Of course, we must strive to improve, especially when it comes to the architecture of the euro area. Ireland will continue to push to retrofit the euro area with the tools necessary to make it a fully-functioning monetary union. For instance, we will push for a Banking Union, amongst other things to prevent sovereign-banking ‘doom loops’ in the future. We will work to re-ignite the Capital Markets Union, so that funds can be better channelled to borrowers in the euro area. Ireland supported the introduction of a Budgetary Instrument for Convergence to help provide area-wide fiscal support.
A previous Minister for Finance once said that “it is difficult to run a surplus in a democracy”.
But let me say that surplus is not a dirty word.
Running fiscal surpluses over the economic cycle is an effective response to looming threats.
Other small open economies like the Netherlands, Sweden and Luxembourg have succeeded in running budget surpluses over the medium term.
I do not believe that the Irish people have any wish to go back to the boom-bust days of the past.
While the risks are always there, this policy framework is driven by me, as Minister for Finance, and my strong intention to avoid that same prospect too.