Philip Lane on the Irish Economy 2010

Flamed Diving

The Irish economy has endured a painful period but the prospects for 2010 are brighter. Reform is essential though, writes Philip Lane.

The 2008-2009 crisis has severely damaged the Irish economy. For households, living standards have declined due to the decline in employment levels, reductions in earnings and increases in taxes. For firms, many have shut down, while those that survive have had to deal with a curtailment in the workforce, a reduction in profitability, a contraction in investment plans and tighter access to credit. Most prominently, the Irish banking system has required extensive State support, while sharp corrective action has been required in order to stabilise the public finances.

Having endured this painful period, the prospects for 2010 are brighter. The improvement in the forecasts for global growth should help the Irish economy to begin growing again in the second half of 2010. However, there is a substantial list of reforms that must be addressed in order to ensure that the Irish economy can sustain growth into the medium term.

First, the restructuring and recapitalisation of the banking sector is a high priority for 2010. The transfer of the property loan book to Nama is a key initial step. In turn, the crystallization of losses on the transferred loans will likely require substantial capital injections into the banks. While there is some prospect of private-sector interest in the banks, it must also be accepted that the Irish government may end up taking very substantial stakes in the two main banks. In relation to the smaller banks and building societies, all the signals indicate that there will be a consolidation process in order to create a viable "third force" bank that can improve the competitive environment in the provision of credit.

Whether in 2010 or at some future date, it would be desirable to increase the presence of foreign banks (through acquisition or new entry) in the domestic system. This is important for two main reasons. First, the small scale of the domestic economy is not conducive to efficiency in the delivery of banking services. Second, the high cost of the Irish banking crisis underlines the importance of geographical diversification in reducing the vulnerability of the banking system to local shocks.

Banking reform should also extend to a new regulatory environment. The reorganization of the Central Bank and the introduction of new leadership should help to improve the quality of supervision and regulation, with greater attention paid to macro-prudential risk. Moreover, it is also desirable that a new legislative framework be developed that would be better able to accommodate the rapid resolution and restructuring of failing banking institutions - the 2008/2009 crisis has vividly illustrated the high costs of not having such a mechanism in place.

In relation to the public sector, the failed negotiations between the government and the unions in December 2009 revealed the potential for substantial productivity growth in the delivery of public services. In particular, significant efficiency gains can be reaped through more flexibility in the re-allocation of workers across tasks, a longer working day in the health sector, the introduction of shared back-office functions across different services, more user-friendly opening hours, the extension of merit-based promotions and staff cooperation in the restructuring of State agencies. A major priority for 2010 should be the implementation of these public sector reforms. A more efficient public sector will raise living standards across the economy and improve competitiveness by reducing the resource cost of delivering public services.

The government should also be pushing reforms in the ‘sheltered' sectors of the economy. Ireland scores poorly in terms of the level of competition in the provision of many domestic services and utilities and more pro-active policies to increase competition and eliminate monopoly rents are desirable. This is very important in improving Ireland's competitive position since the price of local inputs is an important factor in determining Ireland's attractiveness as a business location.

By imposing pay reductions in the public sector, the government has taken an important step in helping to engineer the ‘real' devaluation that is required in order to stimulate. Moreover, pay reductions are superior to the alternative of reducing the level of public services in terms of implementing a targeted level of cutbacks in public expenditure. However, the government could do more in terms of encouraging the required level of wage adjustment. In particular, it could use its effective control of the banks and the utilities to induce a pay correction in those sectors, with the goal of passing on the cost savings in terms of lower prices in those sectors. Similarly, it can go further in reducing fee levels in those professions that rely heavily on the public sector as a source of demand.

Through such mechanisms, there is the prospect that Ireland can successfully rebalance the economy, laying the foundations for sustainable growth over the medium term. A reduction in domestic costs will help to improve export performance and this will be especially important as the recovery of the world economy throws up new opportunities in international trade.

In addition, lower domestic prices will also induce households and firms to switch the composition of expenditure away from imports in favour of local alternatives. This applies within categories (taking holidays at home rather than overseas) and between categories (altering expenditure share across different types of goods and services). In this way, real devaluation benefits domestically-orientated businesses in addition to the export sector.

Considerable challenges remain. Although the 2010 budget should stabilise the public finances, the next step in reducing the structural deficit is to broaden the tax base. Having relied too much on non-sustainable sources of tax revenue during the bubble years, Ireland is now collecting a very low level of tax revenue relative to GDP and needs to expand and stabilise its tax system.

In relation to income tax, this will involve a reduction in allowances and credits in order to increase the average tax rate and collect more revenue from those on lower incomes. An annual property tax would provide an additional revenue stream, as would the more extensive introduction of user charges for certain categories of public services (university fees is one obvious example). The elimination of various tax breaks will also help to raise revenue, in addition to improving perceptions of equity. Finally, while the de facto top marginal income tax rate is now quite high, it is possible that the 20 percent lower band may have to be raised.

Across the economy, a major drag on economic recovery is the high level of personal debt. With the prospect of an increase in the ECB interest rate in 2010, debt servicing costs are set to rise - together with the decline in nominal incomes for many households, this means that the recovery in consumption will be weaker than in past business cycles. High personal debt also inhibits the formation of new businesses and the expansion of existing small enterprises, since the balance sheet of owners is an important determinant of the ability of a firm to obtain credit.

The high level of debt reinforces the importance of stabilising the public finances. The sovereign debt spread influences funding costs for the banking system and the cost of credit across the economy - by reducing the sovereign debt spread, interest costs can be moderated across all sectors. Accordingly, it is vitally important that the government implements the measures announced in the 2010 Budget, even if this means that it must endure industrial unrest in the public sector during the early part of 2010. By the same token, the leadership of the public sector unions have a heavy responsibility in determining its reaction to the cuts in public sector pay, in view of the costs of a reversal in the announced budgetary strategy.

International factors will heavily influence the prospects for the Irish economy in 2010. A key influence will be the external value of the euro against sterling, the dollar and Asian currencies. While it is notoriously difficult to forecast currency movements, econometric models indicate that the euro is over-valued, such that a return to fundamentals would involve a depreciation of the euro. This would be very good news for the Irish economy.

At a global level, the deepest source of currency mis-alignment is the under-valuation of the renminbi. 2010 may be the year in which the Chinese authority recognizes the wisdom of allowing some degree of currency appreciation, which would improve the purchasing power of Chinese households, reduce its excessive accumulation of foreign-currency reserves and re-orientate the Chinese economy away from exports and towards meeting demand for domestic goods and services. In related fashion, the ongoing shift in the pattern of world demand towards Asia reinforces the importance of the government's Asia strategy in facilitating Irish firms to increase exports to these key markets.

From an Irish perspective, the Sterling-euro rate is of central concern. The 30% depreciation of sterling against the euro has plausibly overshot the equilibrium value: if mean reversion takes hold, a strengthening of sterling will improve the competitive position of Irish exports to the UK, while also relieving pressure on Irish retailers that are competing with the North.

In relation to international policies, the recovery of the European and US economies does depend on the careful management of exit strategies from the expansionary monetary and fiscal policies that were adopted in response to the global crisis. If policy support is withdrawn too aggressively and too early, there is a risk that the recovery will be very anaemic or even that a "double dip" recession may occur. This will be a very difficult policy challenge, since the high deficit levels in many countries do require adjustment if fiscal sustainability is to be assured. In relation to monetary policy, the normalization of interest rates from the very low current levels, the tapering of special liquidity policies and the unwinding of quantitative easing interventions must be sufficiently gradual in order to ensure that the stability of the financial sector is not compromised.

In overall terms, 2010 will be a pivotal year in the reconstruction of the Irish economy. Although serious risk factors are still present, the tough policy choices adopted in 2009 provide some prospect for the recovery of the domestic economy in line with the restoration of global growth. However, the fallout from the damaged banking sector, the elevated fiscal deficit and the high level of personal debt means that the recovery is likely to be quite muted and drawn out: there will be no return to boom conditions in the near future.

http://www.businessandfinance.ie/index.jsp?p=109&n=328&a=2414

Philip Lane is professor of International Economics at Trinity College, Dublin.

For those who don't know who Phillip Lane is, you can find more information here, at the IDEAS ranking system.

Quite an extensive overview of things to come. I think he is on the money, for the most part, especially about the need to encourage foreign banks to come over here.

Discuss.

hiorta

Of course, having endured, suffered, gone without, etc, etc. he will no doubt now examine and explain the utter failure of the Banking Regulator - for one - to do what the high salary was supposed to ensure.
Unless he's a part of it all.

Flamed Diving

hiorta wrote: »

Of course, having endured, suffered, gone without, etc, etc. he will no doubt now examine and explain the utter failure of the Banking Regulator - for one - to do what the high salary was supposed to ensure.
Unless he's a part of it all.

I, I... I don't even know what this means.


Sorry.

deise blue

Hopefully co-ordinated union action early next year will put a huge hole in his forecast.

nesf

deise blue wrote: »

Hopefully co-ordinated union action early next year will put a huge hole in his forecast.

Why would one wish for there not to be a return to (admittedly anemic) growth next year? Such would strengthen the Government position and reduce the need for fiscal correction (i.e. budget cuts to some extent).

nesf

hiorta wrote: »

Of course, having endured, suffered, gone without, etc, etc. he will no doubt now examine and explain the utter failure of the Banking Regulator - for one - to do what the high salary was supposed to ensure.
Unless he's a part of it all.

Well, the Current Central Bank Governor (and many Irish Economists) are calling for an inquiry into the matter and one would imagine the failure of Regulation would form a key part of such.

johnnyskeleton

Interesting article. It seems to me though that he like the government assumes that economic growth will just happen. For there to be positive growth next year in nominal terms (as deflation can skew growth in real terms) there will have to be something (or several things) which provides wealth greater than the sum of the following:

1) government cuts in expenditure (c. 2-2.5% GDP)
2) further job losses (unknown, some estimates at 70k, net I think might be slightly less)
3) losses by companies in 2008 (as in only filed final accounts in 2009, which don't register in statistics until 2010) (again unknown, I would expect these to be fairly significant as the losses of the construction sector continue to hit GDP)
4) any revelations about the banks' solvency (again unknown)

All in all, I think that ceterus paribus we will see in the region of a 5-10% reduction in GDP next year, and without any major sources of new growth but with a slight pick up in all sectors I would estimate negative growth of about 3-5% for 2010. If there is to be growth next year, it would have to be an increase in GDP of more than such 3-5% contraction. Examples of such could be a 15bn investment in renewable energy, but I remain sceptical that such will arive.

As regards the other things he says - balance the government books, reform public sector, increase competition in "sheltered" sectors of the economy and reduce costs generally to regain wage competitiveness are all good things, but he's a bit vague about the details.

I disagree that the Euro is over-valued. It is valued higher than Stg and the USD because the ECB's quantitive easment measures were on a much smaller scale than either of these two. Once US & UK return to growth I would anticipate high inflation which devalues their currencies, and that is why the Euro is trading so high at the moment.

I agree that the RNB is artificially low (common knowledge) but I disagree that the PR China will allow it to increase in value. Their economy relies on the RNB being low to keep competitiveness. They are a centrally planned economy after all, and will do whatever they want (irrespective of the rest of the world and their citizens).