What if the electorate is reckless?

It is now received wisdom that the Irish authorities pursued bad or at least inappropriate economic policy in the years before the 2008  crash .Fiscal policy is usually seen as one culprit, with Budgets perceived as fuelling the boom rather than dampening down economic activity. Fiscal policy should have been counter-cyclical, it is argued, with the government of the day seen as culpable in not’ doing the right thing’. If we ignore the hindsight bias present in such analysis it also begs a simpler question- what if the electorate does not reward prudent policies and prefers what by normal economic criteria would be considered reckless ones?

In Ireland’s case the counter-cyclical argument is that the government should raise taxes and/or cut discretionary spending when the economy is growing too fast ( leaving aside the problem of establishing what is sustainable growth at the time). Yet commentary on the Budget and the monthly Exchequer returns is predicated on exactly the opposite- strong growth in tax receipts is seen as opening the door for higher public spending and ‘ a giveaway’ when next the Finance Minister delivers his Budget address to the nation.

A glance at the 2007 general election manifestos, for example, shows that all the main political parties envisaged tax cuts and further strong growth in exchequer spending . Were the politicians being irresponsible or simply rational, based on the belief that electorates want higher spending and lower taxes and will not reward a government which indeed adopts a counter cyclical policy, even if the need for that was  perceived clearly at the time ?

There are additional constraints other than the electorate, although perhaps not well understood by voters. One is the fiscal rules imposed by membership of the euro, and these have tightened considerably since 2010, including the stipulation that Ireland will need to limit current government spending in the medium term and to run a persistent Budget surplus when adjusted for the economic cycle. It remains to be seen what role these constraints will play in shaping the next general election.

The new fiscal pact also resulted in the setting up of the Irish Fiscal Advisory Council, which is there to assess the budgetary stance and monitor compliance with the fiscal rules. Yet it does not appear to resonate with the public and the government has ignored its recent advice, to no great media  clamor or cost in terms of public opinion.

The markets, too, play a role, and can punish profligate governments. Yet bond yields across the euro zone are generally at record lows, despite the fact that debt burdens are still rising, so QE has apparently trumped that potential constraint, at least for a while.

The issue of the electorate’s role in shaping policies is currently on show  in Greece, where the new Government is seen to have a mandate to end austerity, kick out the troika  and yet secure additional funding from Greece’s creditors. It is unclear how they can pull this off but the electorate has spoken. Yet the same electorate has tolerated the fact that no Greek government has run a Budget surplus in 34 years ( and no doubt longer but that is the limit of the IMF data base) with the average deficit amounting to 7.7% of GDP over that period. Clearly the Greek electorate are willing for future generations to pick up the tab. Some might say this is irresponsible while others seek to blame the creditors for funding what must qualify as reckless behaviour.

 

Irish GDP surges, impressing the Government but not consumers

Ireland’s quarterly GDP figures are volatile and often surprise, with the latest no exception; the economy grew by a seasonally adjusted 1.5% in q2, following a 2.8% expansion in the first quarter, the latter revised up marginally from the initial release. That surge in Irish output left the annual growth in real GDP in q2 at an extraordinary 7.7% and means that in the absence of revisions the average growth rate for 2014 as a whole would average 5% even if GDP was to remain flat in the second half of the year. The consensus growth forecast has moved steadily higher as the year  has unfolded , from an initial 2% to around 3%, but this latest data will no doubt prompt a further substantial upgrade- the Finance Minister has already mentioned 4.5% and that requires a fall over the second half of the year. Some commentators prefer GNP as a better measure of economic activity in Ireland (it adjusts for net  external flows of profits, interest and dividends) but that tells a similar story-indeed, the annual GNP  growth rate in q2 was 9%, although base effects in the second half may mean that the annual  GNP growth rate in 2014 will also be around 5%.

The monthly external trade data had implied a strong  merchandise export performance in q2 (the Patent Cliff impact on chemicals appears to be over, at least for now) but the national accounts included  even stronger figures,  which alongside a better performance from service exports resulted in a 13% annual increase in export volume. Import growth was also very strong, at 11.8%, but such is the dominance of exports (now 117% of GDP)  that annual GDP growth would have been 4% even if the other components made no contribution.

In the event they all contributed. Investment rose by 18.5% on the year, adding 2.5 percentage points to GDP growth, following strong gains in construction output and spending on machinery and equipment. Government spending  also rose , and by a puzzling 7.9% in volume terms, which sits uneasily with the idea of spending cuts and fiscal austerity and may reflect problems with the price deflator. The third component of domestic  demand, personal consumption, also rose, but by a modest 1.8%, and even that was flattered by base effects from last year as the quarterly increase in q2  this year was just 0.3% following a meagre 0.2% rise in q1. It is clear from other data sources that Irish households are still  paying down debt at a steady clip and it is impossible to say when this deleveraging will end. Employment growth has also slowed sharply in 2014 and in the absence of a marked change in household  behaviour personal consumption growth in 2014 is likely to be nearer to 1% than the 2% many expected.

Such is the volatility  and unpredictability of exports and investment that real GDP  growth in 2014  could be over 6% or nearer 4%, but we currently expect  5%.Export prices are falling, as is the deflator of government spending, and for that reason the rise in nominal GDP this year may be less than that recorded for real GDP – we expect 4%.That would give a nominal GDP figure  in 2014 of €182bn but still substantially above the €171bn forecast in the 2014 Budget. Tax receipts are also  running well ahead of target and so we now expect the General Government deficit for the year to emerge at 3.4% of GDP compared with the 4.9% originally forecast by the Government. The implication is that a fiscal adjustment of the order of €2bn in 2015, as originally envisaged and still advocated by the Fiscal Advisory Council (although the Council’s latest paper did  not take account of the q2 GDP figures), would probably push the deficit well below 2% of GDP and therefore comfortably under  the 3% target set by the Excessive Deficit procedure. The  strength of tax receipts had moved the Government towards a much smaller adjustment in any case  but the latest GDP figures appear to have convinced them to abandon austerity and at worse go for a neutral budget, with tax cuts funded by higher taxes elsewhere, mainly the Water Charge.