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Covid19 crisis makes sharp economic downturn inevitable but aggressive policy action can make it short lived.
Fiscal policy need to move through ’respite’ and into ‘re-boot’ phase
Budget costs almost impossible to assess at present but could easily exceed 10% of GDP
Much larger deficit and debt likely to happen …either by accident or design
‘Respite’ actions necessary but not sufficient. ‘reboot’ stimulus will be needed to limit lasting negative effects
Failure to implement stimulus could lead to weaker trajectory for economy and ultimately larger bill
EU fiscal constraints temporarily lifted. So, austerity mindset major obstacle to supportive policy.
Current circumstances notably different to 2008 in terms of policy pressures
Housing and other infrastructure bottlenecks as well as green initiatives could be addressed as ‘shovel ready’ projects
History suggests large debt increase the ‘normal’ consequence of economic shocks
Exceptional Central Bank actions mean jump in debt is sustainable
The unprecedented nature of current circumstances mean that guesstimates of the likely economic impact risk being overtaken by events before they are committed to paper. What is clear is that Covid19 is now leading to a sudden and severe downturn in economic activity in Ireland and elsewhere that should give way to a substantial and hopefully speedy turnaround. Importantly, the scale and speed of that turnaround are critically dependent on the nature and timing of economic policy actions taken.
It’s often suggested in elementary economic textbooks that a natural disaster can boost economic activity as initial losses are overwhelmed by the subsequent rebuilding effort (eg the missing output of a factory hit by an earthquake is more than offset by its reconstruction and subsequent recovery in production).
However, in the current episode both the scale of downturn resulting from the economic shutdown and the subsequent upturn are ‘endogenous’ in that the extent and timing both of the downswing and an eventual turnaround are likely to be substantially influenced by policy as much as providence.
It is not particularly useful to think of the current downturn as a recession. The current episode is not a normal cyclical event of the sort that is usually contained by automatic stabilisers in the form of welfare and tax flows, and subsequently corrected by the emergence of animal spirits among businesses and households.
Automatic stabilisers and shifts in sentiment may be adequate resources for mild deviations from the norm but they are entirely inadequate for current conditions. Policy actions must be altogether more ambitious and aggressive both in the respite and recovery phases. The activation of the ‘general escape’ clause of the EU fiscal rules, effectively suspends any EU constraint on Irish budget policy for 2020 and probably for 2021 and underlines the widespread recognition of the exceptional scale of the current crisis. Importantly , the EU finance ministers’ statement of March 23 calls on member states ‘to take all necessary measures for supporting our health and civil protection systems and to protect our economies, including through further discretionary stimulus and coordinated action’.
Significantly, these EU decisions also emphasise key differences between now and 2008 in that there is no pressure from markets or from Brussels or Frankfurt to implement austerity measures. In fact the message from bond yields and the ECB is to implement more supportive fiscal policy. In the same vein, the longer term path for the Irish public finances path has not markedly worsened changed because of the evaporation of a major source of revenues as was the case with the collapse in construction in 2008.
While demand in the Irish economy will recover, the speed and spread of a pick-up in spending will be dampened by elevated uncertainty about the immediate outlook in terms of physical and financial health and an associated shift in which precautionary saving may be far more influential than pent-up demand.
We know from the recent global financial crisis that expectations that economies would recover both quickly and completely proved very wide of the mark. In current circumstances, it seems that downside risk will continue to dominate. The key question is how to minimise the permanent damage to productive capacity and employment prospects.
Significantly, there isn’t a single self-determined path to a post-virus economy for Ireland or other countries. The financial crisis forcefully demonstrates that post-crisis policy errors that amplify rather than absorb economic shocks can delay or derail any upturn.
In the current climate, a fiscal stance that turns towards prioritising adjustment in the public finances over improvements in activity and employment is likely to compound rather than cure economic problems. Austerity is not an antidote to a problem that has nothing to do with imbalances in the Irish or other economies.
In much the same way as policy now seeks to ‘flatten the curve’ in terms of health outcomes by limiting the Covid19 surge, economic policy should be focussing on ‘correcting the curve’ in terms of economic outcomes by ensuring scope for a solid rebound in activity after implementing an initial health related shutdown of output and spending.
While the ‘respite’ measures now being taken to limit the hit to incomes are critically important and expensive, at least equally important and probably as expensive are policy actions to ‘reboot’ activity and ensure a solid recovery takes hold. Such action would need to be large to ensure a sufficient impetus to activity but importantly it would also need to be clearly signalled as temporary in nature. In that respect, domestic spending and tax adjustments should meet with the EU finance ministers recommendation that actions should be ‘timely, temporary and targeted’.
The associated costs have to be weighed against allowing a deep and damaging shortfall in activity, employment and incomes. Such a trajectory would also entail significant but likely permanent fiscal costs that would have to be financed by a less dynamic Irish economy and, in that sense, would likely prove far less sustainable.
Initial official estimates put the cost of measures implemented to date to limit income losses from the shutdown at around €6.7bn and related impacts on tax revenues could directly and indirectly total a similar amount. We previously suggested that fiscal costs could amount to up to €15bn but it now seems likely that ‘respite’ measures and the broader shortfall in in tax revenues could readily exceed this figure. Our sense is that ‘reboot’ measures on a scale likely to ensure a strong and speedy rebound could amount to a further €10 to 15 bn, implying the overall fiscal impact for Ireland of Covid19 could be comfortably in excess of 10% of GDP.
While the near term focus is on re-igniting Irish economic growth, such actions should have lasting positive effects. A marked increase in spare capacity in the Irish economy could allow scope to make a significant start to address longstanding problems in housing and other areas of infrastructure as well as adopting a range of green initiatives. In this way, policy could both revitalise short term growth and raise long term growth potential.
While there is a wide margin of error about all economic projections in the current environment, it is very clear that the fiscal costs of Covid19 will be very large. If budget policy is to act as intended as an absorber rather than an amplifier of economic shocks, it is entirely appropriate that the adjustment should primarily be seen in Irish public finance metrics. Moreover, such an outcome would be consistent with time-honoured experience in Ireland and elsewhere.
As the diagrams below illustrate, substantial jumps in public debt have typically been associated with socialisation of losses incurred as a result of shocks and this allowed the economies to move onto a stronger growth trajectories.
Crises of various forms typically result in public debt moving onto seemingly explosive trajectories that ultimately prove sustainable. In the case of the US, public debt increased by 30 percentage points of GDP during the American civil war and again during the first world war. The increase during the second world war was nearly 80 percentage points of GDP while the increase during the financial crisis was about 40 percentage points of GDP.
For Ireland, the painful experience of the recent crisis and the central role played in that pain by fiscal austerity and deficit adjustment might understandably give rise to concern about allowing a substantial further increase in public debt. However, as the diagram below shows, using historical but broadly comparable measures of public indebtedness, the Irish economy has an exceptional capacity to ease the burden of debt through strong economic growth.
The key justification for aggressive and early but time bounded action at this point is to ensure growth quickly reverts to a trajectory that fully utilises domestic economic resources, thereby returning debt to a downward trajectory. Ireland’s capacity for credible debt reduction together with the actions of the European Central Bank as well as financial markets appreciation of current exceptional circumstances have markedly reduced government borrowing costs. As a result, additional borrowing amounting to 10% of GDP would only boost annual debt service costs by around €150 million per annum, an almost negligible sum in the context of the scale of the current crisis.
Of course, it is possible that borrowing costs for Ireland for measures taken in response to Covid19 could be even lower if Euro area leaders fully live up to their responsibilities to act appropriately in a crisis that could threaten lasting damage to European integration as well as European lives and livelihoods.