There are far bigger Budget risks than overheating

With warnings about a giveaway Budget now widespread, it may be worth considering the risk that the bigger and more lasting risk is that an overly conservative fiscal policy could leave the Irish economy undercooked rather than overheating.

?The short-term outlook is encouraging.

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After a couple of years of below trend growth in activity (as illustrated in the graph above from a recent presentation from Dept of Finance chief economist, John McCarthy, Irish economic developments and outlook 21/06/24), ?the Irish economy is currently showing solid and healthy positive momentum although conditions are a little more mixed across sectors.

Overall activity growth could surprise on the upside through to the end of this year and into 2025, if, and it is? a big ‘if’, major geopolitical catastrophes are avoided. Provided we avoid a major negative international surprise, I think Irish economic growth could be a little stronger over the next year or so than many envisage, growth may be heading towards 4%+ rather than the 2-3% consensus.

A negative overhang from the decline in GDP last year means momentum may take a little while to show through in the official growth data but the sense of an improving Irish economy could become established before long.

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?The global picture is less negative …for now

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If we don’t see a further escalation of hostilities in the middle East or disasters elsewhere, the external backdrop should be notably less of a constraint on Irish growth than it has been in recent years.?

?The UK economy should see a post-election bounce (though I'm not expecting an England Euro'24 win to add fuel to that rebound!). Fiscal policy may be more expansionary across Europe than previously expected and the direction of travel for ECB interest rates, even if the pace is slower than initially thought will also help. Although I would be concerned about the longer-term outlook for the US, lower interest rates should prevent too much of a slowdown next year.

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Domestic policy will move us forward or backward

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For the Irish economy itself, demographics continues to provide a strong boost to short-term aggregate growth. Looking a little further forward, this can be made either a blessing or a problem. My hope is that in coming years fiscal policy will be increasingly set in a manner that is focussed on boosting economic and social investment markedly in order to strengthen medium term growth prospects.

This will require a substantial step-change in public spending over coming years. How this can be managed is far from clear but it must be done if we are not to move away from the Irish economy's current 'sweet spot' in terms of demographics and favorable finances fairly quickly to somewhere altogether less appealing.?

?The upcoming election is likely to be significantly fought on the capacity to deliver infrastructure and improved public services.? Whether winning slogans turn into workable solutions will decide how well the Irish economy turns into the next decade.??

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Fiscal conservatism may undermine rather than underpin growth prospects

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Unlike much of the advice being offered to the Irish government ahead of the upcoming election, I think Fiscal policy must be willing to face what I would judge to be modest and manageable risks in relation to overheating if much bigger risks in terms of future growth and social cohesion are to be reduced.

There is no simple economic playbook to guide us to where we need to go. More importantly, I don't believe there is any practical fiscal rule that will deliver the needed transformation of the Irish economy over the next five to ten years.?Slavishly adhering to a fixed pace of increase in Government spending is a very poor substitute for undertaking a much needed catch-up in economic and social infrastructure.

What is clear is that to deliver the economic and social capital stock needed will require markedly higher investment that can be funded on a finite or ‘once-off’ basis by using significant amounts of current tax revenues that may or may not be 'windfall' in nature.

?The real downside risk for the Irish economy is that we are too slow to increase investment sufficiently to ensure future growth potential isn't entirely and unnecessarily crimped. This would be altogether more damaging than a little ‘overheating’.

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The current health of the Irish economy can’t be sustained without major changes

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The Irish economy is doing well on many fronts but, given profoundly serious issues in areas such as housing, health, transport and climate change, I think it would be wrong to say the Irish economy is in rude health at present. It's a bit like saying that someone with serious lifestyle issues is bound to remain hale and hearty because they are still both relatively young (which Ireland is in demographic and developed economy terms) and putting some money by.??

?The good news is we have (some) time and (lots of) financial capacity to put the economy on a strong and sustainable path. The bad news is a lot of the economic policy ‘medication’ ?being prescribed doesn’t entail measures that are nearly radical enough or rapid enough in terms of a programme of investment needed for Ireland's longer term economic health. ??

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?Will the Irish economy overheat or be undercooked?

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The Irish economy has consistently demonstrated a continuing capacity to grow beyond the expectations of economists.? While it is not unlimited by any means, it has exceptional elasticity and flexibility that mean mechanical definitions of capacity may not be any way helpful as a guide for ‘safe’ policy.

Remember, there were loud warnings of overheating back before Covid. For example, the Central Bank pre-Budget letter of 28th August 2019 advised ‘there will be a material risk that continued expansion would give rise to overheating pressures.? With output at or close to potential, a tighter fiscal policy would help to manage demand pressures.?

?The conventional wisdom suggests that given the current strength of the Irish economy any boost to economic activity further will simply push prices higher. In broad terms, the idea is that the economy’s capacity to produce more is exhausted, its aggregate supply curve is vertical. There are certainly risks in this direction but the experience of recent years implies they may be far less pressing ?or threatening than is often suggested.

?Over the past five years employment has increased by just under 400k matched by a similar increase in the labour force. While there has been a global inflation shock, Irish inflation is below the Euro area average on a one-year basis,two,three, four and five-year basis. If Ireland was overheating, Irish inflation should have been far higher than elsewhere (where activity has been markedly ‘cooler’) over most if not all of this period rather than below it.?

To push the argument possibly too far in the other direction, it might be suggested,? given comparatively low Irish inflation through recent years, that Ireland’s aggregate supply curve has been downward rather than upward-sloping of late.!!! ?It seems more likely that policy has helped ‘bend’ the aggregate supply curve in a more favourable direction meaning the Irish economy’s supply capacity has expanded faster than demand.

?In very crude terms, aggregate demand, as proxied by public and private consumption, was 11.8% higher in Q1 2024 than five years earlier while aggregate supply, even more crudely proxied by employment, was 16.9% higher. Reflecting stronger supply conditions, possibly enhanced by the fiscal stance, ?inflation in Ireland has undershot inflation elswhere in the interim.

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Service inflation speaks of supply issues rather than excess demand

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As in other countries,? service inflation iin Ireland is somewhat elevated but pick the elements apart and it is not a case of a demand -driven surge in service prices-?For example, the pressure on housing rents is not due to demand but inadequate supply and inconsistent policy interventions.

?In the same vein, the pressure on restaurant and hotel prices is significantly amplified by a curtailment of supply for refugee accommodation, by minimum wage changes and by the restoration of the 13.5% VAT rate. However, in any event, according to Eurostat, Irish restaurant and hotel price inflation is below the EU average (May 2024 +4.7% v Euro Area average +5.2%., EU average +5.5%)

?Neither are other areas of relatively fast service price increase in the Irish CPI ,such as airline tickets and package holidays, driven by surging Irish demand but by global developments.? ?Yes, Ireland is a relatively high-cost economy but that is not necessarily a problem. What we need to focus on is how to ensure costs don't move seriously out of line with productivity. Simplistic carping about overheating isn't helpful in this context.?

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Domestic policy needs to focus on supporting supply rather than constraining demand.?

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While some price pressures may ensue, the evidence of strong demand growth in recent years does not suggest that boosting investment materially will lead ?to an apocalyptic rise in Irish inflation. In the same way, measured policy adjustments to tax and welfare that provide some support to household spending power are likely to be positive socially and economically.

?The likelihood is that wages will grow clearly faster than inflation in coming years but nobody envisages a reversal of the double-digit price spike of recent years. So, some element of 'catch-up is needed. I've consistently argued that the fairest and most efficient way to do this is through fiscal policy rather than a free-for-all .

?In this context, it would be entirely appropriate for fiscal policy to ensure income taxes and welfare payments are adjusted moderately more than indexing would imply this year. The problem of the 'left-behinds' is being increasingly felt socially and politically worldwide at present. The evidence from a wide range of countries is clear in highlighting that crumbling societies don’t tend to foster competitive economies. In this context, there is a crucially important difference between a Budget that gives modest and, in most instances, much needed income gains to Irish households and the much feared ‘giveaway’.

?For any number of reasons, It should be possible to construct a series of Budget package that manage to be both meaningful and modest in terms of tax and welfare changes as well as showing altogether more ambition in relation to investment spending.?

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