Government must detail real plan to take us out of crisis - The Irish Times - Mon, Jan 12, 2009

Writing in the Irish Times today, John Fitzgerald of the ESRI on the pressing need for governmental leadership to get us out of the crisis.

AT A TIME when economic doom is being heaped on gloom, it is timely to remember that the Irish economy, properly managed, does have a good future, even if the length of our stay in purgatory is uncertain. However, there has been little discussion to date about how to get from the current hole that we have dug for ourselves to restoring sustainable growth and full employment. The Government's "framework" last month did not show us that pathway.

Up to the end of the summer the recession that had hit the Irish economy was largely a predictable consequence of the bursting of the property market bubble. However, the Lehman Brothers' bank failure in September has resulted in a worldwide financial crisis and recession, which could not have been foreseen by any government. Thus, earlier economic forecasts for most economies, including Ireland, are now obsolete.

The consequence of these foreseeable and unforeseeable events is that output per head in Ireland is likely to drop by around 9 per cent between 2008 and 2009. However, for those in employment the reduction in living standards has so far been negligible. The groups that have paid for this dramatic loss of output and income are the Government (offset by borrowing to be paid by future taxpayers), companies and those losing their jobs.

Before a recovery can begin, the effects of this fall in output have to be shared out more evenly across the economy. It is also essential that order is restored very quickly to the domestic banking system.

There are three key elements that must feature in any recovery. Firstly, whenever the world recovery actually arrives it will partially reverse the dramatic impact in Ireland of the collapse in the international economy. World recovery will help reduce our unemployment and the Government deficit.

Nonetheless, the legacy effects of past policy mistakes mean that even with a world recovery there is still likely to be high unemployment and a deficit of at least five percentage points of GNP. A delayed world recovery would lead to an even higher Irish deficit. The second crucial feature of the current crisis is the very serious loss of competitiveness in recent years. Without further action to deal with the underlying competitiveness problem, Ireland could be left with a legacy of very high unemployment for many years to come.

Low expected inflation in the Euro-zone will result in pay moderation among our competitors. We know we have a lot of ground to make up on competitiveness, even if we don't yet know precisely how much. If, for example, Ireland needs to improve its competitiveness by 5 per cent relative to its partners, this could be done in two ways. A prolonged pay freeze in Ireland would mean that the process could take a painful three or four years. Alternatively, a 5 per cent fall in nominal wages in 2009 might achieve it all in one year, bringing unemployment down faster.

Because the Government does not control wage rates in the private sector they cannot be considered a policy instrument. However, because of the competitiveness crisis facing many private sector firms, some employees and employers are already agreeing deals to cut nominal wage rates to save jobs. If such a pattern occurs across the private sector it will be vital that this is also reflected in a similar (or even a greater) fall in the public sector.

Even with a world recovery and a major gain in competitiveness this will still not be enough to sort out the third major feature of the current crisis - the public finances. Over four or five budgets, starting in 2010, governments will have to either raise taxes or cut expenditure to restore order to the accounts.

Initially, by improving efficiency in public services, savings on expenditure are possible. However, if the public continues to want at least the current level of public services then increases in taxation will be the order of the day.

As Ireland today has one of the lowest tax burdens in the countries of the Organisation for Economic Co-operation and Development (OECD), a significant increase in tax rates over the years of economic recovery would be feasible. However, it will mean that government will have to pre-empt an unusually large share of the fruits of the recovery in its early years in the form of additional taxes, such as a carbon tax, a property tax, and higher excise taxes.

To make the Government's task even more difficult there is likely to be a substantial fall in the level of consumer prices this year. If sterling remains where it is, this shock could further aggravate the public finance crisis. To avoid such a deterioration wage rates in the private and the public sector, as well as all other Government payments, including welfare payments, will need to follow prices down.

Of course a fall in nominal wages throughout the economy, which was matched by a fall in prices, would leave employees no worse off, while greatly benefiting firms in the export sector.

If the Irish economy is to bounce back quickly we all need to take a corresponding reduction in our living standards to reflect the fall in our output. This could be made up of a 5 per cent reduction in nominal wages and a gradual increase in the tax take. If this is accomplished quickly then, over a five-year period, the economy could be restored to its previous growth path with full employment and sustainable public finances.

What is required from the Government is a proper plan which details what needs to be done to restore competitiveness, adjust living standards to reflect the fall in output, and address the public finance crisis. By tracing a path towards full employment, sustainable public finances and steady growth, the Government can help rebuild confidence.