The Maastricht Treaty, which paved the way for Economic and Monetary Union and the euro, established fiscal rules – the balance between taxation and spending. Without rules, if one government in a monetary union ran an irresponsible fiscal policy, it could threaten economic stability in other member states, and ultimately the viability of the euro.
The rules adopted limited government deficits to 3 per cent of GDP and required a country’s national debt, at worst, to converge to 60 per cent of GDP.
These were not theoretical fears. After the 2008 crash, the financial crises affecting Ireland, Spain, Portugal, and Greece were perceived as a threat to stability of other European economies, leading to higher borrowing costs elsewhere. At times the single currency seemed in jeopardy, compounded by the absence of key mechanisms from the euro’s financial architecture.
This experience has reinforced the European Commission’s focus on implementing revised rules to prevent future debt crises in member states.
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Although shared fiscal rules are necessary to ensure solvency, they are often not a good guide for individual governments’ use of fiscal policies to manage their economies.
Ireland’s debt ratio, which peaked at 165 per cent of national income in 2012, will be down to 72 per cent this year. Our government surplus is close to 3 per cent of national income. Just because we satisfy the EU rules doesn’t mean fiscal policy is currently right for our economy.
Ireland’s fiscal policy in 2023 was mildly stimulatory. With the economy at capacity, this was a little unwise, though the boost to demand was small
Ireland has set its own rule, that public spending should grow no more than 5 per cent a year. While that was sensible when inflation was below 2 per cent, it would have resulted in unnecessary cuts to economic growth if it had been strictly applied in 2022 and 2023, when inflation soared.
Keynesian economics underlines the importance of using fiscal policy to smooth fluctuations in the economy. When growth is way below trend, governments should pump money in to boost demand. When there is a boom, the government should call the party to a halt with higher taxes or expenditure cuts to mop up excess demand. When an economy is at capacity, excess demand just pushes up inflation and sucks in imports, not real incomes.
A “neutral” fiscal policy is appropriate when the economy is growing normally, where governments neither add to nor subtract from aggregate demand. That could mean keeping taxes unchanged as a share of income and ensuring that public spending tracks inflation. Alternatively, any extra spending should be funded through higher taxes.
Ireland’s fiscal policy in 2023 was mildly stimulatory. With the economy at capacity, this was a little unwise, though the boost to demand was small.
Department of Finance figures show that in 2024 we are even closer to fiscal neutrality, as is appropriate with full employment. While public expenditure is expected to grow by 5.5 per cent this year, above the 5 per cent rule, this is also acceptable as it mirrors the growth in national income, which is still affected by the after-effects of the inflation shock.
If the economy continues on its current course, it would be damaging to pump extra money into the economy next year. Under these circumstances, indexing welfare payments to inflation and adjusting tax bands and allowances to keep average tax rates unchanged is appropriate, but a further stimulus would be dangerous.
The Department of Finance projects public investment will grow at over 10 per cent next year, which is stimulatory, but appropriate to ease capacity constraints in the economy. It is planned to offset this stimulus by other adjustments to the budget. If the outcome next year is in line with these forecasts, next year’s government surplus will be about 3 per cent.
With all of this cash, the Government could be tempted to go for an election budget, splurging much more than currently envisaged or appropriate. In a fully employed economy, spending more money would add to inflation without making us better off, whatever about its effects on our voting behaviour.
Looking back, Fine Gael-led coalitions deflated the economy coming up to the 1957 and 1977 elections when they should probably have done the opposite. Over-tightening the economy probably added to their loss of those elections.
In contrast, spendthrift policies in 2002 and 2007 may have helped win those years’ elections for Fianna Fáil-led administrations, but ultimately led to the economic crash, which was deeper and longer as a consequence.
More recently, with that crash fresh in their minds, governments resisted the temptation to stimulate the economy before the 2016 and 2020 elections.
In next autumn’s budget, will giveaway politics trump prudent fiscal policy? Will the Government be tempted to spend the cash pile themselves, rather than bequeath it to their successors, even if that means economic damage?
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