Why the Treaty is bad for Ireland right now

I mentioned in my previous post that I’m not sure if the referendum at the end of this month is really going to matter in the end. But I feel compelled to lay out the economic reasons why this treaty will not work. It has a fatal flaw which will lead to the break-up of the Eurozone anyway. Humans, this is not heterodoxy that I’m about to preach to you; you will find this in any university Economics textbook.

First, let’s revisit the Treaty (summarised):

The budgetary position of each government must be balanced or in surplus. Budgetary discipline requires an annual government deficit of no more than 3% of GDP, together with a debt-to-GDP ratio of 60%. The annual deficit target implies a ‘structural deficit’ which should not exceed 0.5% of GDP annually, unless it has a debt-to-GDP ratio “significantly below” 60% and the long-term sustainability risks to the public finances are low.

Ok, what is a structural deficit?:

A structural deficit seeks to measure the underlying state of the public finances, independent of the ups and downs of the business cycle. Such a deficit results from a fundamental imbalance in government receipts and expenditures, in other words when the fiscal regime in a country persistently yields revenue below expenditure.

On the face of it, this is quite good. Let me explain: An actual budget position is not necessarily a good indication of fiscal policy. For this reason economists distinguish between a “full-employment budget” – what we would be spending and taking in with taxes if the economy was at full employment, and the “actual budget” – the real position at any given time with respect to tax revenues vs expenditure. If the economy goes into recession, we expect tax revenues to fall and the deficit to grow. To try to balance the actual budget under these conditions would be suicidal; indeed this is a “policy trap” that the US government fell into in the early 1930s that plunged them into the deepest part of the Great Depression. An actual budget deficit is not in itself an indication that there is a problem with your economic fundamentals. Yet the temptation is there to misdiagnose the problem, ignore external factors and conclude that the government must be spending too much. It’s like if your child does badly in a school test; is your first conclusion that the child is lazy and didn’t study hard enough, or do you also look at how the teacher is presenting the material? I think that would depend a lot on the child’s record in this regard, and that’s really what the above italicised paragraph is saying.

So the Treaty is not saying we should balance our actual budget every year, which would be calamitous. Europe wants us to balance our full-employment budget (this is what is meant by reducing the “structural deficit”). Since this budget doesn’t automatically swing into deficit during recessions, it does not give a false signal that a tax increase or spending cut is needed.

What then, is the problem?

It’s the Recession, baby. This one in particular, which is why it has a capital “R”. In a severe recession, balancing the full employment budget is inadequate. All it does is to allow the automatic stabilisers (economic features that mitigate recessions without changes in policy, such as the existing tax regime) to combat the recession. It does not allow the government to go one step further and actively fight the recession by introducing fiscal stimulus. Such stimulus, for example, a cut in the tax rate, would violate the rule, since it would pull us into structural deficit. So this rule is an unambitious strategy that aims to avoid destabilising actions, not to actively stabilise the economy. It reminds me of the doctor’s motto: Primo non nocere, (First, do no harm).

There are two other ways to ensure a measure of government restraint while allowing the government to take initiative in managing the economy. You could aim to balance your full-employment budget only during times of full employment, allowing a deficit in times of recession, but returning to balance when full employment is achieved. Or you could aim to balance the actual budget over the business cycle (instead of every year), using surpluses in good times to cover deficits during recessions. But neither of these approaches is allowed by the Treaty. Also, remember that we have been asked to write this balanced budget rule into our Constitution (hence the referendum). This effectively removes the power of our government to deal with unforeseen emergencies in the future. It also raises some technical complications. How exactly is the budget to be defined? And who, if not us, is going to interpret what “the underlying state of the public finances” really is?

Let’s look at a real world implication of what I’ve been talking about. Ireland has a very low corporation tax rate, something I agree with in principle. But let’s say the government wants to attract business to a specific part of the country. They would need to introduce a specific policy for that region, perhaps to exempt corporations from local taxes for a period of time, or perhaps payroll taxes. This is a change in policy, which, if it moves us into structural deficit, would not be allowed. Europe already doesn’t like our low corp tax, I can foresee a very close scrutiny of such measures not passing muster in Brussels. I can also see our government (this is Ireland, remember, the land of the “little lie”) being tempted to change accounting methods to remove such deficit items from the structural budget. Europe won’t be fooled. Also, although we’ve been assured that our corp tax rate won’t be changed, what if Europe decides tomorrow that our low corp tax is a fundamental policy error that is causing us to remain in deficit too long? They couldn’t directly force us to raise the tax rate, but they could penalise us in so many other ways that could outweigh the benefits of having it.

I was going to talk about the Euro as well, but this post is too long already. I’m off to tell the human that I’m hungry – maybe he’ll do a special trip to the shops for me. If not, I’ll ignore him for the rest of the day.

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2 thoughts on “Why the Treaty is bad for Ireland right now

  1. Pingback: I get an email from Fine Gael | Penny Wise

  2. Pingback: And in other news…..the IMF also discovers we need air to breathe | Penny Wise

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