IRELAND IN RECESSION: DESIGNING A FISCAL RESPONSE

RGE Monitor, NY
Jul 1, 2008

Europe EconoMonitor

Last week, the Economic and Social Research Institute (the most
respected economics institute in Ireland) forecast that GDP growth
in Ireland will be negative in 2008 at -0.4 percent. This represents
a sharp decline from 5.3 percent growth in 2007 and a long sequence
of high growth rates since the mid 1990s. Moreover, the movement in
the terms of trade (especially important for a highly open economy)
is also negative, such that the recession in real income will be -2.6
percent in 2008. Some recovery is projected in 2009 – with growth
projected to be around 2 percent – with a possible return to trend
growth of about 3.5 percent in 2010.

The primary factor behind this slowdown is the dramatic contraction
in the housing sector, which means that aggregate investment is
set to fall by 15 percent in 2008 and a further 4.5 percent in
2009. Even though the export sector continues to grow (with the
export of services especially strong), the rate of growth is below
expectations and is hampered by the decline in cost competitiveness
(both due to the accumulation of rapid wage growth at home and the
strength of the euro against the dollar and Sterling, the currencies
of Ireland’s two most important trading partners).

The sharp slowdown of 6 percentage points of GDP in a single year has
fed through to the fiscal position. The general government balance
has declined from 3 percent in 2006 to 0.3 percent in 2007 and is
projected to hit -2.8 percent in 2008 and, if no evasive action
is taken, -3.9 percent in 2009. The decline in tax revenues has
been especially pronounced since Ireland had increasingly relied
on asset-based taxes in recent years (in particular, stamp duties
on housing transactions) that were plentiful during years of rising
asset values – these revenue sources have dried up, with the decline
in activity in the housing market and the drop in house prices. (The
decline in the permanent tsb/ESRI national house price index since
its peak in January 2007 has been 11.5 percent in nominal terms and
17.7 percent in inflation-adjusted terms.)

Accordingly, a near term issue for the Irish government is how to
design a fiscal policy response to the economic slowdown, while
operating within the confines of the Growth and Stability Pact. In
particular, corrective action will be required if the 3 percent budget
deficit limit is not to be breached in 2009.

This represents a challenge to the new political leadership – Brian
Cowen was installed as the new taoiseach and Brian Lenihan as the
new Minister of Finance in May 2008, even if Mr Cowen was Finance
Minister for the previous four years. Moreover, with the exception of
some controversial criticism from the European Commission of the pace
of fiscal expansion in 2001, it is a novel experience for Ireland to
be testing the limits of the Stability and Growth Pact (SGP).

However, the current Irish situation represents a clear case that
justifies a temporary breach of the 3 percent limit. First, a
sudden six percent slowdown in economic activity is clearly a large
macroeconomic shock of the scale recognised by the terms of the SGP
as an acceptable reason to break the 3 percent deficit ceiling.

Second, Ireland has a high rate of public investment (4.2 percent
of GDP in 2007), such that the general government deficit can be
interpreted as primarily directed at investment spending, rather
than consumption. A high level of public investment is required
to redress obvious deficiencies in the public capital stock, which
has suffered from chronic under-investment during the long phase of
fiscal austerity in the 1980s and 1990s. Again, the SGP explicitly
recognises a high rate of public investment as an exculpatory factor
in assessing breaches of the deficit limit.

Third, after twenty years of sustained improvement in its fiscal
position, Ireland’s general government debt stood at only 25.4 percent
of GDP at the end of 2007. Moreover, if the assets of the National
Pension Reserve Fund are subtracted (each year, 1 percent of GNP
is allocated to this fund to pre-finance ageing-related spending
from 2025 onwards and this commitment is enshrined in legislation),
the net financial debt of the government amounted to only 14 percent
of GDP at the end of 2007. For this reason, a period of temporarily
high budget deficits poses no threat to the sustainability of the
Irish public debt position. Moreover, the legal commitment to the
National Pension Reserve Fund signals the government’s recognition of
the long-term need to prepare for the trend increase in ageing-related
public spending, providing an important anchor for the sustainability
of the public finances.

Fourth, the central macroeconomic forecast is that the current
recession will be of limited duration: the house-building sector had
clearly grown too large and once activity in that sector returns
to a more sustainable level, the Irish economy can return to its
trend growth path. In view of the transient nature of the slowdown,
deficits in excess of 3 percent can be justified for a limited period.

Accordingly, it would be unwise for the Irish government to implement
a pro-cyclical fiscal contraction just to remain within the 3 percent
deficit limit. Since the option to devalue is not possible for a member
of the euro area, fiscal policy is the main macroeconomic stabilisation
instrument and just letting the automatic stabilisers work in Ireland’s
current situation involves a breaching of the 3 percent limit.

The factors outlined above suggest that the economic case for a
temporarily high deficit seems fairly straightforward. However,
there are political economy considerations that make the calculus more
difficult. Even a high deficit that is agreed by all to be acceptable
under the terms of the SGP would still represent a departure from
the budget surplus orthodoxy that has been dominant in Ireland since
the 1987 fiscal adjustment that rescued Ireland from the very dark
economic conditions that prevailed in the mid 1980s. This requires the
government to lay out a multi-year fiscal framework that explains how
the medium-term fiscal objectives will be restored once the current
phase of economic slowdown and temporarily high deficits is over. To
the extent that this involves a medium-term increase in taxes on
labour and consumption (to replace the windfall revenues from the
housing boom), this will pose a new challenge for a government that
has been long blessed with the capability to combine tax reductions
with rapid spending growth.

Moreover, since Ireland has enjoyed such a long phase of rapid growth
in output and tax revenues that have been above the long-term trend
for the economy, even a neutral policy of setting current spending to
grow in line with the trend growth path for nominal income of about 5
percent will seem like fiscal austerity to the many beneficiaries of
the rapid growth in current spending since 1997, which in nominal terms
has averaged 9.7 percent each year. Again, the government must adjust
its political strategy to manage a new era of diminished expectations.

However, it should also be recognised that the new economic environment
poses an opportunity to improve the quality of public spending. It
is arguable that the boom in tax revenues over the last decade
has slowed down the pace of structural reform in the delivery of
public services, since it has been possible to respond to public
dissatisfaction with health and education services by increasing the
level of public expenditure. The constraints imposed by a tighter
budgetary situation may prompt a more ambitious approach to public
sector reform, which may a politically-popular complement to the
unpleasant task of reducing the medium-term pace of spending growth.

On the capital side, similar issues apply in that not all public
investment projects have been subject to rigorous cost-benefit
analysis during the boom years. Again, the tighter fiscal position
should induce a more selective approach to the appraisal of public
investment projects. Since this will involve some pull back from
the commitments outlined in the very ambitious National Development
Plan 2007-2013, the government may have to suffer some political
embarrassment. However, in the other direction, the cancellation
or postponement of marginal projects will signal the government’s
renewed determination to avoid waste in public spending.

Since the taoiseach is committed to public sector reform as a
defining ambition for his leadership, the timing seems right to
move on this front. To this end, it is important to recognise that
the SGP acknowledges spending that is related to structural reform
as an another acceptable reason to breach the 3 percent deficit
limit. Accordingly, since some elements of reform (for instance,
a redundancy programme for the over-staffed administration of the
health service) may involve short-term increases in spending in order
to achieve long-term cost savings, the current budget deficit is no
reason to delay reform initiatives.

Finally, there are certainly downside risks to the macroeconomic
forecasts for Ireland. In some quarters, these risks provide a
rationale to impose greater fiscal austerity, such that the option
of fiscal stimulus may be deferred until a truly severe downturn
is experienced.

However, the stronger argument is that a pro-cyclical fiscal
contraction may in itself contribute to the deepening of the
recession. Moreover, unlike monetary policy, there is no ‘zero bound’
problem in fiscal policy – a fiscal stimulus today (to the extent of
letting the automatic stabilisers work) does not rule out further
fiscal stimulus in the future, especially for a country that has a
very low public debt.

The true value of the SGP lies in the institutional commitment to a
sustainable path for the debt and deficits over the medium-term which
provides the assurance that such fiscal stimuli will be withdrawn once
the slowdown is over, thereby providing a framework that reconciles
the deployment of stabilising counter-cyclical budgetary policy with
the maintenance of a strong anchor for the fiscal position.

This article is also available in a different format at the VOX
website.

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Differences between the EU and Turkey greatly exaggerated Semih
Akcomak | Jul 1, 2008 Historical perceptions negative about the Turk

In discussions on Turkey’s membership of the European Union the
cultural differences between Turkey and the EU-member states are
greatly exaggerated. Empirical research shows that Turkey is not
significantly different from other European countries. This short
piece argues that there is no solid argument to block Turkey’s
membership and EU dithering on this issue confirms its insincerity,
which is rooted in a long history of negative perceptions about Turkey.

Twenty-five years ago Geert Hofstede in his seminal study, Culture’s
Consequences: International difference in work related values,
investigated the work related values of people in over 50 countries,
who worked in local subsidiaries of IBM. He identified 4-dimensions
of national culture. In all four dimensions Turkey was grouped with
other European countries such as Belgium, France, Greece, Portugal
and Spain. This is still true today. Recently, by analyzing the data
from the European Values Study, 1999, we showed that many of Turkey’s
supposed cultural differences with the rest of Europe are in fact
unsubstantiated. We find extensive support for the argument that
the social and cultural differences between Turkey and the EU are
largely exaggerated, based more on (mis)perception and unsupported
by empirical evidence.

Religion and democracy

In the first place, the analysis shows that basic values related to
religion and democracy, two cornerstones in many of the arguments
against Turkey’s membership, differ greatly among the current EU
members. This heterogeneity has actually increased when the EU expanded
from 15 to 25 member states. This suggests that European "common
values" are not as common as they are believed to be. The success of
the European project significantly depends on the performance of the
EU in bonding, bridging and managing this heterogeneity.

Second, a striking finding in our work is that introducing Turkey
to the analysis does not alter the main patterns of diversity. In
most of the cases Turkey’s scores oscillate between the minimum and
maximum values for the EU25 as a whole.

It appears therefore that the objection by some EU member countries to
Turkey’s membership is based on a misperceived belief that Turkey’s
mix of ethnicity and culture (including religion) is incompatible
with that of Europe in general. The foundations for these arguments
are less than empirically sound and perhaps motivated by other
concerns. Unfortunately, this misperception is systemic and shared
by the European public.

Erasmus

These misconceptions have historical roots. In De bello turcico
(On the war against the Turks, 1530) Erasmus refers to the Turks as
"wicked barbarians" who are trying to confine Christianity to a narrow
land. According to him the Turks have established an immense empire
not because of their own merits but due to Christian sins as he wrote
"…we have angered God and caused him to send the Turks against
us, just as he sent frogs, lice and locust upon the Egyptians long
ago…". Having made such sharp comments about the Turks the document
as a whole has a rather positive conclusion that war must never be
undertaken unless, as a last resort, it cannot be avoided. In part
of the document he even argues that "Turks are men and, what is more
important, half-Christian…" therefore deserve to be treated as other
people. Nevertheless his conclusions do not change the fact that his
perceptions regarding the Turks were negative in nature.

Since then, social, economic and political climate has changed in
great extent. But have the perceptions regarding the Turks changed
as well? Let me give examples from ordinary life nowadays. Whenever
I tell people that I am from Turkey, I can observe the astonishment
followed by the statement "you do not look like a Turk". I call this
an annoying compliment because it praises me as an individual but at
the same time despises the Turks in general. What is more staggering
is how these people are paralyzed when they are unable to answer a
simple counter question; "how does a Turk look like, then?"

In other instances when I found myself in a discussion regarding
Turkey’s membership to the EU, people easily put forward that Turkish
culture is different from the European culture. This is indeed true
in some aspects. However, it is such a pity to observe the tonal
difference and to realize that what they actually meant is Turkish
culture is inferiorly different. But as the French anthropologist
Claude Levi-Strauss argues "one culture has no absolute criteria for
judging the activities of another culture as low or noble".

The two examples above illustrate how these people’s software of
the mind, to paraphrase Geert Hofstede, is programmed against the
Turk. Although such perceptions are softened and have evolved to
another dimension, in essence they have not changed much in the past
500 years.

Unwritten criteria

In addition to this the EU tends to come up with new demands for
Turkey’s membership to the EU in addition to those originally agreed
at Maastricht and Copenhagen. These include the demand by some member
states that accession talks be "open-ended" and not necessarily result
in full membership, that there should be "permanent" limitations on
(Turkish) labour-mobility, insistence on the recognition of Cyprus,
admission by Turkey to responsibility for the killing and persecution
of Armenians during the first world war, and a willingness to address
the unresolved Kurdish question. None of the member states were given
such a long list of ever lasting demands that are not part of the
original list of criteria.

Given this long list of complicated issues, it is perhaps little
wonder that many of the EU member states have no intention of embracing
Turkey as a member. Even Ä°smail Cem, the former Minister of Foreign
Affairs of Turkey, complains that EU has formed a deliberate habit
of bringing specific issues (the Cyprus issue, problems with Greece,
minorities issue etc.) into discussion over and over again, even if
a consensus has been reached on them in previous negotiations. Cem
is disappointed and finds this "extremely unhealthy" as regards to
the future of the negotiations between Turkey and the EU.

EU Sincere?

Indeed, this poses a big question mark on the sincerity of the EU
about accepting Turkey as a member. These issues should not be used
against Turkey’s membership but the membership of the EU should be
used to accelerate and strengthen Turkey’s attempts to address these
issues. It should be clear that Turkey is less likely to effectively
address the outstanding membership requirement issues in isolation
from the EU.

The differences between Turkey and the EU are rather of economic,
political and mostly institutional nature and, as such, can only be
addressed through increased integration of Turkey into Europe through
formal and equitable membership, rather than pressures that could
lead to Turkey’s isolation. Put differently, further work to bring
Turkey into the EU’s fold should be based on the full recognition
of Turkey’s multi-cultural diversity and can only be achieved with
conscious and conscientious EU support in Turkey.

If the EU fails to address such weaknesses in approaching Turkey during
the accession period, the negotiations between the EU and Turkey
will not be sustainable. On the other hand, increased cooperation
between Turkey and the EU offers an important opportunity to start a
process of understanding and healing to thwart a potentially serious
cultural divide along religious lines with quite significant global
implications.

This short piece is partially based on Akcomak, I.S., and Parto,
S. (May, 2006) "How ‘black’ is the black sheep compared to all others:
Turkey and the EU ", UNU-MERIT Working Paper No:2006-024.

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