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Creating the 2003 budget Back  
Dominick Sutton looks into his crystal ball and gives us his economic review of the year 2002 - a year in advance. Here he outlines what issues may be facing the Minister for Finance in formulating the 2003 budget in a light hearted ‘review of the year.’
As the Minister of Finance sits down to evaluate his budget options for 2003 he recalls the circumstances facing his predecessor and the impact of the choices made at that time…

Entering 2001 the Irish economy was expected by most analysts to decelerate from the breakneck expansion of 2000. The GDP growth rate of 11.5 percent year-on-year of 2000 was fuelled by the combination of strong investment flows over the previous few years, a sustainably low interest rate regimen following EMU entry in 1999 and a depreciation of the euro against the other major currencies that was a boost to an already strongly competitive export sector. What was not expected either by private sector analysts or the Department of Finance in framing the 2001 budget was the extent not only of Irish economic slowdown but also the combination of circumstances that would see the US and possibly the euro zone enter recession during the course of the year. This deceleration in Irish economic growth continued in 2002. However, the effects were aggravated by the time lags in releasing Irish national account data as well as the novelty of the quarterly releases. Owing to the near-six month lag on national account publication and the statistical base effects inherent in the lack of seasonally adjusted growth data, the middle of 2002 saw the publication of weak Irish economic growth statistics. This was at a sensitive time for the Irish economy and, by discouraging consumption or investment, may have delayed the onset of recovery.

However, at budget time the 2002 third quarter GDP data had still not been released and the minister, as usual, has to frame his proposal with only a preliminary idea of the actual circumstances facing the economy in the second half of the year.

The year 2001 had started with what turned out to be a particularly ominous signal: the surprise US Federal Reserve 50 basis points interest rate cut on January 3rd. This was followed by a sequence of official interest rate cuts that eventually saw rates close the year at 1.75 percent. Key to this monetary activism in the latter part of the year were the tragic events of September 11th. The Afghan campaign may be almost fully wound down at this stage but the legacy of uncertainty, even fear, is likely to be felt for some time to come. This has had a particularly severe impact on international tourism, something that Ireland was already addressing in the face of the particularly severe foot & mouth disease outbreak in the United Kingdom at the beginning of 2001 that, unfortunately, also led to a small number of related incidents in the Republic.

Against a background of a US economic recession and very depressed growth in the euro zone, including a near recession in Germany, the Irish economy saw a clear deterioration in economic performance throughout 2002. This was manifest by a rise in small business failures and rising unemployment, particularly in the younger age groups. These were particularly hit by the retrenchment of multinational firms, which had targeted the young, more educated sections of the workforce. A gradual appreciation by the euro during the course of 2002 also added pressure to indigenous export firms particularly those exporting to the UK. The introduction of the euro at the beginning of the year added a temporary buzz to activity but once this fizzled out by the end of the first quarter the atmosphere grew darker.

Exports continued growing spurred in particular by the beginnings of US economic recovery, even if the gradual euro appreciation did dampen competitiveness to some degree. Even with the US economy in a clear recovery mode it became clear that the need for firms to reduce excess capacity would see a lag before any strong follow-through to the Irish economy was apparent. This is especially the case with foreign direct investment; indeed, it could be well into 2003 before these flows became active again. 2003 may also see the closure of negotiations for the admission of the next candidates to EU membership; this process is proceeding very successfully and the first new entrants could be ready for admission by the end of 2004. That, in itself, poses a potential problem for Ireland as it opens up a pool of potential rivals for direct investment.

The German economy continued to be of concern in 2002, not only because it reduces the aggregate economic growth rate of the zone but also has significant implications owing to the weakness of the German fiscal position. The German fiscal deficit continues to skirt with a possible breach of the Stability Pact and requires a sustained rise in economic growth as well as greater reforms before a risk of a breach is lifted. Unfortunately, it was the German workforce that paid the price, with German unemployment touching 4.5 million during the course of the year.

Fiscal policy provoked many debates in Ireland in 2002 as well, not only because of the sustainability of the position following the creative measures to generate a targeted surplus in the 2001 budget but also because of the looming general election. For the first time in years the political parties fought campaigns that had to acknowledge a lack of resources that will force political choices on priorities for spending and taxation. Indeed, this may prove to be one of the more lasting consequences of the recent budgets that have yielded a potential general government deficit of nearly eur 3 billion in 2003.

Another consequence was a temporary rise in consumer inflation as a consequence of tax rises on petrol, cigarettes and VAT. Nonetheless, the general inflation climate was benign, with oil prices subdued and a slightly stronger exchange rate. The weakness in the major euro zone economies facilitated further ECB interest rate cuts in addition to the 150 basis points of reduction already enacted in 2001. With the German economy in recession and concern about the solidity of several other economies the official ECB interest rates fell to 2.5 percent. The low level of euro appreciation also supported economic activity; combined with the low interest rate level they gave the Irish and euro zone economies a continued boost.

Against the background of poor first half Irish growth data, sluggish euro zone activity and subdued direct investment inflows the minister had several key choices to make. Will taxation be increased, spending growth suppressed or borrowing grow? Clearly a combination of all three were on the cards but in which proportions?

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