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Sunday, 14th July 2024
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Generational accounts point to over-restrictive Irish fiscal policy Back  
Standing out from Western countries, Ireland has no problem with generational imbalances, but the argument that the pensions problem for major economies could cause EMU to fail is over-cooked, writes Dermot O'Brien
EMU bashing is a popular sport that has not been affected by the fact that the project got off the ground against the predictions of the teenage scribblers and without much of the forecast statistical and political jiggery-pokery. All that has happened is that the game has become a bit more sophisticated and the playing field has moved from the tabloids to more upmarket journals.

An example appears in the latest issue of Foreign Affairs in an article entitled “The Degeneration of EMU”. What is interesting about this is not the conclusions reached but the analysis on which they are based. That analysis is especially interesting in the context of the current policy debate in Ireland.

Generational threat to euro?

The article predicts the demise of EMU within the next ten years on the basis that Euroland members’ fiscal policies are unsustainable. It argues, with some merit, that current measures of fiscal health, and those underlying the European Stability and Growth Pact, are definitionally arbitrary and do not tell us anything reliable about the sustainability. The authors argue that the solution to this is to use generational accounting - an objective approach that provides a clearer view of the long term implications of current policies.

Generational accounting provides a balance sheet on one side of which is the sum of all future net taxes (i.e. taxes less transfer payments) that citizens born in any given year will pay over their lifetimes. On the other side is the sum of all of the government’s future purchases of goods and services plus its net debt. The calculations assume maintenance of current government spending and taxation policies and allow for forecast demographic and economic developments. Since the time horizon for these accounts effectively stretches to infinity, generational accounts have to balance on the basis that at some point government borrowings have to be repaid out of taxes. Any imbalance in the calculated accounts points to a need for policy change.

Exceptionally healthy

The accompanying table is reproduced from the paper. It shows, firstly that virtually all European countries - Ireland is the signal exception - are running policies that are generationally unbalanced and, therefore, unsustainable. Policies favour the current generation at the expense of future taxpayers and cutbacks at some point will be needed. The table estimates the scale of action that would be required to restore balance, producing some intimidating numbers especially for the big Continental European countries and for a few of the smaller ones as well.

Breakdown scenario

So far so good, but the authors go on to make a much bigger deal out of their findings than this exercise in accounting can support. Their conclusion is that the scale of spending cuts and/or tax increases needed to achieve generational balance is unpalatably large for a number of countries and, in any case, none of the main governments has the political strength to implement reform. The authors’ favoured scenario is one where governments, lacking the will to cut back, try to pressure the ECB into using the printing press to ease their problems, the ECB won’t play ball so countries pull out of the system and EMU falls apart.

Leaving the Euro-phobic agenda of the article to one side, the approach to the assessment of fiscal policy sustainability is novel even if the conclusions are not entirely new. It is well known that countries such as Italy, Sweden, Spain and Germany have serious problems to address connected with their aging populations, the generosity of their social security systems and the extent to which those systems are un-, or under-, funded. The article adds a few others - notably Finland and Austria - to the list.

Ultimately the problems in all these countries will have to be addressed and curtailment of some social benefits, raising the retirement age, as well as raising social security contributions will probably all be part of the solution. However, while the burden of existing social security systems is intimidating when the net present value of future costs is calculated, work on the effects of, for example, raising contribution rates or otherwise switching from a pay-as-you-go to even a partially funded system suggests that the problem can be a lot more manageable.

Adding growth

Things can change too. The generational accounting methodology, almost by definition, can make little provision for changes in economic structures. The possibility that higher trend growth could be part of the solution is precluded. Yet, there is a process of reform and deregulation in train in Europe, albeit not on a particularly fast track, that could help to head off the growth constraint that ageing populations entail. In addition, if new technologies have raised the sustainable productivity growth rate of the US, there is little reason why they can’t do the same for Europe as market rigidities are broken down and regulatory obstacles are removed. Doomsday scenarios such as this paper concentrates on are not necessarily the most likely outcome.

Over-restrictive Ireland

Still, had generational accounts been available for Ireland during the second half of the 1970s and first half of the 1980s, we might have avoided the decade of fiscal irresponsibility that lost us a generation of our brightest and best to emigration. Moreover, I suspect that computing such accounts for Ireland in the mid-1980s, when government was still borrowing hand over fist and debt was on an exponential rise, would have produced results to rival the gloomier numbers in the table. Now things have changed but, apart from illustrating that alteration, the article’s calculations for Ireland are a useful addition to the current debate about fiscal policy. As the table shows, Ireland’s fiscal policies are shown not just to be sustainable long term but, in a sense, to be overly restrictive. Government spending would need to be increased by 4% to 4.5% or income tax cut by almost 5% to restore generational balance.

That Irish fiscal policy is in any sense restrictive will come as a surprise to the Central Bank, the EU Commission and many other commentators. The forecasts underlying the Irish numbers in the paper are not described but it is clear that the results reflect the uniqueness of Ireland’s demographic outlook relative to the rest of Europe. The implications of population growth over the next ten years for the expansion of domestic demand and labour supply are profound, ensuring that this economy can continue to notch up growth rates well above the European average. Meanwhile, the kind of population ageing that is at the heart of other countries' problems is a pretty distant prospect here, leaving plenty of time to adequately prepare. Charlie McCreevy’s decision to set up funds aimed at fully financing the cost of public sector pensions and part-financing future social welfare pension liabilities is a first - and quite farseeing - step in this direction.

Not a blip

Much of the current concern with Irish fiscal policy appears to regard the economy’s strength as a lucky break rather than part of a sustainable longer-term trend. Policy prescriptions based on that misconception run the risk of creating obstacles to the full realisation of the economy’s potential. The real challenge for policy is how best to facilitate the growth potential our demographic prospects give us while making best use of the fiscal surpluses strong growth will throw up to adequately prepare for a future when growth will be slower and population ageing beginning to create the kinds of public spending pressures that are now so much a problem for our EMU partners.

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