The Myth of Austerity in Ireland’s Political Economy

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So, the 2011 general election is over. The Irish electorate, given the historical structure of its party system has replaced a centre-right liberal market populist party with a conservative centre-right party. The centrist Labour party became the second biggest party in the state. In ideal terms the two centre-right parties would have formed a coalition and enabled a left-right parliamentary divide open up in Irish politics. Civil war politics, however, is still alive and well. A Fianna Fáil/Fine Gael coalition was never entertained (even if they are identical in policy terms). Despite the rhetoric of change, the Irish polity has slipped back into the traditional Fianna Fáil (with anyone) versus Fine Gael/Labour parliamentary divide. The outcome of the election could have provided for a significant realignment of Irish party politics. But, it did not. In twenty years time Labour party members will probably reflect that entering into coalition with Fine Gael was a mistake on the same scale as not contesting the 1918 election.

Fianna Fáil will become the main voice of opposition – not in economic terms but in purely political terms. Sinn Féin will take on the role of a social (ist) democratic economic opposition, gradually replacing the Labour party as the main left of centre political force in Irish politics. The United Left Alliance will struggle to find a place in Irish politics because their analysis is too far removed from the contemporary Irish political economy. But, they will create a huge headache for the Labour party. Fine Gael won’t take the ULA seriously and given the structural constraints on what passes for economic analysis in Ireland they will win every argument on the public finances hands down (even if they are wrong). The random selection of Independents will also struggle to find political space as they don’t have a coherent or consistent policy platform. However, individuals like Shane Ross will certainly get plenty of air time. I suspect his critique of Irelands banking policy and public sector reform will be taken more seriously by Fine Gael than all left independents and ULA combined.

Thus, unless there is a miraculous turn around in Ireland’s economic fortunes we may see a Fianna Fáil/Sinn Féin government in five years time. It is this election, in 2016, that will really have the potential to radically overhaul Irish party politics. The electorate has a very short memory. If things do not improve the government will be punished particularly the Labour party. Fine Gael makes no apology for being a conservative political force. They will find it easier to ride the political storm if the economic situation remains stagnant.  If the economic situation does improve the government will be rewarded. The most fundamental question therefore is whether we are likely to witness an improvement in national output (economic growth, measured in GNP), employment and the public finances. The government has the stability to pursue whatever policies they want. Thus, political stability and consistency is not an issue. It is simply about whether their policies will improve the economic fortunes of the country. This may sound crude but history has shown that this is what matters in a crisis.

In this regard, it is worth comparing the current situation to what occurred in 1987. This was the year when the Programme for National Recovery (PNR) was negotiated between Fianna Fail, ICTU and the FUE (what later became IBEC). It was agreed that significant cuts in public expenditure had to be implemented. They were nothing on the scale of what we have witnessed over the past 24 months or what is being proposed for the next five years. What is important to note from the 1987 ‘fiscal adjustment’ is that it established a consensus amongst Ireland’s political elite that ‘expansionary fiscal contraction’ (EFC) can work. Irelands economy improved rapidly from 1987-1990. The debt-GNP ratio came down, exports picked up, consumer expenditure increased and investment improved – on the back of a currency devaluation. The public finances rapidly improved but unemployment remained persistently high. Employment did not improve until the mid 1990?s. This success was all attributed to harsh but necessary ‘fiscal adjustment’.

The Irish economy, thankfully for the signatories to PNR, did improve and enabled the continued re-negotiation of social partnership agreements. Given this rapid improvement in the economy, the 1987-1990 expansionary fiscal adjustment was gradually introduced into economic textbooks as an example of how to improve economic performance through fiscal austerity. Ireland in 1987 and Denmark in 1982 continue to be the only two cited examples of where and how this can work. Thus, it is important to note that the fiscal austerity promoted by the Irish political establishment (Fine Gael, Fianna Fáil and Labour), ECB and the Department of Finance as a response to the current crisis is premised on the success of this period of fiscal adjustment. In economic terms, and delightfully praised by Trichet in the ECB, it is called ‘Ricardian equivalence’. But, few if any economists take it seriously. To a certain extent the adjustment in 1987 was required. The debt-GNP ratio had to be stabilised (national debt had grown to 130 percent of GNP in 1986) or the economy would have ended up in the dark ages. The question is whether the adjustment was the ‘cause‘ behind economic expansion.  If it as not then all the policies aimed at economic recovery by the FG/Lab government will be in vain. It may improve the exchequer accounts but not the real economy. This is how they will be judged by the electorate.

Expansionary fiscal contraction (EFC) was not the cause of Ireland’s economic recovery. There was a configuration of factors that led to economic recovery and they are as follows. Firstly, Ireland devalued its currency in 1986. This led to a rapid increase in Ireland’s exports. In this period most Irish exports went to the UK. Interestingly, similar to today, the 1980-1986 economic crises was primarily located in the domestic economy. It was strangled with high taxes and decreasing disposable income amongst the workforce. The export economy remained relatively healthy during the 1980-1986 crises, particularly the MNC sector. But, this sector only employed approx 13 percent of the economy. Domestic industry, on the other hand, was in decline. Thus, the 1986 devaluation improved export performance and overall national output (growth) as it increased exports to the UK.

Secondly, it was not the devaluation on its own that improved the Irish exports to the UK. In the same year, the UK government introduced a whole series of tax cuts. These tax cuts increased the disposable income of UK workers. In turn, they consumed more in the domestic UK economy. UK citizens consumed more and more of Irish exports. Thirdly, public expenditure increased under the FG/Lab government during 1980-1986 because of a rapid increase in unemployment. Thus, more money had to be borrowed to pay for social welfare payments. The increase in emigration from 1987-1990 stabilised the numbers on the live register. Those claiming unemployment reduced by 2 percent during 1986-1989, or from 236,000 to 2310,000. This was almost entirely accounted for by the increase in net migration – which reached approximately 50,000 per annum in 1989. In this regard, an increase in emigration eased the public finance problem facing the Fianna Fáil administration during 1987-1990.

Fourthly, there was a huge tax amnesty in 1988 that brought in significant amount of revenue to the Irish exchequer. It is hard to fathom how archaic the Irish tax collection system was in the mid 1980?s. There was a huge black market and a whole variety of tax exemption schemes enabled the wealthiest in Irish society to avoid paying any tax at all. This was the opposite scenario for the average PAYE worker. Those earning 2/3 of the average industrial wage were paying 55.5 percent marginal tax rate. Those on the average industrial wage were paying 65.5 percent. The tax amnesty gave the newly elected political administration the political space to cut income tax and thus enable an increase in consumption in the domestic economy. This coupled with the substantial increase in FDI – represented by INTEL – improved the domestic economy and thus employment.

Furthermore, Ireland was a net beneficiary of EU Structural Adjustment Funds. This investment from Europe, aimed at improving the infrastructure of underdeveloped regions acted as a mini stimulus to the Irish economy. This was particularly useful in a context where private investment was on the increase. Exports increased by 13.7 percent during 1987-1989 and investment by 13.9 percent. Combined these were very favorable circumstances for economic recovery. Finally, the gains made by the 1986 devaluation and export growth were consolidated in the first social partnership agreement (PNR). Trade unions accepted the need for minimal wage increases over three years. Wages increased by 3 percent during this period which was less than inflation. But, given the cuts in income tax – real take home pay increased substantially.  Wage restraint enabled firms to increase profits which in turn enabled more job creation (this did not occur until the mid 1990s).

Thus, a configuration of factors benefited the newly elected Fianna Faíl government. It was not austerity on its own that caused recovery. In fact, in the absence of all these other ‘investment’ variables it probably would have made things worse. So, to recap, it was not fiscal contraction (EFC) that led to economic growth but a configuration of factors that include; 1986 devaluation, tax cuts in the UK, 1988 tax amnesty, increase in emigration, increase in exports, increase in private investment, EU structural adjustment funds and the stability provided by trade union wage restraint.

The 1987 fiscal contraction did not, on its own, lead to economic recovery. It stablilised the national debt and decreased the burden of servicing the debt (from 12 to 10 percent of GNP). It decreased the budget deficit over three years from 9 percent to 7 percent. The current Irish government are attempting to reduce the budget deficit from 13 percent (32 if you include the bank bailout) to 3 percent over four years. Furthermore, they simultaneously expect to create 100,000 jobs. This is pie in the sky nonsense.

The present FG/Lab government is operating on the premise that fiscal contraction will improve growth. There is no empirical evidence to support this. Furthermore, the Irish political economy in 2010 has none if any of the configuration of factors that lifted Ireland out of recession in 1987. In this regard, adopting and continuing with the plan to extract a further €15 billion from the Irish economy through public expenditure cuts will make things worse not better. Labour has entered a Faustian pact that they will certainly live to regret. It won’t work. A seriously rethinking of policy is required. This requires serious and fundamental political economic change. It may be too late in 2016.

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5 Responses

  1. Seano

    March 11, 2011 8:23 pm

    You’re giving credit to one major right-wing idea in this article – that lowering taxes can stimulate growth.

  2. Aidan R

    March 11, 2011 10:14 pm

    Lowering taxes does stimulate growth. This is an empirical truth. It supplies the economy with more money. It may end being spent recklessly. But, it still produces capital accumulation or ‘growth’. However, to promote lower taxes as a strategy (and normative preference) to generate economic growth is a right wing idea. It was agressively pursued in Ireland and clearly unsustainable.

  3. Alan Rouge

    March 12, 2011 3:12 pm

    Aidan can you clarify on whom lowering taxes is a good thing? The lucrative 6-figure-a-year club, average industrial wage earners (and below) or the rag bag of wealthy & over indebted people in between these two groups?

    What’s your opinion on the corpo tax? The argument given by the “experts” is presented as scientific and empirical. Do you go along with this or is it purely political?

  4. Aidan R

    March 12, 2011 7:41 pm

    I dont argue anywhere that lowering taxes is a good thing. But, in late 1980s, the average PAYE worker was paying a 65 percent marginal tax rate. So, it was absolutely the correct decision to re-design the tax base and lower income tax for the average industrial wage in this situation. One of the most well organised political movements in contemporary Irish/Dublin history were the tax marches in the 1980s. The more important question is how much, on what basis and for what purpose a state raises revenue. Raising tax to raise revenue to pay for private bank debt is completely different to raising revenue to pay for a public health system. As it stands – I think the Nordic countries have the right mix. But, their tax system is based on solidaristic principles of collective action. Ours is not.

    Of course corporate tax rates are political – all tax decisions are political because only democratically elected governments have the power to tax. Europe, for example, does not have this power. So, no, I dont think the 12.5 percent is scientific. It is simply an incentive for large MNCs to engage in transfer pricing. But, as a percentage of overall GDP – Ireland takes in more tax from corporate profit than most other EU countries, despite the low rate. In the long run, having an industrial policy premised on low corporate taxe is in nobodys interest. Do I think raising the corporate tax rate will lead to an exit of capital – no. Do I think raising the corporate tax rate will slow down foreign investment right now – probably. So, raising corporate tax in the midst of a recession (or depression) given the state of the economy is probably not such a wise decision. There needs to be more flexibility introduced into corporate tax. For example, we should be able to distingush between a company employing 4 people in IT with limited profit and a bank. It is a disgrace than banks continue to pay so little tax on their profit.

    But to return to the question on whom lowering taxes is a good thing. Since 2000 successive FF governments removed those earning below approx €23,000 from the income tax net. The logic was – give people more disposable income and they will spend it in the domestic economy. The state will recoup it indirectly rather than directly. So, is it a good thing that those on low income pay no income tax? In most social democratic countries – everyone pays some level of income tax regardless of what they earn. Direct taxes are considered more progressive than indirect taxation. But, in Ireland, the trade unions spent long and hard campaigning to reduce bands and rates for low income earners. In the Irish context this made sense but it is hardly a long term progressive strategy.

  5. Alan Rouge

    March 12, 2011 10:15 pm

    Aidan, thank you for the thorough response.

    What do you make of Michael Taft’s blog on “disturbing the corporate/business sector” ? http://notesonthefront.typepad.com/politicaleconomy/2011/03/a-number-of-commentators-have-referred-to-the-rejoicing-of-fine-gael-and-labour-tds-even-if-some-were-disappointed-by-cabine.html

    Taft makes the point that “Irish corporate and business sector makes the least contribution to public finances than almost all their counterparts in other EU-15 countries.”

    Is it an inevitability that this new government will eventually have to cease squeezing blood from a stone (welfare payments & tax on low-average wages) and take very tough and hard decisions – unlike the so called hard decisions taken to date – by increasing taxes at the upper scale of earners? Or will the blinkers remain?

    Conservatives (and wannabe economists)like Sarah Carey, who have great access to media, bring up the Laffer curve and warn of the consequences against raising taxes on higher earners. [Both she and Eoghan Harris warned Labour pre-election against getting too radical and to send out people the middle class like such as Rurai Quinn]. This together with quoting ad nauseum that half of the (income) tax take comes from a minority sums up the opposition to increasing taxes on the 6-figure-a-year club.

    Will the programme for government’s commitment of a “minimum effective tax rate of 30% for very
    high earners” amount to anything or is just window dressing?

    Finally do you think the political will exists to reform taxation so that the corporations tax actually benefits the common good and not so Ireland represents a tax haven where Google can have an ultra low effective tax rate? Did the Finance Bill that came in to effect in January go far enough in this respect?