Fiscal Policy in the Global Environment: Case

¶ … Fiscal Policy in the Global Environment: Case Study on Ireland Economic Policy

The objective of this work is to examine the key aims of fiscal policy and to determine what the appropriate fiscal policy stance is for the Irish economy at the present.

Research questions in this study include those stated as follows:

(1) What are the key aims of fiscal policy?

(2) What is the appropriate fiscal policy stance for the Irish economy at this time?

The Aims of Fiscal Policy

The role played by fiscal policy in economies that are developed include maintaining full employment as well as bringing about stabilization to growth. Also included in the aims of fiscal policy are the following: (1) mobilization of resources; (2) acceleration of economic growth; (3) minimization of the inequalities of income and wealth; (4) increasing employment opportunities; and (5) price stability. (Buzzle.com, 2011) Limitations of fiscal policy in developing countries include tax structures that are inflexible. Other reasons for limitations of fiscal policy include: (1) a great portion of economies in developing countries are "non-monetized" which results in the government fiscal measures being ineffective; (2) a lack of statistical data in relation to income, expenditure, savings, investment and employment creates challenges for public authorities for form a fiscal policy that is rational and effective; (3) there is no chance for success in fiscal policy unless the citizens are able to comprehend the implications of that fiscal policy and to cooperate with the implementation of that fiscal policy; (4) large-scale tax evasion; and (5) the requirement of administration that is efficient is absent. (Buzzle.com, 2011)

II. The Case of Ireland

The work of Dr. Noel Palmer entitled "Macroeconomic Aspects of the Irish Economy" reports that the instruments of macroeconomic policy are those which are available to governments that are economically independent and are of the nature that help in gaining the macroeconomic objectives which include: (1) monetary policy or the control of interest rates and the supply of money; (2) exchange rate policy or the change or allowing of change to the foreign exchange value of Irish currency; and (3) fiscal policy or any conscious action by the government which affects the magnitude, structure, or timing of government revenue (taxation) or expenditure. (Palmer, nd)

Ireland, a member of the European Central Bank has no discretion to pursue economic policies that are independent in nature and additionally reported is that Ireland is now a member of the Euro zone and monetary policy for the Euro zone is set by the EBC. The ECB has as its principal objective the integrity of the currency, which translates into the control of inflation since inflation erodes the value of the currency." (Palmer, nd) Therefore, the general level of interest rates that relates to the Irish economy is determined by the ECB and decisions as to the appropriate levels of interest rates which are based on confining movements in the value of the Euro within non-inflationary limits." (Palmer, nd)

The one fiscal instrument of macroeconomic policy that is still at the government's discretion is that of fiscal policy. There is concern expressed by the ECB that the government may decide to engage in deficit budgeting for the purpose of economic stimulation. Ireland is partner to a Pact that maintains that a national budget deficit is considered excessive when it is in excess of 3% of the GDP of a country and results in the imposition of financial penalties when a country is in violation of these guidelines. (Palmer, nd, paraphrased) The primary features of a monetary union are the following features: (1) The complete liberalization of capital transactions and full integration of banking and other financial markets; (2) The irreversible locking of exchange rates; (3) Complete convertibility of currencies; and (4) The introduction of a single currency; (5) The conduct of a uniform monetary and exchange rate policy. (Palmer, nd)

O'Donnell (1998) states that the "most significant feature of Ireland's adjustment to European market integration was a substantial inter-industry adjustment" and that the nature of this adjustment "is best illustrated by identifying three groups of industries, each of which had a different pattern of response." Those three groups of industries are stated to include: (1) Foreign-owned, grant-aided, export-orientated industries; (2) Industries in which the domestic market is naturally protected; and (3) Internationally traded, relatively large-scale, industries. (O'Donnell, 1998)

O'Donnell states that the first group or that of the chemical, pharmaceutical and electronic machinery are such that "experienced continuous expansion, rapid export growth, throughout the period of EC/EU membership. Because of their reliance on the domestic market, the industries in the second group (which include paper and printing, drink and tobacco, some food industries and small-scale metal and woodworking firms), faired well in the 1970's -- when domestic demand was buoyant -- but suffered severe contraction in the 1980's, when the Irish economy languished in prolonged recession. For example, between 1980 and 1987, employment in furniture declined by 25 per cent, in metal articles by 33 per cent, in dairy products by 25 per cent." (O'Donnell, 1998)

Many of Ireland's large manufacturing firms were in the third group, which included textiles, clothing, footwear, leather, parts of chemicals, motor vehicles and parts, electrical engineering, shipbuilding, bread, biscuits, flower and confectionery and other food industries. When tariff protection was removed, there was rapid import penetration and in an environment that was highly competitive, that resulted in secular decline in these industries. The removal of these industries resulted in them being replaced by firms that were foreign-owned and high-technology segments of chemicals, pharmaceuticals and electrical machinery which is stated to have "constituted a much more significant inter-industry adjustment then was found in the case of the EEC6 or, indeed, in Britain or Denmark." (Palmer, nd)

It created an enormous increase in unemployment, and is the major source of the continuing problem of long-term unemployment and poverty." (O'Donnell, 1998) Stated as the fourth effect of market integration or that of industrial concentration was not something that observed in Ireland's industry and instead there was observed a "...fragmentation of indigenous manufacturing industry. The opening of trade induced a sharp reduction in average manufacturing firm size, thereby reversing a slow process of industry concentration that had operated since the 1930s. This seemed to further reduce the possibility of building a large-scale indigenous industrial sector." (O'Donnell, 1998)

This adjustment was radical in nature and is stated to have been interpreted, "...as the response of firms to European integration." (O'Donnell, 1998) Since the basic scale of the firm in Ireland was very small in comparison to competitors and due to other various competitive disadvantages, the relief of indigenous industries was only temporary in nature. Due to the pressure for further adjustment, there were forced contractions of labor and output and the result is that a long path of decline ensued. Richard Doyle and Junior Sophister report in the work entitled "Fiscal Policy in Post-Independence Ireland" that the past ten years have observed a "restoration of the public finances" in Ireland." (1998) Fiscal policy is stated to be left with "its integrity but in a limited state." (Doyle and Sophister, 1998)

It is reported that the Irish economy presently suffers from three primary challenges, which must be addressed if the economy is to return to a growth path that is sustainable. Those three challenges are: (1) the serious loss of competitiveness, which the economy experienced between 2003 and 2008, reflected in the burgeoning balance of payments deficit; (2) the structural imbalance in the government accounts; and (3) the restoration of order to the banking system. (Bergin, Conefrey, Fitzgerald and Kearney, 2009)

The problems experienced presently in the Irish economy are due to serious problems reported to be "a legacy of past policy mistakes culminating with the building and construction bubble" and which are of the nature that must be addressed by tough measures on fiscal policy and a need for competitiveness to be restored. There are reported to be four main sources from which the reduction in the output growth potential of the Irish economy derives including: (1) reduction in EU and U.S. potential growth; (2) reduction expected capital stock in Ireland due to low investment; (3) the expected higher long-run cost of capital; and (4) the burden of government debt that will be higher due to recession. World recovery, once having gained a momentum will affect Ireland but this is reported to only have the capacity to "reflect a restoration of some of the losses sustained over the period 2008-10." (Bergin, Conefrey, Fitzgerald and Kearney, 2009)

The Irish economy is presently operating within a financial system that is global and the largest part of government funding is stated to be likely "come from abroad while the bulk of debt repayment by the banking system will be to its external creditors." (Bergin, Conefrey, Fitzgerald and Kearney, 2009) Beyond 2010, it is stated that a recovery in the economy of Ireland is likely to occur "through a recovery in the world demand that increases the demand for Irish exports. Consequently, the next few years are likely to see an increasing surplus on the balance of payments counterbalanced by a gradual fall in government borrowing. This is likely to mean a continuing reduction in the net foreign liabilities of the banking system." (Bergin, Conefrey, Fitzgerald and Kearney, 2009)

John Fitz Gerald (nd) reports in the work entitled "The Monetary Union: The Case of Ireland" states that the government's appropriate stance for fiscal policy is highlighted by various issues of greater importance for the euro area and in fact is a question "of the extent to which coordination of fiscal policy is needed within Economic and Monetary Union (EMU) and if it is needed, how it is to be implemented." According to Fitz Gerald in the case of Ireland the question is different and asks "…even if the current stance of fiscal policy is unlikely to have any negative implications for other member states in the union, is it appropriate for Ireland? The best estimate of the potential growth rate of GNP in the Irish economy is that, while it was around 8 per cent a year between 1995 and 2000, it should fall to 5 per cent a year over the period 2000 to 2005." (nd)

The Irish economy productivity rate is stated at 4% annually when measured in terms of GDP and 3% annually when GNP measurements are used. Growth in employment is stated at an average 5% annually over the past five years and growth of labor force is predicted to fall to 2% annually over the next five years. Presently unemployment levels are low and employment growth in over the next several years will be mirroring the labor force growth. This will result in a shortage of labor that will hold back the rate of growth of the economy approximately 5% annually between 2000 to 2005. (Fitz Gerald, nd, paraphrased) Labor growth estimates have historically proven unreliable and migration to have "confounded expectations." (Fitz Gerald, nd) According to modeling research on behavior during migration, findings indicate that the supply in labor has been traditionally "very elastic in the past." (Fitz Gerald, nd)

Constraints of an infrastructural nature are unable to "accommodate all the returning emigrants and skilled foreign labor prepared to work in Ireland." (Fitz Gerald, nd) In the event that the infrastructural constraint is relaxed by investment of the government, the potential growth rate could exceed estimations although it takes years for investment plans in the present to have a noticeable impact. A standardized method has been utilized by the EU commission to make estimates of potential growth rates and the government's fiscal stance in each country as well as in Ireland is applied in what is known as the national Stability Program (Budget 2001)." (Fitz Gerald, nd)

The potential growth rate utilizing the methodology of the EU is an application of a filter or a moving average "to output in the relatively recent past, it takes no account of the changed circumstances in labor supply, suggesting a potential growth well over 5% in the immediate future." (Fitz Gerald, nd) Using this method, that 2001 Budget is stated to appear "only mildly stimulatory. By contrast, a model based approach as described in Kearney et al. (2000) indicates that the budget has made provision of a strong demand stimulus…" (Fitz Gerald, nd) The economy is reported to be still growing and the expected surplus is reported to remain high in part reflective of the fear that the economy is "growing well above its long-term-term capacity growth rates, indicated by a large output gap." (Fitz Gerald, nd) Fitz Gerald reports that it is difficult to increase output in response to a demand for increase and the outcome is that the stimulus effect must be "some combination of increased imports and a rise in the price of domestic factors of production and non-tradable goods and services." (Fitz Gerald, nd) According to Fitz Gerald, all studies examining the process of inflation in Ireland over the past 25 years have stated findings that "goods prices are externally determined." (Fitz Gerald, nd) It is reported that the Irish economy presently suffers from "excess demand due to it being 'too competitive'." (Fitz Gerald, nd)

The external sector is the source of the excess demand, which is reported to be reflected in "the balance of payments, which has remained close to balance over the last three years, in spite of the very rapid growth in the economy." (Fitz Gerald, nd) Stated as the danger for the economy of Ireland is that "inflationary expectations in the labor market may result in the real appreciation of overshooting. People may get used to an annual rate of wage inflation of 10 per cent or more a year. While this may be sustainable this year, if it continued it would rapidly price Ireland out of its external markets. Unless wage rates adjust instantaneously to clear the market in the future, any overshooting of wage rates could prove costly. Under EMU, if nominal and, therefore, real wage rates grow too rapidly, making the economy uncompetitive, correction can only come about through either a cut in nominal wages, or through nominal wage rates standing still while inflation in the euro area catches up. Cuts in nominal wage rates are most unusual. Relying, instead, on a slow process of attrition could see the economy remaining uncompetitive for some time, with a consequential serious cost in terms of unemployment and lost output. For this reason stimulatory fiscal policy, that aggravates the rate of wage inflation and fuels expectations about future wage increases, is unwise. The rapid increase in domestic labor costs could expose the economy to unnecessary dislocation in the event of an unexpected external shock." (Fitz Gerald, nd)