The Irish Central Bank’s Fiscal Problem
What does a central bank do when it can’t control interest rates?
No, this isn’t about the zero lower bound problem, which is fast becoming a non-problem, at least in the United States. It’s about Eurozone countries. Specifically, it’s about Ireland.
Currently, Ireland boasts the fastest-growing economy in the EU. In 2017, headline GDP rose by 7.8%. Because Ireland hosts a large number of foreign firms that remit profits back to their own countries, “gross national income” (GNI) which excludes their profits is arguably a better measure of economic growth for Ireland. But GNI growth for 2017 was also strong, at 6.6.%. The Central Bank of Ireland says that the Irish economy is “approaching capacity limits.”
On this basis, you might think that the Irish central bank would be worried about the economy overheating and inflation taking off. Not that there would be much it could do about it. Ireland is a member of the Euro, so its interest rates are set by the ECB. Currently, ECB interest rates are on the floor – indeed the deposit rate is negative – and it is doing QE, although it plans to end this by the end of 2018. Rising inflation in a small periphery economy would not make enough of an impact on the whole Eurozone economy to make the ECB change course.
Anyway, inflation is on the floor. The Irish central bank’s most recent inflation forecast shows inflation well below the ECB’s 2% target, and indeed well below the Eurozone average, at 0.8% in 2018 and 0.9% in 2019. Additionally, the central bank projects GDP growth slowing to 4.8% in 2018 and 4.2% in 2019: GNI would be perhaps a percentage point lower. It forecasts that unemployment will fall from 5.6% in 2018 to 4.8% in 2019.
So inflation is far below target, unemployment is higher than in Germany, and economic growth is slowing. Clearly, the Irish economy is not overheating.
Yet the central bank is worried. As a small open economy, Ireland is exposed to external shocks that could be severe enough to trigger another economic crisis. And currently, the risk of such a shock is – to say the least – on the high side.
In a recent speech, the Governor identified four significant risks to the Irish economy:
- Abrupt loss of international investor confidence and flight to “safe havens.” Such a “sudden stop” happened to Ireland after the 2008 financial crisis, resulting in widespread economic destruction, an IMF programme and years of austerity to restore the fiscal finances. The scars still hurt.
- Lower future global growth prospects, possibly due to international trade war. Ireland’s economy is now export-led – in 2017 its trade surplus was 12.5% of GDP. A sharp drop in global growth could mean export income drying up, with disastrous consequences.
- Other countries could lose patience with Ireland’s tax haven status and enact legislation to force foreign firms to repatriate income or even relocate. The U.S. has already enacted some measures along these lines.
- Hard Brexit, which would abruptly cut trade links with one of Ireland’s largest economic partners.
The Governor observes that the first two risk factors would similarly affect other countries, but the third and fourth are a much bigger risk to Ireland than other countries. They would be “local shocks”.
How could the Irish central bank deal with such a shock, given that it cannot adjust interest rates, and it cannot do QE? Well, the last crisis was propagated through the banking system, so firewalling banks is a priority:
In relation to financial-sector buffers, the Central Bank is working to ensure that the capital positions of banks are sufficiently strong to withstand the losses that could be triggered by a negative shock. Our policy interventions include the recent activation of the counter-cyclical capital buffer: in the event of a downturn, this capital buffer can be released, thereby avoiding a pro-cyclical withdrawal of credit supply under adverse conditions.
And so is stopping them lending excessively, especially against property:
In relation to new mortgage lending, our borrower-based measures that impose (flexible) ceilings on loan-to-value (LTV) and loan-to-income (LTI) ratios are designed to limit the risks of over-borrowing by households and over-lending by banks.
All well and good. But a hard Brexit, for example, would not primarily be a risk to banks. It would be a shock to trade. Abruptly cutting supply chains across the border with the UK would decapitate many Irish businesses. How could the Irish central bank protect the economy from such a shock?
It couldn’t. Because Ireland is a member of the Euro, its central bank is completely out of macroeconomic ammunition. Only the government has sufficient firepower to help Ireland’s export-led economy recover from a severe shock to trade and production – and only if it has the borrowing capacity to do so. If it hasn’t, then a hard Brexit could be very hard indeed for the Irish economy.
And the Governor knows it. In his speech, he calls on the Irish government to build up “fiscal buffers” to protect against an economic shock:
…the running of budget surpluses that fund some combination of reducing the stock of public debt and building up a rainy day fund of liquid assets would allow the government to implement a stabilising, counter-cyclical fiscal expansion in the event of a future downturn. If fiscal buffers are not built up in good times, there is a risk of repeating the costly experience of past episodes by which economic downturns were amplified by pro-cyclical fiscal austerity.
Currently, the Irish government is running primary fiscal surpluses, but the absolute budget position (i.e. including debt service) is a deficit of about 0.5% of GDP. Debt/GDP is about 68%, but debt/GNI is over 100%.
The Governor says the Irish government should raise taxes to eliminate the remaining deficit and reduce debt/GNI. Specifically, he calls for higher taxes on property and savings. So not only has the Governor told the government what its fiscal targets should be, he has also specified how those fiscal targets should be achieved.
This is completely understandable. For small Eurozone countries like Ireland, monetary policy is impotent and fiscal policy is the only game in town. But the emasculated central bank is nonetheless expected to manage the economy. It has no choice but to dictate fiscal policy.
But the Governor’s comments nevertheless go far beyond his remit. Tax and spending decisions are the responsibility of elected politicians, not central banks – and for very good reasons. “Taxation without representation is tyranny,” as James Otis famously said. Elected politicians are accountable to their voters for their decisions. Central bankers, especially in the Eurosystem, are not accountable to anyone. The Governor’s attempt to dictate to the Government is a serious threat to Irish democracy.
Of course, the Irish government does not have to do what he says. But if it does not, then it might be unable to respond adequately to another economic crisis. The central bank would have covered its own back, but the ordinary people and businesses of Ireland would pay the price. Power struggles between central bank and fiscal authority are hardly a good way to manage an economy.
The impotence of Eurozone national central banks also forces the ECB itself to act in a quasi-fiscal role. Large imbalances between EU member states threaten the integrity of the single currency, but because monetary policy is set for the Eurozone as a whole, the only way of shrinking the imbalances is fiscal policy. To protect the single currency, therefore, the ECB inevitably dictates and enforces fiscal measures designed to reduce member states’ trade and fiscal deficits.
By depriving central banks of their responsibility for monetary policy, the Euro forces them to take on a role that is not theirs. Eurozone voters need to decide whether they really want central banks dictating to elected politicians – or whether the Euro needs a rethink.