Rainy Day Fund could help make sense of spending rules
IN FISCAL space, no one can hear you scream. That’s how a seldomlaughed-at joke in the Department of Finance goes.
But there may be a genuine cause for concern when it comes to fiscal space. To understand why, we need to talk about something equally unfunny: ‘pro-cyclicality’. This can be a feature of the fiscal rules themselves
– a feature that may be counteracted by a welldesigned Rainy Day Fund.
Pro-cyclicality is no stranger to Ireland. It means providing more support to the economy when it is already in good shape and taking away support when its health deteriorates.
In Ireland, an economic recovery has been under way since at least 2014 and there are supply pressures in housing. Housing could recover faster than expected. With unemployment already at low levels, a budgetary policy that douses the fire with fuel now could deprive us of some fuel in future, when it is needed.
It’s not hard to identify potential sources of economic shocks: Brexit, the international tax environment, US trade policy. That’s why Paschal Donohoe is correct to focus on the right ‘budgetary stance’.
But this is a challenging task. Fiscal rules can help. They are designed to help policymakers keep to the right path.
The challenge of sticking to a sensible stance would be made less difficult if the fiscal rules worked perfectly. If perfect, a Government that stuck to the spending rule would grow its spending at a pace in line with the economy’s sustainable growth rate plus inflation.
Spending would rise in line with taxes and policy would look past the boom-bust cycle to what made sense over a longer time horizon. Any additional tax cuts or spending increases would have to be financed in a sustainable way.
But it is inevitable that the fiscal rules are imperfect.
THOUGH sensible in principle, the EU and Irish fiscal rules depend on having good measures of Ireland’s sustainable growth rate. The estimates of sustainable growth that underpin the rules are themselves prone to pro-cyclicality.
Therefore, the growth in rates of spending allowed under the rules tend to rise as the economy undergoes a cyclical upturn and fall as it experiences a downturn.
This means that, in fiscal space, speed limits rise as you go faster and fall as you slow down. If this seems like a bad thing, that’s because it is. In fact, it is clearly dangerous.
A Rainy Day Fund can help fine-tune the rules. In a new paper, my colleagues and I propose modest changes to the fiscal rules that would allow for the operation of a truly countercyclical Rainy Day Fund.
In essence, these changes would achieve two goals.
First, they would enable appropriate contributions to Rainy Day Funds when the pace of allowed spending growth gets too fast. This would ensure that spending growth remains at a sustainable pace.
Second, they would allow withdrawals from the fund to help prop up the economy when allowed-spending growth rates get too slow.