Economic trends in the US and Britain are bad news on the double for Ireland

Despite six years of solid growth, this is no time for false optimism, writes Colm McCarthy

MANAGING expectations is one of the key tasks of economic policy. Opposition politicians and a populist media continually identify groups in society deserving of extra government spending or reductions in taxation, knowing full well the aggregate of their proposals cannot be delivered.

The ritual of the oncea-year budget provides an annual challenge to expectation-management and Irish governments routinely fail, so every budget is a disappointment. So it will prove when Finance Minister Paschal Donohoe delivers on October 9 and he has been struggling to explain the limits to what is possible.

After six straight years of solid economic growth and steady concessions in recent budgets, the collective memory has been distorted to the point where anything short of substantial giveaways will be seen as ‘more austerity’.

It is possible, but highly unlikely, that the economy will expand merrily into the middle distance, making impossible sums add up. A slowdown is always in the cards after such a sustained recovery and the inevitable costs of Brexit will begin to impact early next year. But there are additional reasons to justify caution.

Ireland’s recovery from the 2008 crash has been more vigorous than elsewhere in the eurozone and far better than could have been expected in the dark days of 2010 and 2011. One of the reasons is the timing and strength of recovery in the USA. Ireland has bigger export exposure to the US than other European economies and is a beneficiary of strong inward investment when corporate America does well.

The US responded to the financial crisis more promptly than did European policymakers, and the recovery started sooner in America. But there is a downside. Last Wednesday, the US central bank, the Federal Reserve, continued the hiking of interest rates, which it started almost three years ago. It also discontinued central bank purchases of government and corporate bonds shortly thereafter. Short-term official interest rates in the US have now edged over 2pc and the Fed has signalled they will exceed 3pc before the end of next year. The Fed also reversed engines in the bond market and is selling bonds rather than buying.

The European Central Bank was behind the curve in both departments: it actually increased interest rates for a period in 2011 and started to loosen monetary conditions through bond purchases later than either the Fed or the Bank of England.

Some northern European governments had the latitude to loosen budget policy in the depth of the crisis but declined to do so while the first American stimulus package came promptly in 2009. The result is that the US recovery started sooner than in continental Europe and has proceeded at greater pace. Ireland has been a beneficiary, offsetting to some extent the negative impact of unhelpful policies in the eurozone.

The US monetary authorities are now focused on ‘normalisation’ which means restoring the customary excess of interest rates over inflation, itself back to the Fed’s target of around 2pc. Long-term rates on government debt, currently about 3pc, could end up somewhere between 4pc and 5pc. There could be further conflict between President Donald Trump and his central bankers — Trump has gone for tax cuts and a fiscal boost, even though the US economy is close to full employment. The jobless rate is below 4pc and heading for a 50-year low.

US monetary policy has impacts around the world and the pressure is on for tightening action elsewhere. At the European Parliament last Monday, ECB president Mario Draghi reiterated his intention to stop buying government and corporate bonds at the end of December. This policy, started rather late in the day in March 2015, was instrumental in reducing interest burdens for Ireland and other heavily-indebted eurozone countries. Draghi indicated the ECB will not immediately become a seller of bonds and that official interest rates (the key rate is zero) will remain unchanged at least until next summer.

At some stage, the ECB will begin actually raising rates: it expects inflation to head back towards 2pc next year and must eventually follow where the US is already headed. ECB official rates cannot stay lower than the inflation rate indefinitely and could be two or three points higher than today’s level by 2021. The belated loosening of monetary conditions in the eurozone has come to an end.

Along with his pro-cyclical fiscal boost, Trump has initiated trade conflicts in the form of unilateral tariff impositions with friend and foe alike. Neighbours Canada and Mexico, allies in Europe and rival China have all incurred the presidential wrath. Trump has sought to undermine the World Trade Organisation through declining to nominate American appointees to its dispute resolution arm. Some of his tariff measures are violations of WTO rules and he has threatened to withdraw from the organisa- tion. The WTO’s precursor, the General Agreement on Tariffs and Trade, was established in 1947 to re-order the world trading system after World War II. The GATT initiative was driven largely by the US, with support from Britain, currently engaged in withdrawal from the EU’s single market, which it did so much to create in the 1980s. These two victors of World War II are now engaged in the deconstruction of a free trading system which was largely their own handiwork.

This is bad news on the double for Ireland. Small countries have little choice but to be free traders and Ireland just happens to be located between two major economic partners heading in the opposite direction. Trump is less confused than the British — he is an equal-opportunity protectionist, and measures already taken or threatened will inhibit Irish exports. The UK professes enthusiasm for free trade with the whole wide world while withdrawing from the European single market next door.

There is every chance both the British and American economies will weaken over the next couple of years. Brexit will damage the UK even if there is an orderly withdrawal, while the US recovery is facing capacity constraints as well as policy dysfunction. It is not plausible to expect only minor negative impacts in Ireland.

In any event, the Irish recovery has begun to hit its own capacity constraints which would presage a slowdown even in benign external circumstances. Reports of labour shortages are increasingly frequent and firms in several sectors are focused on recruiting overseas. Especially in the Dublin area, the excessive cost of housing is a constraint on economic expansion as well as a challenge to social policy. This no time for false optimism.

‘A slowdown is always in the cards after a sustained recovery’