Oireachtas Joint and Select Committees
Tuesday, 6 October 2015
Joint Oireachtas Committee on Finance, Public Expenditure and Reform
Macroeconomic Forecast for 2016: Department of Finance
I remind members to ensure their mobile phones are switched off. This is important as they cause serious problems for broadcasting, editorial and sound staff. The topic of the meeting is the macroeconomic forecast in the context of budget 2016. I welcome the following officials from the Department of Finance: Mr. John McCarthy, chief economist; Mr. Brendan O'Connor, assistant principal; Ms Laura Weymes, assistant principal; and Mr. Ian Power. I apologise for the slight delay but there was a vote in the Dáil. Our witnesses will make some opening remarks which will be followed by a question-and-answer session.
I draw the attention of witnesses to the fact that by virtue of section 17(2)(l) of the Defamation Act 2009, witnesses are protected by absolute privilege in respect of their evidence to the committee. However, if they are directed by the committee to cease giving evidence on a particular matter and they continue to so do, they are entitled thereafter only to a qualified privilege in respect of their evidence. They are directed that only evidence connected with the subject matter of these proceedings is to be given and they are asked to respect the parliamentary practice to the effect that, where possible, they should not criticise or make charges against any person, persons or entity by name or in such a way as to make him, her or it identifiable.
Members are reminded of the long-standing parliamentary practice to the effect that they should not comment on, criticise or make charges against a person outside the House or an official either by name or in such a way as to make him or her identifiable. I invite Mr. McCarthy to begin to begin.
Mr. John McCarthy:
I thank the committee for the opportunity to present the short-term economic outlook in advance of budget 2016. I am accompanied by colleagues from the macroeconomic forecasting team, including Ms Laura Weymes, Mr. Ian Power and Mr. Brendan O'Connor.
By way of background, regulation 473/13 requires non-programme euro area member states to submit draft budgetary plans to the European Commission and the Eurogroup by 15 October of each year. The regulation further specifies that the macroeconomic forecasts upon which the budget is based must be either produced or endorsed by an independent body. Ireland, like the vast majority of euro area member states, has taken the endorsement route with the endorsement function assigned to the Irish Fiscal Advisory Council, IFAC.
The endorsement process for budget 2016 has been under way since mid-September, culminating in a presentation by my colleagues and I to IFAC last Thursday. For the annual budget, as distinct from the stability programme, IFAC has a role in assessing just the short-term projections, namely, those for the current year and the following year. I can report that last Friday, IFAC formally endorsed the Department's economic projections for 2015 and 2016.
The numbers are 6.2% real growth in 2015 and 4.2% in 2016. The letter of endorsement from the Chairman of the Irish Fiscal Advisory Council has been placed on the website of both institutions. We have provided the committee with a version of the presentation that was provided to IFAC. It is a large set of slides so we will present a more concise version to members today. We sent this to the clerk on Friday last. We will put this on the Department's website this evening.
The economic projections we are presenting are based on the technical assumption of a budget package amounting to €1.2 billion for next year, which is the latest stated policy position. It was set out in the stability programme update, SPU, that was published last April. It is a purely technical assumption and does not represent the Government's policy position. The economic forecasts that will be presented on budget day will take account of all budgetary measures. As the Minister has outlined in his letter to the Chairman of the committee, we are not in a position to discuss the fiscal situation or the implications for policy. I stress that we did not discuss any of these issues with IFAC, as our discussion was purely on the macroeconomic situation.
I propose we go through the presentation very briefly. Of the 50 odd slides, I propose we go through the first 30 as the later slides are somewhat more technical. We will put them online and we have supplied them to the committee. We will, of course, take questions on the later slides if the committee so wishes. Mr. Power will outline the latest international economic developments, Mr. O'Connor will then make a presentation on the domestic situation and Ms Weymes will discuss the labour market outcomes and I will then summarise the key trends and what they mean for the short-term economic outlook. It should last between 15 to 20 minutes and, subject to the agreement of the Chairman, we will then take questions.
Mr. Ian Power:
I will take members through the main external assumption underpinning our macroeconomic projections. Let us turn to slide 3. As members will be aware, commodity prices have fallen significantly in the past year, in particular oil prices have fallen sharply, owing to a weak global demand and robust supply. To put it in perspective, oil prices excluding the very peak of the global downturn in early 2009, have suffered the largest year on year decline since 1986. Ireland as a net energy importer should benefit from this decline.
Let us now turn to slide 4. Currency developments are acting as another significant tailwind for the Irish economy, with the euro depreciating sharply against both the dollar and sterling in the past year. To put this in perspective, it is the largest year on year depreciation of the euro against the dollar and sterling since the inception of the single currency in 1999. Both these factors are acting as significant tailwinds for the Irish economy.
Let us now turn to slide 5. External demand remains reasonably solid with our main trading partners performing relatively well. The graph shows quarterly GDP growth rates for the US, the UK and the euro area, which collectively make up approximately two thirds of Ireland's exports. The US is performing well with steady job gains underpinning the consumption and recovery there. One can see a slight blip in the first quarter, which is mainly due to one-off factors such as labour disputes at west coast ports and the extreme weather conditions on the east coast. One can also see there was a resumption of robust GDP growth in the second quarter of this year of 1% relative to the previous quarter. The UK economy also continues to grow steadily with strong domestic demand and, importantly, the growth outlook in the euro area is picking up, perhaps not as fast as might be expected, given the tailwinds, but it is moving in the right direction.
Let us turn to slide 6. This slide summarises our external assumptions. Our external GDP growth assumptions come from the OECD's interim economic assessment. The main difference relative to the stability programme update, SPU, is the marked decline in the US GDP growth rate. Again, this is mainly due to the very weak key 1, which I touched on earlier. There has also been a pick-up in the growth outlook for the euro area for this year relative to the SPU. As required, we make the technical assumption that exchange rates are unchanged as of end September going forward. As a result our exchange rate assumptions are broadly in line with those at SPU.
Mr. Brendan O'Connor:
Thank you. I will start at slide 7, which kicks off with exports. That is a useful place to start, given the external environment that Mr. Power has described.
If we look at the recovery in recent years, it commenced with an export-led recovery and then firms started to invest in machinery and equipment in recent years. We had positive investment growth and in the past year or two we had growth in consumption by households. In the first half of the year, when one looks at the monthly trade series in respect of goods or overall exports in the national accounts, growth has been extremely strong. We see double digit growth in goods and services in each of the first two quarters. If we look at the monthly trade data, we will see year-on-year growth relative to the same month in 2014. This growth is in double digits. Let us take the example of July, merchandised trade was 25% higher than in July 2014 and plus 22% in June. That is not just in the foreign sectors of the economy. If we look at what we might consider to be indigenous sectors, products that are exported by Irish companies, such as food and tobacco, we are seeing from the monthly trade data robust large high single digit figure growth as well in those areas.
On the services side, it is interesting that there was double digit growth in the first two quarters this year, mainly driven by ICT services. Turning to import growth, given the structure of the Irish economy we have had consumption growth in the first half of this year and last year. Let us think about the types of things that households have started to consume. We had a record number of car licences, in the order of 100,000 by August this year, which is the first time this has happened since 2008. The consumption of white goods has increased. These products are imported into the economy. We have had quite high import growth as well. In the second quarter of this year, there was an importation of a patent of intellectual property into the economy, so service imports may to some extend may have overstated the import growth.
That describes the external situation in terms of the economy. We will move to domestic demand and this is illustrated in slide 9, with the investment story. This is important and it is what the private and public sectors are doing in terms of construction. This is a complex graph, unfortunately I do not have a screen but we have the overall investment series, which is GDFCF, Gross Domestic Fixed Capital Formation. It is expressed on a quarterly basis back to the first quarter of 2014. We have four sub-components. In the past we probably thought about investment in terms of just building and construction and machines. Due to recent methodological changes by statistical agencies, we have things like intangibles showing up in investment, that is, investment in things like R&D and other types of intangible assets as well. Aircraft has also become more prominent. There was a methodological change this year. Ireland has a very large aviation leasing sector and as of the national accounts released in the summer of this year, all the purchases of aircraft by leasing companies, regardless of where those aircraft are used, are regarded as investment by Ireland. At the same time they show up as imports as well because we import aircraft. There is no impact on GDP, although in the future it will give rise to fee income by the leasing companies, which is a service export in future years.
What stands out this year is the positive growth in core medium enterprise, that is, what is happening in factories. We also had positive growth in intangibles. In the second quarter of this year a large patent was brought on shored by an Irish company. This will give rise to fee income to patent income going forward. That did not give rise to GDP in the second quarter of this year because it was imported.
Let us turn to the next slide, which deals with residential house building. We are forecasting approximately 13,000 units this year. This is a 16.5% growth in new housing. We can see how the curve has progressed. It is coming off a low base.
Slide 11 deals with commercial real estate. This data from CBRE are quite important. They are showing vacancy rates in the Dublin area for office accommodation. In the first half of this year, the vacancy rates were in the order of the mid-2000 levels. There are big demand-side pressures which we think will give rise to investment in the medium term.
Let us turn to the next slide. I have already mentioned machinery and equipment investment by the private sector. I want to be clear that foreign companies in Ireland do not have too many financing constraints. They are able to borrow on liquid capital markets internationally. This graph gives some consideration to what is happening in the SME sector - so Irish companies - and it uses some data that we collect from the RedC SME credit demand survey. There are two panels here - turnover and profitability. I will focus the committee's attention on the blue bars on each of the panels which show that an increasing number of respondents have reported higher turnover and higher profitability in the last six months. This suggests what is happening in the trading environment for SMEs.
The next chart, which is number 13, speaks to credit growth. Again, we are looking at the SME credit status from the Central Bank of Ireland's credit, money and banking statistics. Since winter 2013, we have seen a rise in new lending to the SME sector right through to the second quarter this year - it is on a continuous upward trend. That speaks to our view on what might happen in terms of investment by the private sector. That concludes investment.
Slide 14 is about the household sector. In 2014, after a number of years, the consumption by households finally turned positive, in the order of about 2%. In the first half of 2015 it was about 3.5%, which is large in relative terms compared to recent years. This is consistent with what we have seen in the retail sales data. The retail sales index has been extremely strong right throughout the year. By end of August 2015 it was up 9% year on year and that is not only driven by car sales. If one looks at core retail sales, it was up about 6%. It speaks to positive consumption growth for the year.
Slide 15 shows recent quarterly growth. It brings together what I have just been speaking about. We have seen quarterly growth in the first two quarters of this year of about 2% but that was 7.2% year on year in the first quarter and about 6.7% in the second quarter of the year. The level of GDP passed its pre-crisis peak in 2014 and the level of GDP per capita passed its pre-crisis peak in the second quarter this year. That is per head of population.
Mr. John McCarthy:
I would point out that there is an important subtlety there in that during the bubble it was all concentrated in one sector whereas now it is much more balanced between the external sector and domestic demand, so it is a better composition of aggregate demand. Even though we are now at pre-crisis peaks, we are in a better space than we were back in 2007.
Mr. Brendan O'Connor:
I will continue with the graph on slide 16. This is a technique that we use called a carryover analysis. It is a guideline for what we think GDP will be for the year if the same level of GDP that we saw in the second quarter continued in quarters 3 and 4. In other words, if it did not grow, but went sideways. We can see in the blue bar at the right of that panel that if that was the case overall GDP would be in the order of about 5.7% for the year. We forecast that it will be in the region of 6.2%. One can see very high investment growth of approximately 21%, assuming that the trend in the second quarter continues into the third and fourth. We do not think that will be the case. The figure was probably overstated because of this big patent acquisition. The figure for consumption of approximately 2.6% assumes that the level of consumption by households was the same in the third and fourth quarter as it was in the second, but we have seen from the retail sales data that has come out that the momentum has continued into the third quarter, so we think that the growth has continued in the third quarter and this carryover analysis would be on the conservative side.
My final slide talks about the current account. The current account is the balance of payments, which is Ireland's position vis-à-visthe rest of the world. There are four things going on in the graph. The line, again consistent with other charts, is the overall current account balance, which is in surplus. As a percentage of GDP, it is up around 5% in the second quarter. The components of that are that the goods balance - goods exports minus goods imports are shown on the brown line. The blue line is services, services exports minus services imports, and green is the income balance, the flow of money in and out of the country. We forecast a surplus in the balance of payments in 2015 of approximately 6% to 7%. That is a very good position for Ireland to be in. It speaks to the external sustainability of Ireland. Our exports are greater than our imports and we are paying our way in the world.
Ms Laura Weymes:
Let us turn to slide 19 and look in a little bit of detail at the outturn developments and what we have seen happening in the labour market. Latest quarterly national household survey data to quarter 2 tells us that there has been quite a strong pick-up in the volume of employment growth in the first half of this year, which totals in the region of 2.6%. In terms of the contraction in the levels of unemployment, levels are down since peak by about 117,000. Some flatlined in the three months to August when the unemployment rate stayed relatively static, but levels began to contract again in September.
Turning to the next slide-----
Ms Laura Weymes:
Although the levels were falling, what is happening under the line in terms of labour supply is that we see the beginning of a pick-up and positive growth in labour supply so that is constraining an otherwise sharper decline in the rate of unemployment. We will look in a little more detail at those drivers in the coming slides.
Slide 20 looks at what has been happening in terms of average wages over the last couple of quarters. For the first half of this year, there was an average wage growth of 1%, although that disguises what is happening between the public and private sectors. All of the recovery and wages are predominantly driven in the private sector where they have been growing at 1.4%, as opposed to a slight contraction on the public side. In terms of the sectoral colour of what happened in the first half of the year, there has been some quite significant wage strength in certain sectors - the wholesale, retail and trade sectors were up 2.1% in the first half of the year. There was also some evidence of wage strength in the ICT and administration sectors.
The next slide informs our outlook for the labour market, particularly the employment volume projections for this year. The chart on the left combines what we have seen in terms of the change in employment volumes contrasted with what the vacancy rate suggests. A two-quarter lag of the vacancy rate operates as quite a good predictor for volume growth in employment in a given quarter. The sharper decline in the number of vacancies relative to the contraction in employment volumes over 2009 and 2010 in the chart points to evidence of labour hoarding during the crisis. The pick-up implied in vacancy rate data, certainly for the first half of this year, underpins our outlook for employment growth for the second half of this year of about 2.8%.
The next slide shows our outlook for the pick-up in labour supply. There will be an uptake of about 15,000 in volume terms for 2015. This is split broadly evenly between contributions from participation rate pick-up and also from the demographic channel.
In 2014 there was quite a significant drag coming through the participation rate effect but that is lifting and turning positive for the remainder of the forecast horizon.
An overall wage bill projected in 2015 at just under 5% is driven by a small positive contribution from the pick-up in hours worked, as we might anticipate, given the cyclical recovery in the labour market. There will be a slightly stronger contribution from wage growth in 2015 and 2016.
Mr. Ian Power:
Prices in Ireland have been moving broadly in line with the euro area over the past year, after several years of inflation running well below the euro area average. We had several months of falling prices, starting last December, and as a result the average inflation rate this year is still negative at -0.1%. This is mainly attributable to falling oil prices, which continue to act as a major drag on headline inflation. If, however, we consider core inflation, excluding volatile energy prices and unprocessed food prices we see that core inflation is up 1.1% on average this year. Core inflation is being driven by increases in the price of services. We anticipate that, as the impact of lower energy prices wanes, headline inflation will move back broadly in line with core inflation.
Mr. John McCarthy:
Short-term growth dynamics are benefiting from several tail winds - trading partner growth, which is fairly robust, especially in the United Kingdom and the United States; a fairly accommodative monetary policy stance and the associated depreciation of the exchange rate, which is beneficial to exporters; and trade gains associated with falling commodity prices, in particular oil prices and on the back of all these favourable developments we expect output growth of 6.2% for this year. This is yielding positive developments in the labour market. We expect employment growth of just under 3% this year, approximately 53,000 jobs, and an unemployment rate that will average approximately 9.5%.
For 2016, on the assumption of a continued recovery in our key export markets this should support export growth of approximately 7% for next year. Our base line assumption is that domestic demand continues to strengthen as headwinds subside further. In overall terms we expect output growth of approximately 4.2% for this year. On the nominal side, some of the factors that have been holding inflation back this year should begin to subside and we are expecting an inflation rate just north of 1% for next year. In the labour market we expect employment growth of 2.4%, which is approximately 47,000 jobs, and unemployment should average approximately 8.4% for the year.
Our assessment is that the risks to the baseline situation are tilted somewhat to the downside. There are some upside risks if oil prices fall further but on balance the risks are tilted to the downside. They are mainly external in origin. The main cloud on the horizon is China where growth dynamics are unclear. There are certainly mixed signals at the moment. What appears to be going on is that the investment-driven growth model is running out of steam with declining returns to investment and the transition from that sort of investment-driven growth model to a more sustainable growth model. There is a concern that it may not be an entirely smooth process. This is having a spill-over effect in terms of emerging market economies and we have seen capital outflows and pressure on currencies. Some currencies in emerging market economies are pegged and there have been devaluations, for others there have been depreciations. Advanced economies are potentially affected through several channels, the key ones being trade, exchange rate and, potentially, the financial market.
There is also the risk that the euro area could disappoint once again. Its performance in the past has to an extent flattered to deceive. There are risks in respect of financial markets. We are in a position of extraordinary monetary policies in advanced economies. The policy rate is at the lower bound and central banks in advanced economies have been adopting non-standard techniques, including quantitative easing, QE, and so forth and this has prompted a hunt for yield, capital inflows to emerging market economies and a compression of risk premia on the periphery of the euro area. Term and other risk premia are at historically low levels. There is a concern that, given the uncertainty in emerging market economies, the potential for monetary policy normalisation in the US, this could trigger capital flight and a decompression of risk premia with implications for the cost of capital. They are the main downside risks.
We acknowledge the uncertainty with regard to economic forecasts. Our forecasts, like all forecasts, are contingent. They are contingent on making various assumptions regarding world growth and so forth. What we try to do is to construct a fan chart around the central scenario and the probability distribution is based on previous forecast errors. The fan says that our baseline is that nominal gross domestic product, GDP, in 2016 will probably be of the order of €223 billion but there is a 90% probability that actual GDP will be within the range of €207 billion to €240 billion with a 50% probability of GDP being in the range €210 billion to €230 billion. We are trying to highlight the uncertainty of the forecasts and to model what that might mean in terms of where GDP could end up.
We provided another 20 slides to the council. They are econometric and technical in nature. We are quite happy to go through them but the main points of our narrative of the forecasts are contained in the 30 or so we have given the committee.
In the context of the framework for the forthcoming budget and changes to the new national fiscal framework, now that we have entered the preventative arm of the pact, one of the key rules is expenditure benchmark, which will allow expenditure to grow only with reference to potential GDP within the context of the medium-term economic strategy. That was based on a ten-year rolling figure up to now. The Minister for Public Expenditure and Reform, Deputy Howlin, confirmed that the Minister for Finance, Deputy Noonan, got that changed to three years. When, where and how did that change? On what date or at what meeting did that happen? What impact can this have on expenditure in the forthcoming budget and in the years ahead?
I refer to a statement that the revision of the expenditure benchmark means that the amount of fiscal space was estimated at €1.33 billion in April 2015. A subsequent announcement by the Minister for Finance at the national economic dialogue suggested that this may increase to €1.5 billion at budget time in October. Were that and the spring economic statement based on the ten-year or three-year expenditure period? Could the witnesses give us an indication in monetary terms rather than percentage terms of the additional financial space available as a result?
Mr. John McCarthy:
There is quite a lot in that. I will not stray into the policy space but I will do my best to answer the Deputy’s question.
The Deputy is correct that from next year onwards we will move into the preventive arm of the pact. We will move from assessing the headline deficit to progressing and improving the structural deficit. Under the reforms of the Stability and Growth Pact introduced in 2011 as part of the six pack rules, a complementary pillar was introduced. It is called the expenditure benchmark. What it is trying to do in terms of operation is to ensure that expenditure moves in line with growth in the tax base, the tax base being determined by the potential growth rate of the economy. It is designed to address situations like those which prevailed in Ireland and Spain where expenditure was increased permanently on the basis of cyclical revenue. That is the reason for looking at trend growth rate in the tax base over a ten year horizon. It is the rationale for introducing this expenditure benchmark.
Initially, in terms of the code of conduct - it is not a legal document but more of a gentleman’s agreement as to how this will be operational - it was agreed that in order to give more certainty, the ten year timeframe would be assessed every three years. The ten year timeframe has backward looking and forward looking elements. In Ireland we have a problem in that our potential growth rate is very pro-cyclical so when the economy went south so did potential.
Mr. John McCarthy:
-----so to be fair, that is where I was coming from. It was done on a three year basis. We felt that because there was a backward looking element that it took into account the very negative potential growth rates from too far back. As a result there was discussion between the Minister and his ECOFIN colleagues and the Department then produced a technical paper which we submitted to the directorate general of ECOFIN, which monitored us for compliance with the pact. It said we had a very strong economic case – this was back in April or May - and it agreed that it would be reassessed for all member states on an annual basis. This meant that our potential growth rate, on average, over the horizon was moved up by three or four percentage points. It went from 0.7% up to 1.9%. This resulted in us having additional fiscal space of 0.4% of GDP. I cannot do the arithmetic, but the GDP is approximately €200 billion. If the Deputy has a calculator, 0.4% of spending of €60 billion could be worked out from that. At the time of the stability programme this meant there was somewhere between €1.2 billion and €1.5 billion of fiscal space available for 2016. The stability programme was based on the assumption of €1.2 billion, as mentioned in my opening statement, but that is the amount of space available to ensure compliance with the preventive arm of the pact.
On page 27, okay. I direct the witness to his own chart No. 13 where it is stated that the SME credit growth is strengthening. That intrigued me. What does the witness mean by SME? Is that based on the number of employees in an organisation?
Excuse me Deputy Fleming. The figures presented by Mr. McCarthy are not quite in keeping with the belly-aching that one hears from the representatives of the SME sector.
That is a fair point from Deputy Rabbitte. From what Mr. McCarthy has said about the SME credit growth, it might indicate that there is other lending to the SME sector that is not captured in the Central Bank figures if it is only looking at regulated figures.
There is, however, no caveat to say that in the figures. The other point I wish to make is that the SMEs produce figures to show that the bulk of the increase in lending has been in the form of very large loans to the bigger SMEs rather than the smaller SMEs. Where is the Department of Finance on the demographic factors in respect of its forecasts for this year? Or is it able to give an estimate, in monetary terms, of the deficit for this year?
Would it be easier to achieve a deficit in 2016 if the deficit is higher this year, for example, if there was a splurge of money spent before the end of 2015? We would be making life more difficult for ourselves in 2016 if we had a small deficit this year, so there is a-----
Deputy Fleming has traced the area I am interested in but I have one question. If the witness was on RTE he would be asked, “What can go wrong?” That is usually their opening gambit. I understand that Mr. McCarthy has dealt with the down-side. He does not deal with the question of oil. Just as we had almost no notice of the fact that oil collapsed from €100 a barrel to €50, is there anything in the ether to suggest that this situation might change in the year ahead?
Mr. John McCarthy:
No, there is not. For our oil price assumptions we look at the futures markets and what is the market's best perception for buying oil now for delivery in six months. It shows that this will be unchanged relative to this year. I do think it is interesting to ask what is going on and what drove the oil price.
I think there are both supply and demand side factors at work. The growth dynamics movement in China is not as strong.
Mr. John McCarthy:
China is moving in the wrong direction. It is very oil intensive in terms of production, as are other emerging market economies. World growth is slowing, so there are demand side-effects. There are also supply side-effects, there has been a new supply from non-conventional sources and there is also an element of some of the oil cartels boosting supply in order to disincentivise investment in shale, to kill that sector off. They are playing the long game. I think supply is a factor as well.
I would not attach a very strong probability to an increase in oil prices. One could not rule it out. Some people have suggested that if China continues to move in the wrong direction, oil prices could fall a bit, which is the reason I put in an upside risk as a further decline in oil prices. Goldman Sachs had a report stating that oil prices could be $20 per barrel in the short term. It is not the baseline scenario but one could not rule it out at the same time.
I have a final question, Chairman. Would the officials in Merrion Street be sleeping easier if inflation was slightly more than Mr. McCarthy would project?
Mr. John McCarthy:
Yes. I can elaborate if the Deputy would like.
I think there is a problem on the inflation front, both in Ireland and in the rest of the euro area. As members know, we have the non-standard monetary policies from the beginning of the year, I think it was March when quantitative easing was introduced. That was because there had been a de-anchoring of inflation expectations. There were two or three years in which the rate of inflation was well below the ECB's target and it was beginning to feed into expectations. The euro system will buy €60 billion of both private and public sector bonds in order to try to re-anchor inflationary expectations. What has happened since then? Inflation remains very low. In September in the euro area, headline inflation was still in negative territory. Core inflation was running at 0.9 % to 1% but headline inflation was very low. If one looks at some measures there has not been any significant re-anchoring of inflationary expectations. That is a problem and it creates a problem for us and for others in the sense that falling or very low inflation increases the real interest rate, so it is a de factotightening of monetary policy. It makes the debt burden much more problematic. It places a premium on deleveraging and further balance sheet repair, like a Richard Koo's balance sheet recession, and it also makes the relative price adjustment more difficult. Countries on the periphery of the euro area need strong growing economies, such as Germany, to have high inflation so that they can improve competitiveness by running an inflation rate of 1%. If Germany and other economies are running 0.2% or 0.3% they have to be in negative territory to improve competitiveness, which is problematic from a debt perspective.
I have laboured the point a little but the answer to Deputy Rabbitte's question is that yes, I would sleep a little bit better if inflation was a little bit higher.
Go raibh maith agat. Mr. McCarthy mentioned the tailwinds that are adding to the increased growth, as well as many external factors. Is it possible to measure the proportionate effect of those external factors on the level of growth? If other external factors were passive in terms of not having a negative or positive effect, what type of growth rate would we have in the State?
Mr. John McCarthy:
I could not do that right now, but I could try to answer the Deputy's question by pointing to a number of things we do. If one looks at the stability programme, we carry out a sensitivity analysis and we give a baseline scenario for our macroeconomic outlook and then we say it is a conditional forecast based on growth of x% in the US and y% elsewhere. We then ask ourselves what would be the situation if world growth was 1% higher or 1% lower?
Mr. John McCarthy:
Let me give one example. If world growth was 1% higher over a period of two or three years, the level of GDP in Ireland would be 1% higher as well. The elasticity is almost one for one. That is a kind of roundabout way of answering the Deputy's question. As growth is now stronger in advanced economies that is one tailwind and it is boosting ours by x%. One can quantify it and some of the other factors as well, such as the exchange rate. We have not published model simulations here but one can certainly do it. I do not have the figures.
It would be very interesting for proper analysis of economic levers to understand exactly which are internal and which are external. In respect of credit to small businesses, Mr. McCarthy's graph starts in December 2010. I imagine if one goes back to 2007, it would dwarf our credit to small and medium sized enterprises at current rates. If we extended the chronology of the graph, we would be significantly lower than -----
With regard to the demographic changes, up until April of this year about 80,000 people had emigrated. Is there any information with regard to what is happening now and do these demographic changes indicate any level of net inward migration?
Mr. John McCarthy:
I think the Deputy is correct, there were about 80,000 gross outflows and something like 70,000 gross inflows, making for net outward migration of 11,000 allowing for rounding. That applied to April, which is the time the CSO compiles its annual population estimates. We are forecasting net inward migration, we are forecasting a very modest increase for next year. It come back to Deputy Rabbitte's question earlier as to why unemployment is not falling more rapidly. He mentioned July, August and September. The reason is that there is a labour supply increase. One of the reason for the labour supply increase is probably inward migration at this stage and the second is the participation rate , which tends to be cyclical for various reasons. Probably in the short term we will move into net inward migration.
With regard to aircraft transactions, which is a very big sector, these must create distortions and I think they are being included in GDP. What distortion effects are they having in the national accounts?
Mr. John McCarthy:
It is a very big sector. There are two elements, one of which is the actual purchases of aircraft by the Irish owned aircraft firms. It distorts the investment figure but it does not distort GDP because they are all imported. We do not produce aircraft here. I think the Deputy is probably referring to the aircraft leasing sector, as some of the largest aircraft leasing firms in the world are based in Ireland. There was a methodological change introduced to the current account over the summer, which moved from a cross-border to a change of economic ownership basis.
In the past, if a good or service did not cross the Irish Border, it was not an import or an export. Moving to a change of economic ownership means that if an Irish resident aircraft leasing firm purchases an aircraft from Seattle, for example, and then sends it directly to a large aircraft firm in France, it is not crossing the Irish Border but the leasing firm is based in Ireland so it is included in the Irish capital stock. There is an income stream that is generated from that so that it should be included in the Irish capital stock. That is the rationale for it. I will get the Deputy the absolute levels.
Purchases of aircraft this year will amount to about €4 billion compared to about €6 billion last year. However, I stress it is GDP-neutral in the sense that all of the aircraft are imported.
On European interest rates being low, the NTMA is holding cash in the region of €15 billion. Is there an opportunity cost in holding that amount of cash in the State when there could be a net gain if some of it was invested in infrastructural development?
Mr. John McCarthy:
The ISIF which used to be the NPRF is, obviously, undertaking investments of various amounts. As the Deputy rightly says, there is a cost in holding that cash, but there is also a balancing act in play. We want to have a certain amount of cash in order to have buffers, if one likes, in case the markets turn against us. There is that trade-off. It is probably a cost that is worth bearing.
There has also been a startling increase of 45% in corporation tax receipts in the first three quarters of the year. Why is that? Does it involve multinationals anticipating changes to the BEPS and so on?
Mr. John McCarthy:
The honest answer is we do not know. It is very difficult to get a handle on the reason for the very strong rates of increase. One theory is that corporations are becoming more conservative on foot of the BEPS and perhaps reputational damage to some firms internationally; perhaps, therefore, they are becoming a little more conservative in making payments and so forth. However, that is only one theory and we cannot really test it. I have to admit that it is somewhat of a puzzle.
Mr. John McCarthy:
Revenue has suggested it may be because of a more conservative approach by some firms or because international trading conditions have been good. The depreciation of the exchange rate may also be having an effect. I cannot provide an econometric answer that provides a strong evidence base for any of those suggestions. The answer to the Deputy's question is that we are not fully sure of the reason for it. There are many theories but I cannot say definitively what the reason for it is.
Mr. John McCarthy:
Figures in that regard are included in the Budget Statement to be delivered this day week. Figures around what the fiscal space will be in the medium term were published in the spring economic statement. I do not have the figures for the Deputy but they are available in the spring economic statement.
Would it be fair to say that most of things that are leading to an apparently positive picture on paper of the economy are external, be that the favourable exchanges rates, lower energy prices, lower interest rates, quantitative easing, or the US measures taken over recent years? Mr. McCarthy might when responding to that question also comment on the effects in this regard of the increase in property prices and the development of the property sector. Are we just bobbing around on a sea of external factors with little control or influence over them - and, equally, are we, for the same reasons, extremely vulnerable to all sorts of external factors over which we have absolutely no control?
Mr. John McCarthy:
Many of the tail winds are on the external side. There can be no getting away from that. The Deputy mentioned in this regard the strong trading partner growth, competitiveness gains on foot of the depreciation of the exchange rate, QE and so forth. Looking over the data over the past two years we have seen a very robust recovery in domestic demand - not exports, C plus I plus G in economic terminology. In particular, the figures over the past year show that personal consumer spending has risen very strongly and that confidence has improved.
On that point, are the good news stories we hear from Government and the Department of Finance about all how all is going well, which encourages confidence and spending, based precisely on what Mr. McCarthy just said, and nothing else?
Mr. John McCarthy:
My own view would be that the recovery in confidence is mainly due to what is going on in the labour market. We now have a level of employment that is 7% above its low point. As a result of the creation of approximately 130,000 additional jobs the unemployment rate has come down. Households are in general more confident about where things are going. I think they are aware that the deficit is coming down and that progress is being made. The Deputy will see from the figures when eventually published that there has been a decline in the savings rate. This is due in part to the need for less precautionary saving. Confidence is crucial. The growth in confidence is supporting strong consumer spending. We estimate that consumer spending will increase by approximately 3.5% this year. More than 100,000 cars have been sold this year and retail sales are running at 6% or 7%.
Mr. John McCarthy:
No, although the Deputy's question is very relevant. During the crisis period households were deleveraging such that there was a massive destruction in household net wealth, mainly on foot of a decline in house prices. I think there was an approximately 45% decline in household net wealth. Households responded to this by accumulating financial assets and reducing financial liabilities. In other words, they were deleveraging. However, household net wealth has been on a rising path over the past three to three and a half years such that it is now 35% above its low point. I think that is a positive. One could also look at this from the point of view of the leverage ratio.
Mr. John McCarthy:
House prices are now rising and households are also now accumulating financial assets such as stocks and shares and so forth and reducing their financial liabilities. One's assets minus one's liabilities is one's net wealth. The net wealth of the household sector is one third higher than its low point. Again, this inspires confidence. Balance sheet repair is progressing. There are pockets of very high leverage, and there are problems in that regard, but in aggregate terms household net wealth is improving. Another measure we would tend to look at is the leverage ratio - in other words, debt to disposable income. That has fallen for approximately 14 consecutive quarters. Households are making progress in repairing their balance sheets and with that, and the recovery in the labour market, they are now more confident and are consuming. There are tail winds on the domestic front as well.
Arguably, all of that is largely inspired by external factors. However, that is for another debate.
On capital expenditure and the recently announced capital plan, what is the percentage of capital spending pre-crash versus proposed capital spending, on an annual basis, under the current plan?
I completely disagree with Mr. McCarthy on that point. This is one of the questions I wanted to put to him. What does he have to say about the housing crisis at the moment, as a macroeconomic problem? It seems to me that we need major investment, and not only from the point of view of the people who are homeless on the streets. I imagine it will start to become a problem in terms of foreign direct investment as well if people cannot afford to live here. Average rents now in Dublin for two-bedroom accommodation are approximately €1,700, €1,800, €1,900 or more, perhaps €2,000. What proportion of an average income is that? To my mind, there is a major macroeconomic imbalance if the cost of accommodation is perhaps half or more than half of the average income. Does Mr. McCarthy not consider that this is something we should be concerned about?
Mr. John McCarthy:
From a forecasting perspective, which is why we attended the committee, we are projecting approximately 13,000 units for this year. In equilibrium, on the basis of demographics and changes in headship rates and so forth, it is estimated that we probably need somewhere in the region of 25,000 units per annum. Clearly, there is an imbalance in the sector and that is reflected in rising prices, although the macroprudential tools are certainly dampening developments in the more expensive areas. It is also manifesting itself in rents. From a competitiveness and foreign direct investment perspective, it is something I would be concerned about.
I have many questions, but I might come back in later.
We were doing some work today on the question and tonight in the Dáil we will be discussing corporate taxation. I noticed something last week when I was looking at the Department of Finance study of the effective rates of tax in this country. The deductions on total profits in 2006 came to €5 billion, off approximately €69 billion in gross profits. Has Mr. McCarthy noticed that too? By 2011 - the latest available figures - deductions amounted to €21 billion. I understand the Department of Finance paper indicates that much of the figure is made up of royalties. Does Mr. McCarthy find it alarming that, according to the paper, the royalty deductions which reduce taxable profits increase dramatically, from 10% of total profits to 33% of total profits between 2006 and 2011? Did he not consider that somewhat concerning?
Given that the Department of Finance is unable to tell us why there has been a 45% increase in corporation tax, does Mr. McCarthy believe that the Department's capacity to forecast accurately is still challenged?
Mr. John McCarthy:
The corporation tax numbers are very volatile. We work with the Revenue Commissioners to try to get a handle on it. However, when we have various company-specific issues, it is difficult to get into a granular level of detail. We have to remember that in Ireland, a small number of multinationals account for a large portion of gross value added and profitability. If one firm or a small group of firms are recording strong activity and increases in profitability for sector-specific reasons, we cannot model that from an econometric perspective.
I appreciate that. Is there a possibility that this small number of firms, which account for the majority of the corporation tax paid, could have achieved a 45% increase in profits in recent months, and this led, in turn, to a 45% increase in tax taken by the State?
Okay. We might come back to that in future to try to figure out what is going on.
We are dealing with the Department of Finance forecasting. We discussed the expenditure benchmark and the fiscal space. The figures published in April were between €1.2 billion and €1.5 billion. Which is it? Is the space for this year's budget €1.2 billion or €1.5 billion?
Who tells who? Mr. McCarthy is the chief economist in the Department. I presume Mr. McCarthy informs the politicians that the expenditure benchmark is either €1.2 billion or €1.5 billion. I presume the Irish Fiscal Advisory Council has already endorsed Mr. McCarthy's projections.
Mr. John McCarthy:
There is. We informed the Irish Fiscal Advisory Council that the forecasts were based on the €1.2 billion figure. We also informed the council what the relevant multiplier would be, in other words, if there was a different fiscal package, what the impact on the economy might be. Typically or on average we use a multiplier of 0.5, but that depends on various instruments used, whether on the tax or the expenditure side, since there may be a slightly different multiplier. The numbers that we will publish this day week will take into account the full budgetary package. We will have to change the economic forecasts should there be any deviation from the €1.2 billion figure. However, I am not in a position to say whether there will be a change. I will be informed in the coming days and we will adjust the macro forecasts accordingly.
That is fine. Since the Department is forecasting five years out and five years back, I imagine the officials have done the arithmetic in terms of the fiscal space for each of the subsequent years. What is the fiscal space for next year? What is the range?
Mr. John McCarthy:
There is not really because it is averaged over a ten-year horizon, it does not really change that much. The one caveat to that, to which I would point, is that because of the change in aircraft leasing, it affects the capital stock and hence the potential growth rate in the economy, so there can be some changes but we are not talking about dramatic changes.
The Irish Fiscal Advisory Council pointed out that the ratio of Government spending to GDP is projected to fall by five percentage points between 2015 and 2020. How will that be addressed given the demographic pressures the State faces?
The Minister and the programme update stated 2.3% so there is about €400 million which could be spent and still come in at the 2.3%. Is that correct? The Minister has indicated that there will be Estimate processes, particularly in health and other areas, to deal with overruns and that he still plans to come in on target at 2.3% but because of the tax profile and buoyancy, there should be enough to cover the overrun in health, which we understand is in the region of €600 million. From the figures presented to the committee by Mr. McCarthy, if we take the best case scenario of 2.1%, there does not seem to be more than €400 million available.
Mr. John McCarthy:
Honestly, the Exchequer is relatively easy to project. We have a good handle on where tax receipts might be for the year as a whole and ditto on the expenditure side. When one comes into general Government terms, one opens up a whole can of worms. There are literally hundreds of moving parts. We are trying to finalise what those moving parts might be at the moment but on the Exchequer side, we expect a tax overshoot as well as an overshoot on the spending side, mainly due to health.
I welcome our four visitors. There is the technical exercise which has been operating. There is room for some debates around the numbers but there is broad agreement on them. Looking into them, so much of the growth has happened due to something that is completely outside our control, namely, Mr. Draghi's policy of devaluing the currency. We have been a major beneficiary of that because so much of our trade is outside the eurozone. That is a hard one to predict and it might even reverse. Mr. McCarthy mentioned the accommodative monetary policy. It is just quantitative easing on steroids and that may not last either. In respect of the domestic signs, I hear from my colleagues, who come from the country and visitors, that we will not have tourism growth because hotel prices have doubled in Dublin. We are supposed to be very much into tourism but people tell me that what they got for €40 in the past is now €80.
We need to stop screw ups, a bucket load of which were referred to by the Comptroller and Auditor General. Turning public sector inputs into outputs remains a problem. Everybody on the Joint Committee on Communications, Energy and Natural Resources thought the Eircode system was nuts. People came in and said that they would not use it. I have not yet received a letter that used it but €38 million has been spent on it. The Comptroller and Auditor General is most caustic. The benefits were all over the place. The Revenue Commissioners opted out, as there were no benefits to it. An Post and the private sector opted out also. This is a project somebody within the permanent government just kept pursuing. We have gone ahead with it and it is as useless as people predicted it would be. We cannot keep doing that. The article by Colm McCarthy in The Sunday Independentabout the metro to the airport argued that it would be slower than the bus from Busáras, the bus from Lucan and the bus from Sandymount. Why is this the case? It is because we already have a tunnel to the airport. It does not conform to the Government's own guidelines. Maybe we can say that this was just something we throw out because there was an election coming up but having published it, we will put it through the mill. However, there was no evidence that the Irish Government's economic evaluation service had any input into what was announced.
The ESRI thinks that house prices are six times average incomes. They are still high by international standards. From watching the Irish economy, Mr. McCarthy knows that there are so many people who regard high house prices are economic growth. At six times average incomes, they are high by European standards. We tried it at 12 times average incomes and wrecked the place. I do not see that Irish banking has been reformed. The auditors will move to the Irish Auditing and Accounting Supervisory Authority in June 2016, about eight years after they produced audited reports on Irish banks that were completely useless and cost us €64 billion.
I see an awful lot of things that are wrong. That nice data is a good exercise in itself but perhaps economics should be more about resource allocation and less about doing twiddly little bits of forecasts and so on because that is the kernel of economics as far as I am concerned and that is where I saw Rip Van Winkle. There is a load of people in Ireland who would be quite happy to wake up and pretend it is 2007 again. They include builders with massively high costs, which is why we are unable to house people. The houses the Minister brought in for €65,000 seem to be okay but there is nothing less than €250,000 elsewhere. What does Deputy Boyd Barrett think of it? He would not go for it.
We have all these sheltered sector industries and policies. I would like the Irish Fiscal Advisory Council to inquire more into them because if we keep doing those, we could kill the golden goose again despite the favourable international things mentioned by Mr. McCarthy like the accommodative monetary policy and a very favourable exchange rate. This is why I want to see reform if I get back the next time. We have staunched the decline and that is a fantastic achievement. I do not underestimate it for a second but an awful lot of the underlying problems are still there, which makes me worried about the future. We might have a good year but in respect of 6.2% growth, what is the stimulus package doing? Is that a repeat of the magic money in the Celtic tiger era? Most people outside Ireland say 6.2% is pretty good. Those are my thoughts. I thank the witnesses for the exercise. I hope it provokes more debate but my key point that we should not do it all over again because it has been such a disaster.
In respect of the labour market, the OECD notes the decline in graduate starting pay by about €4,000 per year from €27,000 down to €23,000. The growth of the so-called precariat compared to what we traditionally regarded as jobs is a serious aspect of a labour market. There may be a lot of younger folk who have just entered the labour market wondering why people in secure jobs are saying that this is a wonderful labour market. It is not that wonderful if one is in the precariat. Our four visitors stimulated me a lot and I like that.
Mr. John McCarthy:
On the role of economics, I agree that we need more of an evidence base and more evaluation of the projects. That is the role of the Irish Government economic and evaluation service. Forecasting also has a role and is certainly one of the key inputs in terms of trying to set fiscal policy.
The Deputy mentioned the sheltered sectors. It is purely a personal view, but I tend to agree; it imposes costs on the economy. As it is detrimental to our competitiveness, I personally would welcome an opening up of some of the sheltered sectors of the economy.
To summarise the position - this follows on from some of what Mr. McCarthy and Senator Sean D. Barrett said - we have seen a big jump in corporate profits. We have some of the highest growth levels anywhere in Europe, but because of fiscal treaty requirements, particularly as they relate to the debt burden, there is very little latitude to do anything. In fact, we are, effectively, debarred from translating buoyant economic growth into investment in the economy or redistributing the dramatically increasing profits through various means. Is that, more or less, the picture? We are not allowed to do this and will not be allowed to do so for whatever number of years because of the fiscal rules. We are, therefore, in a straitjacket. We see massive profits and economic growth, inflating wealth which is probably concentrated in a few hands and which we are not allowed to put back into the economy through public spending, capital investment or anything that might benefit the people who have been hit the hardest.
Mr. John McCarthy:
No, I disagree with the Deputy. The rationale behind the fiscal rules is that cyclical revenues cannot be used to finance permanent increases in expenditure. That is what was done in Ireland until 2007. It is also what was done in Spain and some other countries and it meant that once the crisis hit, cyclical revenues collapsed overnight and we were left with a massive structural deficit. The fiscal rules are aimed at preventing this from happening again. What they do not do is state we cannot invest, redistribute or spend here, there or wherever the Parliament chooses. That is a matter for the member states involved to decide. What the fiscal rules do state is that if we want to do this, we must be able to finance it. In other words, if a country wants to invest more, it has to be able to finance the investment or take it from somewhere else. It is about redistributing towards priority areas. The fiscal rules leave plenty of scope for member states which are not in a straitjacket. They are about ensuring fiscal sustainability and that we do not repeat the mistakes of the past. There are flaws in the rules, but, by and large, they are good.