Wrong Direction

The Malta Independent
23rd July 2004
 
It does not take much depth of economic knowledge to realise that government’s strategy to get the public deficit under control by 2007 is pointing in the wrong direction.

There are three methods how the deficit could be addressed: raising revenue, cutting expenditure and growing the economy. In reality it has to be a mixture of all three measures, a tri-pod of solutions.

Raising revenue basically means more tax revenue flows either through new measures or better enforcement of existing ones. This has been pushed hard these last 9 years since the introduction of VAT but on its own could not deliver the bacon. Expenditure growth more than neutralised the increased revenue flows and economic growth was nothing spectacular.

Expenditure controls need to be enforced but this takes time, it is often painful and scares politicians to death. Expenditure controls are unavoidably inversely proportional to electoral popularity.

Consequently any plan to bring public deficit under control has to rely mostly on economic growth so that the deficit gets addressed more in relative terms rather than in absolute terms, meaning that the growth of the economy is faster than the growth of government expenditure.

Government seems to have given up on economic growth for the Convergence Programme period till 2007 and is planning real growth below the EU –15 average. This contrasts with the plans of other new EU members that are planning much more aggressive growth paths to speed up their catching up exercise to EU average GDP. It looks as if government itself is not convinced that it can succeed to stimulate new private investment, both foreign and domestic, and given its own inability to continue pump-priming the economy through capital spending, has accepted anaemic growth as an unavoidable reality.

This need not, should not, indeed, must not be the case. Addressing the deficit without substantial economic growth will be just too painful. Government will unavoidably lose the power to stay on course as the electoral challenge approaches. Whilst we know where we have to go we seem to have no idea how to get there and are consequently setting out in the wrong direction.

Economic growth can be stimulated provided we make our economy globally competitive. We are not doing so because our rate of exchange has been allowed to overvalue itself in real terms whilst running rates of inflation higher than our trading partners. The Conversion Programme submitted to the EU admits “during 2003, the real effective rate index gained 1.1percent…. as year on year inflation in Malta picked up and exceeded inflation abroad”.

It fails to state however that this has been going on quite consistently since 1995 and according to Central Bank’s own estimate our real rate of exchange is more than 10% less competitive than it was in 1995 – the last year when we were not suffering structural disequilibria in government finances.

How is it being proposed to address this inflation differential? Don’t laugh, but what is being proposed is actually meant to increase the inflation differential to the further detriment of our international competitiveness. It is as if a doctor diagnosed smoking induced lung problems and instead of counselling the patient to quit smoking, actually exhorts him to smoke more!

If as the report admits we lost real rate of exchange competitiveness in 2003 even though “the inflation rate for December 2003, based on a twelve month moving average stood at relatively low 1.3%” how is it prescribed as a cure that “during 2004, a one-off increase in Retail Price Index is expected, with annual inflation rising to 3.4%….mainly the result of increase in the VAT rate… and introduction of reduced Vat rate at 5% on printed matter and medical equipment”.

The supposed one-off VAT measure is now being loaded with further one-off eco-tax measures which will further raise the inflation differential between us and our trading partners to the further detriment of our international competitiveness if we continue to operate the current rate of exchange regime. Rising inflation in the context of economic stagnation delivers the worst of both worlds. While other competitors and trading partners enjoy strong growth and low inflation we are setting out on exactly the opposite route.

Unless we come to our senses before it is too late we are set to compromise our international competitiveness in a way that will scare rather than attract investment, with the consequence of little or no real growth, making the addressing of the public finance deficit unbearably painful and politically unfeasible.