Finance minister Brian Lenihan: showing a common-sense approach to balancing the public finances

Department of Finance mandarins found themselves in a surprising position last week, being accused by some economic watchers of suffering from an over abundance of caution and pessism about the economy.

While the EU Commission believes the Irish economy next year will shrink by 1.4% in GDP terms, the Irish government says it will be worse than that, with at least 1.5% coming off GDP. The IMF, the world's financial supervisory body, is pencilling in a 3% contraction, but this is expected to be hugely revised downward.

Nevertheless the government must have been surprised to hear Alan McQuaid of Bloxham Stocbrokers say in a radio interview that its forecasts were too pessimistic, both in terms of unemployment and GDP decline.

For the last year and half the Department of Finance has been under a hail of economic fire, accused of not having enough economists, of presenting massively optimistic tax receipt projections and being evasive and disengenous when talking about the potential cost of bank rescues.

Now the charge sheet has expanded to include over-pessism. This may seem strange to many when one considers that the government sees positive GDP growth starting in the second half of 2010. While this will take some time to be picked up in the usual quarterly figures, the government still sees a key tipping point arriving some time after July of next year.

The simple truth is the government needs to see sustainable economic growth as soon as possible, because off in the background is an unpleasant brew of high oil prices, rising interest rates, unfavourable currency movements and bank capital calls is hovering, threatening to choke off any nascent recovery.

Last week the government released its pre-budget outlook and while there was plenty of talk about the economic picture not being as dark as originally feared, the presentation released by the Department rather skated over the considerable risk factors to the government's projections.

For example, the following sentence was all the Department would say on the threat posed by interest rate rises: "At some stage over the medium term interest rates will inevitably return to more 'normal' levels, raising the cost of borrowing for all."

The threat from higher interest rates, particularly for a country with the levels of personal debt Ireland has, has to fall into the category marked systemic. Just take one alarming statistic - aproximately 80% of all mortgage debt is standard variable or tracker. In other words 80% of borrowers, by value of mortgage, would be facing a rise in their borrowing costs if the ECB embarked on an aggressive rate hiking cycle.

While some of the predictions for interest rates rises mentioned in Ireland have been a little excitable, there is no doubt money is going to become more expensive and, with €148bn of mortgages in circulation, this represents a considerable threat to hopes of sparking a national economic recovery.

It is a threat for two reasons - one because rising debt costs could cause mortgage defaults and dent bank balance sheets, but also because at a more elementary level rising interest rates are going to result in a major drag on consumer spending which traditionally powers about 58% of the Irish economy.

If the government skated over the implications of this problem last week, it entirely omitted to mention in its pre-budget outlook what the exchequer may need to pump into the Irish banks, post-Nama.

JP Morgan, which has a much larger team of bank analysts than the Department of Finance, estimates that €11.5bn may yet be needed to fund the banks and bring their capital ratios into line with international norms. This is an estimate the Department of Finance refuses to discuss and the pre-budget outlook contains no reference to the potential capital calls likely to come from the Irish banks within months.

The government will have to borrow this money (or some portion of it), but so far it has got away without having to explain to the bond market what the potential exposure of the Irish banks is over the next few years. The Department of Finance should have some idea, as its officials and other outside advisors have stressed tested the loan books of the main banks to see what fragilities are present, even though its shied away from sharing this information with those who will provide the capital - the taxpayer.

The failure to account for what the banks may yet need and the failure to devote more space to what higher interest rates might mean for Irish consumer spending were the two big gaps in the pre-budget outlook, even if the publication was written with a jauntier tone than usual.

While uncertainties abound, the government will probably get an extra year to get its fiscal house in order, although it has commited to finding €4bn in savings and tax increases for 2010, regardless of whether the EU cuts the State some budgetary slack or not.

This is sensible by minister Brian Lenihan. Confidence is a precious commodity for deficit countries. International investors will feed off deficit reduction confidence, thereby lowering interest charges and getting Ireland mercifully out of the international headlines.

The consumer will also do the same, at least according to most economic theory. A swift and credible move to lower the deficit should help savings ratios to lower as taxpayers will stop fearing future tax increases and loosen their purse strings. While plenty of economists refuse to accept that deficit reductions can be expansionary, it is generally accepted that consumer confidence can be stoked by credible signs that the government is getting the deficit down.

Last week's publication - with all its gaps, evasions and optimism/pessimism- should help to start that process.