The Irish Economy – Out of one wood, into another?

This is a version of my column published in the Irish Examiner 8 Feb 2014. It takes a long time to recover from a banking crisis. If we were unsure of that we need but look around and notice that we still are talking and fretting about ours.

Seven years ago Irish bank shares share prices were at or near all time highs. Lending for house purchases and deposits inflows to Irish banks were also at all time highs. So also were house prices. And then it all began to unravel.  The children born at the bursting of the bubble, who will carry the cost most of their working life, are now in senior infants or first class in school. And still it isn’t fixed. Only this week do we see the first criminal trial arising from the banking shenanigans. This week also we saw a report by the EU which sharply criticized our lethargy in dealing with bringing criminal, especially white collar, trials to justice.  The Cowen government moved neither swiftly nor decisively when the storm hit.

But things may be changing.  At the annual meeting of the Allied Social Sciences, a sort of Woodstock for economists and likeminded folks, a paper was presented on banking crises. The link above is to the paper – there is a longer version but it is firewalled. Reinhart and Rogoff have previously come in for some (more or less justified) stick on account of a missed spreadsheet error in one of their papers. The paper in question was at the heart of the meme propagated that after 90% debt/GDP countries enter a death zone. However, to my mind their more important work by far is in economic history, where in a series of books and papers they have provided comparative data on banking crises and bubbles. Much of the problem with modern macroeconomics is a twin crisis of insufficient data and a lack of a historical perspective. There is no excuse for this in the area of banking crises as we have not only the work of RR but also a comprehensive database from the World Bank.

The RR work provides details of 100 banking crises. Its well worth reading. The main finding is that the effects of the crisis take a long time to peter out. In 50% of the cases real GDP per capita has not recovered to pre crisis levels even after 6 ½ years. On average it takes 7 years.  Ireland has had a really severe banking crisis. RR create a measure of the crisis severity – the data are shown below. In terms of the post WW2 period it ranks in the top ten most severe crises as measured by declines in per capital GDP.  What is however apparent is that we may, based on the real GDP per capita data available, be right on target to be an average recovery. Our GDP figures of course are somewhat distant from the reality of people on the ground, but the fact remains that GDP is what the rest of the world measures as being available for the state to distribute. That we have chosen to in effect shelter a large chunk (the fdi sector) is our own decision. Mind you, with the international moves to make tax arbitrage by MNCs less attractive, how long the GNP/GDP wedge will persist is debatable.

This does not mean we are out of the woods by any means. Entering the crisis with a healthy debt to GDP ratio of 25% in 2007 we are exiting it with one closer to 125%.  Whether high debt causes slow growth, slow growth high debt or more likely both working together, this ratio needs to come down. And herein lies a problem. Europe, and Ireland, are teetering on the brink of deflation. We are used to inflation – rising prices. Deflation however is where prices fall. And while inflation can be bad at high levels deflation at even moderate levels is disastrous. With deflation there is little incentive to spend – prices will fall so why spend now. There is little incentive for firms to invest in new products –demand will be depressed until people consider that prices are likely to stabilize or rise. And for those with debts, that including states with high debt/gdp ratios and households with mortgages and personal debt, it is ruinous as the real level of debt increases over time.

At a wholesale level, the price that companies get, deflation is already a reality. Across a wide swathe of the Irish economy prices have been falling for 6 months or more. This is particularly evident in manufacturing and related areas. Indeed, surprising as it may seem to the consumer, it is also the case in most food areas, save dairy. At the consumer price level of the 12 main categories of goods and services 6 have shown deflation in the last two months. Indeed since 2010 deflation has been the norm in clothing, furniture, communication and recreation.  At a European level overall inflation is now close to zero. What is needed is moderate, 3-6% inflation.

The ECB, again, is in the firing line, as it controls the money supply. However facing  broken banks and close to the zero interest rate bound there is a limit to what monetary policy can do. Eurozone governments cannot pump inflation by fiscal means as they are constrained by the various macroeconomic treaties. We are heading for a decade or more of stagnation unless the ECB can both clean the banks and prime the pumps. What chance that ? Draghi has dismissed deflation as a risk – in his press conference he noted that while there was some deflation (but he didn’t call it that) in the program countries (Ireland, Greece, Spain and Portugal) this simply didn’t matter for the core. We have left the woods of austerity for the darker woods of deflation. And nobody who matters cares.

deflation ireland


Year Country Severity
1857 France 10.9
1857 Germany 4.8
1864 Germany 13.8
1866 Italy 22.8
1866 UK 3.8
1873 Canada 18.7
1873 Germany 15.2
1873 US 7.4
1873 Austria 6.3
1890 Brazil 42.7
1890 Uruguay 40
1890 Argentina 23.3
1890 USA 20.2
1890 Portugal 11.3
1890 UK 10.3
1891 ITALY 15.4
1893 Australia 48
1894 NewZealand 9.8
1907 US 21.5
1907 Italy 6.6
1907 Japan 5.9
1907 Sweden 5.7
1907 France 2.8
1908 India 13
1908 Canada 10.8
1908 Mexico 3.2
1920 UK 29.7
1920 US 10.3
1921 Italy 46.5
1921 Norway 15.8
1921 Denmark 6.2
1922 Sweden 12.4
1923 Canada 40.1
1923 Portugal 8.9
1923 Brazil 7.7
1923 Japan 6.7
1926 Chile 62.6
1927 Japan 13.3
1929 Mexico 47.1
1929 India 39.2
1929 USA 38.6
1929 Austria 33.4
1929 Brazil 21.3
1930 France 25.9
1930 Italy 13
1930 Norway 12.4
1931 Spain 60.6
1931 Uruguay 53.1
1931 Argentina 34.4
1931 Poland 33.9
1931 Germany 24.8
1931 Romania 22.1
1931 Belgium 21.4
1931 Switzerland 18.8
1931 Hungary 18.4
1931 China 13.9
1931 Greece 12.9
1931 UK 11.6
1931 Finland 11.1
1931 Sweden 8.8
1931 Denmark 6.5
1939 Netherlands 37
1980 Argentina 39.8
1980 Chile 26.9
1981 Philippines 39.8
1981 Mexico 31.1
1982 Turkey 0
1983 Peru 57
1983 Thailand 0
1985 Malaysia 8.7
1987 Norway 3.6
1990 Brazil 17.2
1991 Finland 19.8
1991 Sweden 11.2
1992 Japan 8.7
1992 Japan 2.1
1994 Venezuela 38.2
1994 Mexico 10.7
1996 Thailand 19.6
1997 Indonesia 23.1
1997 Malaysia 15.8
1997 Korea 8.4
1997 Philippines 5.7
1998 Colombia 12
1998 Russia 7.2
2001 Argentina 28.9
2001 Turkey 12.3
2002 Uruguay 26.9
2007 Ireland 24.9
2007 Iceland 23.2
2007 UK 18.1
2007 USA 10.8
2008 Greece 36
2008 Italy 23.3
2008 Ukraine 22.4
2008 Spain 20.4
2008 Portugal 19.2
2008 Netherlands 15.8
2008 France 9
2008 Germany 3

Ollie and the Rehnation of the EU….

img_pod_2402-olli-rehn-news-conf-RTR2YAW5This morning on Morning Ireland there was an interesting interview with Ollie Rehn, the EU commissioner for economic affairs. He dismissed the notion of coordinated austerity as being a problem, dismissed the ruination of the social compact, and generally displayed a chilly technocratic aloofness that shows the paucity of leadership we have now. He even invoked confidence fairies in regard to Italy…. He was asked repeatedly what was the aim of the continued austerity programme, now that we had some headroom from the “resolution” of the anglo promissory notes. He, not surprisingly, rejected the calls for slowing down of the process. He repeatedly stressed that the aim here was to enable Ireland to “return to the markets”, in other words to exit the troika programme and to borrow on our own account.

On his webpage he states his aim as “The first and foremost priority for me as Commissioner for Economic and Monetary Affairs is growth and jobs, in the context of macroeconomic stability. He is head of the economic and monetary affairs in the Commission, who state   “DG ECFIN reports to the Commissioner for Economic and Monetary Affairs, Olli Rehn. It strives to improve the economic wellbeing of the citizens of the European Union”

In his interview Ollie shows he simply doesn’t understand his brief. It is NOT an aim to get back to borrowing. That is a tool to enable a state to fund itself. Other tools include tax, transfers, the sale of natural and other resources, pillage and foreign aid. In elevating a tool to the status of aim Ollie shows the final capitulation of the EU under its FANGS hegemony to being simply a tool for the financial system. Perhaps he should read the preamble to the Treat of Rome which states

AFFIRMING as the essential objective of their efforts the constant improvement of the living and working conditions of their peoples

Right now its hard to see how this is being achieved.

Holding my Nose and voting Yes

This is an expanded and linked verison of a column published in the Irish Examiner Saturday 12 may 2012. http://www.irishexaminer.com/business/a-reluctant-yes-voter-for-vital-access-to-funds-193627.html

I have decided, very reluctantly, to vote yes in the upcoming referendum on the fiscal compact. I have previous expressed many many doubts, most of which have remained unanswered. The compact is bad economics, it is inserting an ill-defined and inestimable concept in the constitution, it is highly likely to be a moot compact as soon as a large country deems it domestically expedient to be dropped, and it will result in us having to radically change our way of doing things. The latter may not be a bad thing given how poor at governance we have shown ourselves to be.

The debate has rapidly, and predictably, gone off the rails of the actual debate onto tracks that are only vaguely parallel. It has morphed into a debate on austerity, driven for the most part by the ideologues of the left tapping into an inchoate if understandable desire on all our parts to see an end to austerity. At some levels the debate has been farcical, with Richard Boyd-Barrett claiming that an unspecified 10b (presumably per annum) can be found from “wealth” while at the same time arguing against taxing housing….wealth. The 10b wealth tax meme has been roundly exploded by Seamus Coffey, but as is all too common in Ireland RBB has decided to engage in policy based evidence rather than evidence based policy. At least we are spared so far the more extravagant claims (YES For JOBS) on the yes side but expect the ludicrous level to rise there as the debate intensifies. Another feature of the no side is that it features the same old same old – SF have opposed every single EU referendum since our entry into the EU and one can assemble a DIY ULA Speech from a box of 1982 Socialist Workers Party posters.

The most often repeated argument is that signing to the treaty will institutionalize austerity as we drive towards a 60% debt gdp ratio. This is possible but not necessary. It all comes down to growth . Adopting the fiscal compact will require that in the end the debt to gdp ratio head to 60%. That is a massive fall from where we are now, and many of the commentators, including to some extent myself, see that trajectory as most probably involving a requirement to not simply run small or zero deficits but to actually have surpluses. Underlying the concern that this will institutionalize austerity is is pessimism about growth. The reality is that debt at the national level is rarely paid down. The debt/gdp ratio, the metric that will be used in the fiscal compact era, can fall as a result of debt being paid down (which doesn’t happen), gdp rising, or both. These figures are measured in nominal terms also, so the ratio can be eroded by inflation. An examination of the 1990s onward shows that debt/gdp ratios can fall very quickly.

From 95% in 1992 the ratio had fallen to 53% in 1998. Admittedly the 1990s was an era that in many ways was more benign in terms of the external environment and in terms of the degree of policy maneuver available to government, but the lesson stands: so long as debt does not grow the ratio should fall. It is abundantly clear from the debt-GDP analysis that first, this can can change for good or ill rapidly and second the deterioration since 2007 is appalling, driven by the collapse of the tax base (hence the need to rebalance and re broaden), the collapse of the economy (driven as it was in large part by a credit boom) and by the bales of wet straw that were placed on it by the gargantuan folly that was and is the bailing out of Anglo. The latter is important but it is not by any means the font et origo of our problems. While it may be tempting to call it bank debt treaty (as the superlative Namawinelake has when explaining that that is why he/she/they are agin it) the reality is that 2/3 of the increase in debt since bout 2007 to 2015 in down to our own deficit. It is without a shadow of a doubt true that the bank debt is usurious, that it should never have been loaded on the state, that we have shown ourselves to be singularly unable to gain meaningful change in its repayment and that it is an albatross around our necks. The issue is not that – it is whether or not voting yes or no is more likely to allow us a better negotiation position. As to whether we can effectively use that position is quite another thing.

So we are fine if we get growth but where will that come from? This is the key dilemma for Ireland and for the world. The latest IMF World Economic Outlook is at best cautious on prospects for growth. . We face a period of significant fiscal consolidation through 2015 to simply move to a state where the level of debt stands still. Indeed, at present the plans are still to run a deficit. Structural or otherwise a deficit where debt continues to grow is not conducive to reducing the debt/gdp ratio. The Fiscal council has suggested that additional to the government plans to have fiscal consolidation of 12.4b through 2015 an additional 2.8b might be required to achieve balance. This will weigh on any recovery and regardless of any fiscal corset or compact getting to a broadly balanced budget when the debt-gdp ratios are as high as they are is a good macroeconomic aim.

Nonetheless, as the fiscal compact is specified on nominal levels, so long as we keep debt rising by less than the nominal growth rate we will be reducing the ratio. Given that our average annual nominal growth rates over the longterm have been in and around 10%, achieving even modest nominal GDP growth should be feasible. So long as we do that we will, almost automatically, comply with the headline adjustment figures (see Seamus Coffey again and Karl Whelan on that issue)

A major problem with the plan “going forward” by the government is that it relies in essence on an export led recovery. The entire world seems to now be betting on export led recoveries, which makes sense only if we have found a Martian civilization willing and able to pay for our goods and services. Successive government projections for growth have been shown to be on the optimistic side, and it is clear as a bell that coordinated and prolonged austerity, lite or heavy, in the Eurozone is not going to lead to a recovery and all the evidence is that this is beginning to sink into the political consciousness. Thus at some stage we can reasonably expect some pro growth measures at a European level, whether written into a revised compact or as an addendum. The French and Greek election results guarantee that.

The main reason why I see myself, reluctantly, voting yes is to secure access to funding as and when we need it. The reality is that even if we were not to require a single additional euro of debt, by running a balanced budget, we face a massive refunding requirement. To reiterate, national debt doesn’t get paid off – it gets rolled over and over. Paying off the maturing debt with new debt does this. The trick, as we have noted above, is that with a modest amount of growth the burden on the state falls as a proportion, and with a modest amount of inflation the burden in present day funding terms falls further. The challenge then for Ireland is to achieve this. But we will still have to pay off the debt. We need to repay, to refinance, over €30b between 2014-2018 in national debt, and some 23b in funds issued under the bailout. There is guaranteed funding from the ESM for this. There is the argument that we can apply to the IMF which is true but application is by no means the same as acceptance. The IMF have previously expressed doubts (P 12 here) as to the appropriateness of them sharing the burden alone. The EFSF continuation would also seem to me to provide some cover only for the existing bailout, leaving the remainder of the rollover of national debt and any additional funding to be sought from the markets.

Voting no would thus expose the state to having to fund at least a part of its total requirement from the markets or from internal resources or from the markets at a still usurious price. As States can always fund themselves from internal sources, as a consequence the argument that “they will not let us collapse” do not hold as strongly as did the same argument for restructuring the banking debt. Ireland no longer holds the cards that it did when our banking system was a source of major potential contagion.

Banks reliance on the ECB has fallen and continues to fall, and we now are approaching a percentage of borrowing from the ECB more in line with our economic size. The ECB will support banks (although that support has to be coming to its limits) but they will not and cannot support states. Thus we face a “lesser of two evils” argument : this is pragmatic and economic reality no matter how much it may stick in the craw. Voting No would be the eviler of two lessers, and would rapdly expose how unimportant we now are.

The Fiscal Compact and Ireland

I was asked to address the Oireachtas Subcommittee on European Affairs on the issue of the Fiscal Compact, and did so this morning (18 May 2012). Below is the briefing note which I forwarded to the members. We were asked to be succinct and to talk for 5 minutes prior to questioning, hence the rather stripped down nature of the material.

I have previously expressed my concerns on the fiscal compact in a number of fora, including my blog and my fortnightly column in the Irish Examiner. We are in effect being asked to incorporate into our constitution an econometric concept in order to become more Germanic. It is as Davy Stockbrokers put it in February “an abstract theoretical economic concept that cannot be observed with certainty.” We are therefore asked to support the immeasurable in pursuit of the unattainable. The only rational argument to support the compact is one of utter expediency : as we will require access to ESM funds from 2013 onward, whether we call it a ludicrous word such as “bailout” or a mere technical extension of the present “bailout”, and as such funds are as of now contingent on the fiscal compact, we need to think long and hard before rejecting it.In the context of the committee today, I have a number of points.

  1. Ireland as a state is broke. This is not an ideological but an arithmetic matter. We are forecast to have a net exchequer balance of -€21b in 2012, which is in the largest part made up of current expenditure running at €51b while current revenue reaches only €38b. Thus any proposal that can hold out a prospect of reducing this towards zero, especially on the current side, is to be carefully examined. That is not to say that I welcome the Fiscal Compact unreservedly- I do not. It has many issues which I would like to see modified, changed, dropped or better phrased. As the focus here is on the effect of the treaty were it to be adopted let me concentrate on that.
  2. Trajectory of debt. The fiscal compact states a maximum permissible deficit of 0.5% of GDP. It is easy to work out that with modest growth of nominal GDP the deficit rule will result in a long-term debt to GDP ratio of extremely low levels. The stable steady state debt/gdp ratio converges to d/g, where d is the average nominal deficit as a % GDP and g is the average nominal GDP growth. Since 1980 the average deficit has been 4.1% with average GDP growth at 8.2%. The figures since 2000 are 2.8% and 4.8%. We will if we wish to achieve the 60% debt to GDP figures have to achieve a nominal growth rate of at least 2% while keeping deficits at 1% or less. We are forecast to have a structural deficit of 5.5% in 2012. To move to a 0.5% deficit therefore is a massive multibillion-euro demand shock. To move from the forecast 2015 115% debt/GDP ratio to the 60% permissible is to remove some 90b in debt from the stock of Irish government debt, or the equivalent of the entire national debt as of 2010. To do this will require that we run structural surpluses (or find somehow that austerity does in fact lead to growth in nominal GDP). Demand effects aside, one has to wonder if this is within the capacity of the state to achieve such a massive transformation?
  3. An area of the treaty that has received scant analysis, surprisingly so, is the effect which it will have on bond markets and Europe.As noted we can amend the ratio of government debt to national income by decreasing debt and/or by increasing wealth. The focus of the compact is on the former. Europe as a whole is significantly over the 60% limit. As of 2011 eurostat figures the majority of individual countries are also over. Thus the adoption of the compact suggests a prolonged massive de leveraging of the European sovereign bond market. The euro 17 countries as a whole need to reduce debt/GDP ratios from 85% to 60%. At present terms that is a reduction of some 2.3 trillion euro. That is a massive fiscal drag to pose on Europe and compact is that if it succeeds it will gravely damage the sovereign bond market. Even well run countries such as Netherlands ( 2012 debt/GDP forecast 65%, 2012 GDP growth 1%, Unemployment 4.5%) and Austria ( 2012 forecasts Debt/GDP 73%, , Unemployment 4%, GDP growth 1%) will be required to retrench. This is not a recipe for growth in Europe, and given that exports are forecast to be the entire contribution to any GDP growth we may see will see the stifling of demand in one of our major markets. This point has been reiterated in the Financial Times which stated on Tuesday 17th in its editorial “A fiscal compact worth its name would have matched belt-tightening in deficit countries with expansion in surplus countries. Universal austerity will instead erode the gains from fiscal discipline by stunting the economic output from which public and private debt can be serviced” It has also been critiqued by a wide variety of other market and academic economists (see this Reuters article for a synopsis of the argument) . Swabia housewives alone cannot reinvigorate Europe. Nouriel Roubin has statedWithout a much easier monetary policy and a less front-loaded mode of fiscal austerity, the euro will not weaken, external competitiveness will not be restored, and the recession will deepen. And, without resumption of growth – not years down the line, but in 2012 – the stock and flow imbalances will become even more unsustainable. More Eurozone countries will be forced to restructure their debts, and eventually some will decide to exit the monetary union.” Such policies are the direct opposite of what we now see, with strict money and frontloading of austerity. He further stated The trouble is that the Eurozone has an austerity strategy but no growth strategy. And, without that, all it has is a recession strategy that makes austerity and reform self-defeating, because, if output continues to contract, deficit and debt ratios will continue to rise to unsustainable levels. Moreover, the social and political backlash eventually will become overwhelming. A large (but not overwhelming) stock and flow of relatively low risk assets are required to support pension and investment funds. A shrunken market will be less able to fulfill that role. The fiscal compact therefore requires that over time trillions of euro of assets are removed from consideration of investors. The consequence of this will be an intensified move to safe haven assets such as the (to be radically shrunken) German bund market, driving down further German interest rates. Investors will have to accept radically lower long-term returns. Alternative investment classes seen as safe havens such as gold, or denominated in currencies such as the Norwegian kroner or Swiss franc will also attract investors, with knock-on consequences. The effect on Europe of a perpetual low cost of capital in the core and higher costs in the periphery cannot but exacerbate the existing core-periphery problems. In addition, low nominal rates lead ro negative real rates, a form of “financial repression” . Faced with a growing pension timebomb the shrinking of the pool of safe assets seems not sensible. Mercers 2011 Asset allocation survey indicates that most pension funds including Irish desired to increase not decrease their absolute and relative investment in domestic government bonds. There are plans to market up to 2b in domestic bonds to pension funds for annuity purposes. How these will be squared with decreases in the asset pool is unclear
  4. The fiscal treaty contains not just a set of macroeconomic thresholds but also under the Alert Mechanism Report looks at a series of more detailed ‘warning signs’. (See below). The first of these came out in mid February and as one might expect these show Ireland (as well as Greece and Spain) as being problematic. The warning indicators are shown below (courtesy of a CitiBank report). In the February report Ireland was shown to be in breach of 6 of these ( also shown below). What is interesting in the recent Citibank report (see http://ftalphaville.ft.com/blog/2012/04/16/962221/return-of-the-stability-and-growth-pact/ ) is that while the Irish economy in the boom years would have shown relatively good adherence to the headline fiscal treaty requirements, there is some evidence that the indicators below would have triggered concern. Ireland began to exhibit significant numbers of breaches in 2004 onwards, mainly due to house prices, private sector debt, labor costs and real effective exchange rates. However, these were all a consequence of the credit boom. While a procedure now is available to fine countries that, having been found to be severely imbalance do not take steps to adjust towards balance, this fine is only up to 0.1% GDP . We are all now painfully aware of the political reaction that was evident (and voted for enthusiastically) when people were ‘cribbing and moaning’ as one Taoiseach so memorably put it. One can easily imagine the same Taoiseach cheerfully explaining how a fine of ‘eh, a few hunnered million’ was a small price to pay for the continuation of our unique way of achieving economic success. In other words, the flaw in the fiscal treaty is that it concentrates on trying to achieve political economy aims by exclusively economic means. Is there now and will there be in future the political will in Ireland to face down domestic calls for the ignoring of warnings?
  5. There are a host of other issues with the compact that bear on domestic competency. First, we will need to ensure that we have domestic capacity to estimate independent credible (from a technical sense) structural budget estimates, in an economic environment where there are no set rules on how this is to be done. To do otherwise will be to force us to rely entirely on the commission. This will be a net additional resource requirement for universities, the fiscal council, ESRI or a new body. Below we see (courtesy of Davys http://www.davy.ie/content/pubarticles/fiscalcompact20120227.pdf and Dr Constantin Gurdgiv http://trueeconomics.blogspot.com/2012/03/2532012-irish-gdp-and-structural.html) how IMF and EU commission estimates of the structural deficit can differ wildly, and in the context of a strict limit this mattera. Is there willingness and resource to spend on this? Second, and following on from this, is there sufficient technical knowledge in both economic and negotiation skills in the government to argue the case where as is inevitable there will be divergence between the commission and the domestic estimates? Third, there is no mechanism that I can see whereby on re-estimation of the models countries that were previously deemed in deficit are now deemed in surplus (or vice versa) are ‘reimbursed’ for the mis-estimation de jure, and again will there be sufficient skill sets for such an argument? The experience of Ireland with regard to the promissory note saga suggests to me that we have demonstrated neither the technical nor the negotiation skills that would be required under either of the last two questions. Fourth, the present fiscal compact is one leg of a stool, and as such while it can work it will be a precarious balancing act. The interaction of government with society in the economic space consists of fiscal and monetary policy. We do not have government control at a European level over monetary policy, and again one can see the way in which this leads to direct countervailing of purposes where increased austerity over and above the domestic requirement is imposed in pursuit of a flawed monetary vision. This treaty will provide a (Germanic ordoliberal) common spending policy. What is missing is a common tax policy and a common policy on transfers. Is there domestic will or competence to open up the latter two as a European aim, with the certain knowledge that for compromise on one (transfers) compromise on the other (tax) will be demanded?

Macroeconomic Imbalance Indicators

Estimates of Structural Deficit

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Euro crisis will require some hard choices to be faced.

This is a version of an opinion piece originally published in the Irish Examiner Sat 14 April 2012. See http://www.irishexaminer.com/business/euro-crisis-still-very-much-alive-and-pressing-190499.html.

It hasn’t gone away you know? The Euro crisis? Its back, waxing and waning. Italy struggles to raise money at the short end even with significantly increased rates, and there is event talk now of france being in trouble. To recap: last year the ECB finally began to take action to deal with the acute problems in the sovereign bond market and the banking market, now increasingly and worryingly scrambled together. Through two successive waves of cheap (1% pa) money a massive trillion euro was pumped into the banks. in what was called LTRO – Long-term rollover. Although significantly less in net terms this injection of liquidity (in November and march) was sufficient to significantly cool the sovereign bond markets. It was also a mechanism, as I have noted previously, to allow the banks to begin to fill some holes in their own balance sheets.

Modern economics absolutely needs banks. They are the pumps that drive money and credit around the rest of the system. In Ireland these pumps are broken and we see daily the effects of same. What the ECB has done is quite proper, but in mathematical terms it is necessary but not sufficient. Other factors in the ECB and elsewhere to my mind make this policy less likely to succeed than might be hoped.

First, this approach depends on the banks ultimately passing on their money to productive sectors of the economy. The way in which central bank actions filter into the real economy is one that has been much studied. The bank channel has been the focus of much scrutiny in recent years. The BIS concluded that individual bank capital positions were crucial to their ability to lend on. The also concluded that the key issue was structuring the capital base to allow this to happen. European banks and in particular Spanish banks are not yet fixed. We see in Ireland that the next wave of losses from mortgages is now beginning to consume political and economic capital.

Second, it is in any case treating the symptom not the cause of the problem. European sovereign states display high borrowing costs because of too much debt. The cost of debt is a function of supply and demand; at present there is a lot of cheap liquidity sloshing around which allows banks to purchase this high yielding debt and make a profit. But this exacerbates the issue if states consider that the lowering of bond yields indicates that they can take reform slow. European states are on a tightrope: too much austerity and the economy crashes – this is Greece, where real poverty and want are now rampant, and still the debts are unsustainable. Too little and the markets fear a Greek or worse write-down, this is Portugal or Spain. The circles of austerity-growth-market confidence are unsquarable in my view. We cannot solve too much debt with more debt.

Third there is evidence that the ECB is beginning to adopt a core-periphery approach. In his press conference after the last ECB board meeting Dragi made a number of comments that suggest to me that the ECB board was preparing a Plan B. He restated that where central ECB liquidity operations were not available for banks then domestic central bank liquidity was available. He also reiterated that this was however at the risk (read certainty) of exposure of the domestic sovereign. We have seen this here: despite the best spin that the government has put on it and notwithstanding that there is another game in town with the final settlement of the banks, the brutal reality is that at the end of march this state DID pay 3.1b to the Central Bank of Ireland to pay down ELA which it had advanced to prop up the rotting corpse of Anglo. When the ECB speak of ELA being advanced at local risk this is what they mean. Prop up your banks if you wish but it’s on your own head. Oh, and don’t let them fail. This is a recipe for a Europe populated by Anglo Irish Bank zombie clones. On household (read mortgage) debt overhangs being somehow adjusted (read, written down), The IMF suggests, and the ECB kinda agrees that it should be talked about, but of course the ECB also want us to continue to repay for the ghastly corpse of Anglo (but if he can find some money lads, after that, why not write down a bit of debt)…More recently Jörg Asmussen of the ECB told audiences in Ireland that, in essence, we were on our own with the banking debts.

Fourth, there is a growing theological strain in discourse that debt is not just wrong; it in some ways indicates a moral laxity. Backbench government TDs are increasingly adopting a ‘tullamore housewife’ approach, that government should not spend more than they earn. This of course ignores completely the reality that a state is not a household, and displays a dangerous ignorance of modern macroeconomic reality. At the same time we are being asked to vote on a fiscal compact which will not only in effect ban borrowing but given our debt levels will require us to run cyclical surpluses. That will, inevitably, lead to more austerity.

There are irreconcilable forces beginning to emerge in the European and national debate. At the heart of these lies the ECBs insistence that under no circumstances must banks fail coupled with its abhorrence of any hint of inflation. This is of course counter to the emergent European commission perspective on bank resolution and to the historic reality that debts do get restructured either via inflation or default. Europe will have to choose. There is too much debt. Either it gets written off via inflation, anathema to the Bundesbank , now incarnate as the European Central Bank, or it gets written off in a more or less organised fashion via a Greek style arrangement. The alternative is that the strains on the euro grow, and something breaks. Even now Citibank estimate a 50-50 chance greece will have to exit. Like a seat of flywheels, when one part of the euro breaks off it is highly probable that that a majority of the other parts will fly off also. The German politicians who have then demanded impossible things of the periphery will find the export chickens coming home to roost rather rapidly as their exporters face 30% plus deutche mark appreciation. Then we will see that competitiveness is relative, not absolute.

Eolas: Knowledge is power on the Fiscal Compact

The below is a version of an invited opinion piece done for Eolas magazine, an information magazine for senior public officials.

The fiscal compact treaty, an intergovernmental but not EU treaty, is in essence a further codification of the existing rules to which countries are supposed to adhere under the Maastricht Treaty.

The main elements of the compact are that countries maintain a balanced budget, that they move to a debt to GDP ratio of 60%, and that they generally act prudently. It does not, quite, rule out occasional breaches of the budget balance but these will it seems have to be agreed before hand at a central level. Countries that do not sign up to the treaty will be ineligible to obtain funding from the European Stability Mechanism, the new permanent bailout or rescue fund that the EU will set up. The details of the treaty are set out in the box.

In so far as these broad provisions go, there is little in principle to object to. Where problems arise for me and for many are in the details, where the devil always lies.

First, the advice of the AG was that this needs to be placed securely in the constitution, as the automatic requirements on budget processes and paths interfered with the powers of the oireachtas. The constitution should in my view be the place for broad statements of principle with the details of how these are to be implemented left to the interpretation of parliament. It is not clear to me that it is a good principle or precedent to place detailed rules into the constitution, tying the hands of future governments.

Second, the definition of whether the budget is balanced or not is dependent on a rather slippery economic concept. From an accounting basis we can see if the government is in surplus or deficit. But it is possible to be in accounting surplus or deficit and under the terms of this treaty be classed otherwise. The precise wording is “the annual structural balance of the general government is at its country-specific medium- term objective as defined in the revised Stability and Growth Pact with the annual structural deficit not exceeding 0.5% of the gross domestic product at market prices.” Thus, a concept, which is not uniquely defined, a structural deficit, is introduced. To consider this further, we need to understand what the structural balance is. This is the financial or accounting position that the government would find itself in were the economy to be growing at its ‘optimal’ pace. In other words, excluding temporary and one off issues, such as windfall gains and losses, what would the position be? More formally it can be defined as the actual balance less one off measures less the effect of where the country is in terms of its business cycle. Thus to estimate the structural deficit requires the actual balance (easy enough), one off measures (in principle easy enough) plus a measure of the effect on the balance of the output gap or where the economy is versus the business cycle. The latter is the problem, as it in effect requires a model of where the economy SHOULD be at, and clearly different models will give different results. There is no generally agreed model, and we have seen over the last decade that as models change there can be large variations in whether countries are in structural balance, deficit or surplus. The EU commission would appear to be the determining body in the compact and they have one model, but it is entirely probable that with advances in econometric modeling and our understanding of the economy this model will change, and with it perhaps the determination of whether an economy is in surplus or deficit. Absent an agreed definition, which is improbable, this would seem to me to be a dangerous metric to set ourselves against

Third, the compact requires that countries that are over the 60% debt to GDP level adjust the excess by 1/20 of the outstanding balance each year (as well as complying with the injunction to be not in deficit). Given that the peak debt/GDP ratio is now expected to be c120% we will have to run not a balanced budget but a budget that is in surplus (whether measured by reference to structural or other criteria). Given the fiscal, economic and political difficulties we face at present in adjusting to a 3% deficit in 2015 the reality is that the next several decades will be ones that will see fiscal policy dominated by the need to adhere to the compact and pay down debt.  The fiscal compact will in essence set the budgets for the next twenty to thirty years

Fourth, it is simple to show that in the long run an economy’s debt to gdp ratio converges to the ratio of its average % deficit to the average % nominal growth rate. Leaving aside the structural issues above the actual deficit cannot under the pact be more than 3%, and if we are to stay on the convergence path it will be considerably less. If we have 3% growth in nominal GDP and an average deficit of say .75% over the years our average debt to GDP will converge not to 60% but to 25%. While excessive debt is a fiscal drag the existence of a pool of quality government bonds is a prerequisite for a healthy pension and fund management industry. Too little debt can be as deleterious as too much.  Taken across the EU even to move to the 60% rule will require the removal of over €2 trillion of government debt from the asset pool. The consequences of this will be to concentrate demand on remaining assets and this will have the effect of driving up prices for government bonds and driving down interest rates. While that may seem a good thing, too low an interest rate can result in negative real rates. Faced with that pension and asset funds will either have to accept this or seek other baseline assets outside of government bonds. This aspect of the Fiscal Compact has received scant coverage

There are other problems with the compact: it is not clear that had it been in place the credit bubble would have been pricked earlier, nor is it clear that it would preclude another.  The clear desire of the EU is that the compact be in a strong legal position domestically. In most European countries that is achievable via changes to the constitution without referenda. The government here had an opportunity with the Fiscal Responsibility Statement Bill introduced in by Senator Sean Barrett, to have in place a legislative base on which to build the essence of the compact, but the history of non-government bills is that they do not make it into law. That was a missed opportunity as the main kicker of the Fiscal compact is the exclusion of states not adhering from further aid via the European Stability Mechanism. Although the government has determinedly stuck to it s guns that we will not need this, as we will be back in the market, the brutal reality is that few believe that to be the case. One could have imagined a scenario where the Fiscal Compact was in its form amended to give a codicil whereby domestic legislative measures could be ‘taken as being’ the equivalent, but absent such a provision here this would have been useless. This threat of exclusion, faced with the reality of an ongoing if declining deficit after 2015 and the need to refinance tens of billions of existing debt is the only reason to (find oneself forced to) vote yes for such a treaty.

BOX: What is the treaty -
  • Budget must be in structural balance or surplus, defined, as structural deficit cannot be higher than 0.5 percent of GDP 
  •  Countries, which have debt/GDP below 60%, can have a structural deficit of 1% or less 
  •  A country with debt/GDP above 60% has to reduce the excess by one-twentieth a year 
  •  If the budget is not in balance, automatic correction rules must be enforced 
  •  If a euro zone country does not write the balanced budget rules into its national law, it can be sued in the European Court of Justice and can be fined 0.1 percent of its GDP. 
  •  The agreement will enter into force once 12-euro zone countries ratify, or on January 1, 2013. – Euro zone countries will coordinate national debt issuance plans in advance. 
  •  Only countries that have ratified the fiscal compact and written balanced budget rule into national law will be eligible for bailouts from the European Stability Mechanism. -
  •  all EU countries, whether in Euro or not, apart from Czech Republic and UK, are signatories to the compact.