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 17^th 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 stated “Without 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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Down the Memory Hole: why we should give more priority to economic and financial history

A few months ago I found myself teaching third-year students for about one hour on the historical experience of stocks and bonds in relation to the risk/return characteristics. I’m sure most people who have taught finance will have come across these phenomena, where one finds oneself referring to a for the students historical but in ones own case very pertinent event, in my case the 1987 crash, and looking up realizing that this is so far beyond the life abd professional experience of the students that you may as well be talking about the reforms of the Roman bureaucracy by the Emperor Titus.

We know that people generally speaking tend to engage in what financial economists call “hyperbolic discounting”, which applies both to the past as well as the future, resulting in a shorter term perception, giving greater weight, greater than would be appropriate given the distribution of outcomes, to more recent events. This also manifests itself in a number of other financial and behavioral biases. The bottom line is that there is always a tendency for people to consider that this time really is something new. And of course, this flies in the face of what we know from history. Probably the best book on economics and finance over last couple of years has been the book by Reinhard / Rogoff ” this time is different”, credit should know, it’s almost certainly not. In my view this book should be compulsory reading for anybody who thinks about being involved in financial and economic markets at any level. In my case the 1987 crash was memorable, of course as a major event in finance, and also because on that Monday I started work on the Central bank of Ireland.

This memory, and the realization that for many students, and don’t forget them in a couple of years these students will be the ones that will be managing your money, and knowledge of financial, business, or even economic history, is lacking. Earlier this year a study was undertaken by the St Paul’s Institute, which looked at the economic and financial historical knowledge of London finance professionals. The full study, available here, is a fascinating read about the attitudes of finance professionals in the city of London around the areas of ethics and integrity. What was reported widely, see for example an interesting report here, was a city professionals exhibited a profound lack of knowledge around the economic and financial history of the own profession. Quoting from the London Independent

In an indication that memories fade fast within the banking sector, less than a third of employees were able to pin point 1980 and 1991/92 as the last two dates major recessions took place in the UK. In contrast, more than three-quarters of respondents correctly answered that the post-credit crunch recession began in 2008.

Equally, almost seven in 10 people had no idea that this year is the 25th anniversary of the “Big Bang”, the major deregulation of Britain’s banking industry that allowed London to become the financial capital of the world – and an inevitable epicentre of the ongoing economic turmoil.

To me this is profoundly worrying. The words of George Orwell are very apt: he who controls the past controls the future. And it’s not just me that worried…the CFA Institute, the professional body that certifies and regulates the “front office” portfolio and institutional managers, is reported today in in the financial Times as also being concerned. The report is behind the financial Times registration barrier, registration is free, and provides limited access to a number of articles per month. Nonetheless, some quotes from it are illustrative.

CFA UK, which represents 9,000 investment professionals, argues that the study of financial history should form a major part of all compulsory education for retail and wholesale investment professionals. “Financial amnesia disarms individuals, the market and the regulator,” the body said. “It causes risk to be mispriced, bubbles to develop and crises to break.”

The education requirements for investment professionals in the UK do not oblige them to have “any understanding of financial history”, added Will Goodhart, chief executive of CFA UK. While the UK’s Financial Services Authority sets the framework for the Investment Management Certificate, the country’s most widely recognised qualification for investment professionals, CFA UK sets the questions. Mr Goodhart suggested that about 15 per cent of the syllabus focus on financial history.

The British CFA programme should be reformed to include “a practical history of financial markets, designed to remind us about the effects of liquidity, psychology and regulatory failure”, the report said.

It also advised the boards of financial institutions to undertake an annual “amnesia check”. “It would be reassuring to know that once a year the board of a financial services firm had reminded itself that this time it is not different,” Mr Goodhart said. The

The CFA Institute have a relationship with the number, about 100, universities where they provide input into Masters level degrees in finance The idea here is that the Masters in finance cover much of the ground of the professional qualifications of the CFA Institute, although no exemptions are given, and that they therefore provide both an academically rigorous as well as industry focused experience for students. Trinity College Dublin and University College Dublin are the only two such universities in Ireland which have courses so aligned. The MSc in finance in Trinity College, and the MBS in finance in UCD are the relevant courses. It’s instructive to note that examining the syllabi for these courses there appears to be no opportunity for students to study financial history. I should note that the initial design of the MSc in finance and Trinity College was mine, and therefore I should take some responsibility for not having included as an optional module, ab initio, a module on financial and economic history. In my defense I can note that there was a proposal the following year have such a module, but it was not felt that there would be sufficient numbers of students interested to warrant offering the course. And, the sad fact is, that this is probably the case. Students who have never been exposed to history are not likely to have an inherent appreciation of the importance of history.

What about other courses? I am the external examiner for the Masters in financial economics at University College Cork, and it is an excellent course of course, but it does not have a module on financial history. The University of Limerick offer a wonderful degree at Masters level in computational finance, the Masters In finance and capital markets in Dublin city University has been on the go for a number of decades and again provides excellent training, and there is a recently developed masters in financial engineering at NUIM. None of these, insofar as I can see from examining the course lists online, offer students a module in financial history.

it doesn’t seem to be any better in economics. The TCD masters in economics does not appear to have a module available on financial or economic history; nor does the largest masters in economics degree course, that run by UCD. This also seems to be the case in NUIM, and in Cork.

What about MBA degrees? If our financial and economic professionals were not been trained in a manner, which incorporates as a formal module and understanding of history perhaps, business masters of the universe are so being taught? Again from my knowledge there is no such module on the MBA Trinity , nor on the MBA offered in UCD, despite it being the only MBA in Ireland which is “triple accredited” and the only MBA in Ireland ranked in the Financial Times rankings. In fact the only mention of history on the UCD MBA site appears to be in the promotional brochure outlining the history of Dublin.

I haven’t looked at the situation in UK, USA. That would be an interesting master’s thesis, for a student to examine attitudes and approaches to the incorporation of financial and economic history into graduate professional training programs. But I am pretty certain that situation which I have described here in Ireland is representative of the vast majority of courses. The teaching of economic and financial history has never been a core strength, particularly in Ireland, of business schools. Even within economics departments economic history, still less the history of economic thought, has tended to be a very minority sport. Ireland in recent years has been blessed in having exceptionally talented economic historians, such as Kevin O’Rourke in TCD, and Morgan Kelly and Cormac O’Grada in UCD . Kevin has now left Trinity College, has taken a professorship at All Souls College Oxford; Cormac has retired; Morgan showed in his analysis of the economic crisis the benefits which a good grounding in historical concepts can provide.

The reality is that as people move and retire they are unlikely to be replaced, certainly not the same levels, and given that it takes decades of dedicated skill to achieve the levels of knowledge then certainly not at the same level, ab initio, in terms of intellectual firepower. Yet, who can doubt that a greater knowledge of history would be useful? Who can doubt that were people, particularly those entrusted with our financial and economic well-being, more aware of the cycles of the economy and of the markets, that they would be at least better armed in relation to realizing that this time is not different, and that by observing and learning from the past we can at least not be excused the knowledge that “we never knew this could happen”. Of course, there are no smart green nano bots, no patents, and very few high-tech spin-offs that come from providing economic and financial history courses. And therefore, given the dreadful trudge towards turning universities into some form of annex to an ill-defined “Smart economy” we will continue to churn out highly technically skilled economic and financial graduates whose only exposure to economic and financial history has come about through individual course leaders dropping nuggets of information into their courses, or for the select few more so motivated, from their own autodidactic endeavors. And that is one way to ensure that we have a dumb economy and one that is doomed to prove Santayana right : Those who cannot remember the past are condemned to repeat it.