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 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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What if Ireland Defaults?

Well, if you want to know the answer to that question you will have to buy my new book, which contains a bunch of essays.

Contributors include:

• Nobel Laureate Joseph Stiglitz
• Constantin Gurdgiev, Megan Greene, Seamus Coffey and  Stephen Kinsella
• Peter Mathews TD
• Senator Sean Barrett
• businessman and political activist Declan Ganley
• politics lecturer and journalist Elaine Byrne
• Sam Roberts, urban affairs correspondent for the New York Times
• Huginn Thorsteinsson, philosopher and adviser to the Icelandic Minister of Economic Affairs and the Icelandic Minister of Fisheries and Agriculture
• John Walsh, editor of Business & Finance
• Peter Brown, director of the Irish Institute of Financial Trading
• Karl Deeter, director of Irish Mortgage Brokers

Aimed at the general reader and published by Orpen Press it is available from all good bookstores and from Amazon.  An ebook/kindle version should be available by 6/April/12

The €31b question : answered

And the results are in :

 

 

 

 

 

 

 

 

 

 

 

 

76% of people DO NOT think there will be a meaningful deal on the Prom Notes, 17% DO and 8% dont know what a PromNote is. These may include members of the oireachtas….

 

the €31b question

So another day and more discussion on will we/wont we get a deal on the Anglo Irish Promissory Notes….

What do you think? Here is a short poll, I will leave it open until 1700h today. I define “meaningful” as a deal that will at the very least allow the state to save €1b or more per annum over the next decade on these notes….

The Fiscal Compact, LTRO and sovereign debt

This post is a longer version of an oped published in the Irish Examiner Saturday 3 March 2012

So, another European referendum looms, with all that heat and lack of light that we can expect based on previous referenda. Expect the arguments from the no side over the months ahead, to revolve around septic tanks, water charges, local hospitals, waste collection policy, calls for imaginary non-austerity policies, anything but the substantive issue. This will be matched on the yes side by increasingly every more apocalyptic warnings of a no, stating the dangers of being expelled from the euro, the EU, EFTA, the UN, the planet, with accompanying rains of frogs. The reality is that the fiscal compact, as I have noted prior, is a poorly specified and blunt instrument to institutionalize euro wide a particular style of Germanic fiscal policies. It may however be the best poor and blunt instrument we can get at this stage. Many questions remain, and I await answers to them as a voter.

To reiterate, the core of the compact is that countries should adhere to a 60% debt/GDP limit, getting there via a deficit target of 3%, and a structural deficit of 1% per annum.

The present state of Euro affairs is that for the most part countries are outside these limits. For 2011, looking at the Eurozone, Estonia, Finland, Luxembourg, Slovakia, and Slovenia are at or below the 60% limit and only the first three comply with all the requirements. Outside the zone only Sweden is compliant. Thus the entire EU is being asked to adhere to a rule that at present less than 4% of the union, by GDP, can achieve. This is strange to put it mildly.

The good idea at the heart of the Fiscal Compact is that in the long-term a lower debt/gdp ratio is more sustainable, the country is more solvent. The 60% level is well below the by now generally accepted 80% as being danger and 120% unsustainable rubrics which research has indicated. Thus, the fiscal compact is one of good intentions. My concern is whether we can in fact get from here to there. For many of the highly indebted countries we are seeing the limits to austerity. The danger of self reinforcing negative feedback loops, where more austerity leads to a faster decline in the economy requiring more austerity to reach targets is evident in Greece and spain and in my and other opinions we in Ireland run that risk also. Indeed, the EU commission has noted this stating

“negative feedback loops between weak sovereign debtors, fragile financial markets and a slowing real economy do not yet appear to have been broken.”

In the Irish case, which is the one we should in the first instance be concerned with, we face two separate but interlinked debt burdens. First, we have a debt burden, the largest part of the total, which is as a consequence of previous overspending by governments. Second, we face a debt burden arising from the disastrous banking policy of 2008-9. Much of the talk on the compact is around whether we can get relief on the 3.1b per annum repayment of the Anglo promissory notes. The Irish times posits this talk as being “a quality of deep naivety or cynical politicking”, a Manichean view that omits the possibility that…one might think it the right and correct thing to do. I have been arguing for years , sometimes in the Irish Times no less, that whatever about the other banks, Anglo (the black sheep of the Irish banking crisis) and INBS (its dingleberry) should not be a drain on the taxpayer. So have many others, including even now the IMF, and it is sad to see a lamentable lack of understanding of the basic elements of the Promissory Notes that once again the Times seems to think that the interest rate on the notes is an important issue. While complex it was not beyond the comprehension of the members of the Oireachtas committee to see that this is not the case. See here for my presentation, here for Karl Whelan and here for Stephen Kinsella.

At present the success of the austerity policy is being noted via the fall in bond yields. While this has happened, it is in significant part down to the trillion euro of cheap three year money which the ECB has made available to banks over the last months vi its Long-term RollOver programme. What has happened to this money is that banks have taken the cash at 1% and either paid down own debt or invested in high yielding peripheral bonds, gaining significant profits either way. The effect has been to restore faith in the bank bonds, again showing the importance that the ECB can play if it desires. Very little of this money has or will trickle down to the real economy. This money is for three years only, as otherwise it would result in a seemingly unacceptable increase in EU money supply.

A proposition then appears which while logical and in my view sensible would almost certainly not be approved by the inflation and austerity hawks of the bundesbank manqué that the ECB has become. It is to explicitly link the writing down of all national debts to 60% GDP via monetization of debt combined with the fiscal compact. At the bottom of the post see a table where I show the present state of debt and how much of a reduction would be required to get it to 60%. If we think that the broad outlines of the fiscal compact are reasonable sensible (and with reservations, I do) then we should ensure that all countries are able to adhere to them. The issue is that we might not be able to get from here to there. So, while as a general principle monetization of the debt leads to inflation (defined recall as too much money chasing too few goods, and it is undoubtedly the case that at present there is a lag in aggregate demand in Europe making the too few goods argument weak), as a once off restoration of state balance sheets along the lines that the LTRO has done for bank balance sheets I would support it. Inflation in the Eurozone is hardly raging out of control.

While Eurosystem central banks are prohibited from directly purchasing government debt the use of LTRO funds via banks has indirectly breached this. But reducing government bond yields is only of use to a country seeking to raise funds if that country is solvent. To reduce the debts of all , even Germany, to the 60% level would require 2.4t to be mobilized, used to purchase and retire debt. We have seen that While this is a very large amount, it would be of direct benefit to the citizens of Europe. If we can, in effect, bail out the banks via the LTRO then we should be willing to bail out the citizens. To do otherwise would be in my opinion immoral.

	Debt as % GDP 2010	Debt €M	GDP	60% Target	Reduction in Debt
Greece	144.9	329,351	227,295	136,377	192,974
Italy	118.4	1,842,826	1,556,441	933,865	908,961
Belgium	96.2	340,739	354,198	212,519	128,220
Ireland	92.5	144,269	155,966	93,580	50,689
Germany	83.2	2,061,795	2,478,119	1,486,871	574,924
France	82.3	1,591,169	1,933,377	1,160,026	431,143
Hungary	81.3	78,250	96,248	57,749	20,501
Austria	71.8	205,576	286,318	171,791	33,785
Malta	69	4,250	6,160	3,696	554
Netherlands	62.9	369,894	588,067	352,840	17,054
Cyprus	61.5	10,653	17,321	10,393	260
Spain	61	641,802	1,052,134	631,281	10,521
total					2,369,586

 

 

Fiscal Compact Referendum : why I am voting “maybe”….

A number of people over the last while asked me how I intend to vote in the forthcoming referendum on the fiscal compact. At the moment  I am firmly in the I don’t know camp.
I have previously blogged and written about my concerns regarding the fiscal compact. I think we’re being asked to sign up for something which  is in principle a good idea, that is to say it is better for government not to be ill-disciplined with regard to the taxpayers money. There are problems with regards to how we measure some of the key aspects of this proposed fiscal compact, issues around its effectiveness, and concerns as to whether or not it will have an overly large impact upon the bond market.
If we do not sign up for this fiscal contact what happens?
We will not be thrown out of the Euro. No such mechanism exists, and if we can countenance a Eurozone which contains Greece then we can    imagine a Eurozone that contains an  Ireland which is not adhering to the fiscal compact.
Nor will we be thrown out of the European Union.
As things stand at present if we do not adhere to the fiscal compact then we will not be in a position, should we need to, to obtain funds from the proposed European Stability Mechanism.  Of course, obtaining funds from the European stability mechanism is only something that would occur if we required a second bailout, and the government have previously described the notion that we would need such a bailout as ludicrous. So would be signing up to obtain that which we do not need….
There is some question about whether or not not adhering to the fiscal compact would cast doubt on our bona fides in relation to  acting like a financially mature country.  The concern is that if we did not do so then, having to go back to the bond market as we will be doing if we believe the government, we would be facing into higher bond costs than would otherwise be the case. There’s nothing whatsoever to stop the Irish government from putting in place a domestically originated fiscal responsibility Bill. In fact, such an opportunity was presented by the tabling of exactly that Bill by Sen Sean Barrett, which the government declined to support but which to their credit did not vote down. A set of slides explaining the background to the bill and to fiscal rules in general is here.
There will not be a rain of frogs, nor will we see (somewhat contingent on the proposal in item 4) in mass outflow of deposits or a mass outflow of foreign direct investment. These may outflow anyway, but the mere declining to participate in a European fiscal compact (but making it clear that we would pretty much do the things that are  suggested by the compact, although in a more sensible manner)  is in my view unlikely to be the catalyst.
If we do not sign up for the compact then, as noted, we are not able to access the European stability mechanism.  This to my mind is perhaps the only compelling pragmatic reason to consider signing for the compact.  At present the funding under the first bailout extends through the end of 2013.  The intention of the government expressed the number of times is that we will then be “back in the market”, and able to borrow an reasonable terms both to fund our ongoing government deficit and to meet the maturity schedule of existing debt.  It is this issue that seems to be missed by many of the proponents of the no vote who seem to think that in voting no we will escape  austerity. Even on the governments own proposals we will still be running a deficit of approximately 3% of GDP in 2015.  Let’s assume that we decided to close the deficit by 2014, in that case we would have to take an additional €5-€6 billion out of the system over the next three years.  But even if we were to run a balanced budget by 2015 we would still not be of the woods. We face significant repayments of previously borrowed monies from 2014 onwards.

From 2014 to 2020  €30 billion worth of previously borrowed Irish national debt needs to be repaid.  If we are not able to borrow from the European stability mechanism to repay these then we will have to borrow from the bond markets, but in that case we will not, I would submit, be in a position to both borrow for the  maturity of existing debts and for ongoing deficits. In fact, with an ongoing deficit and not adhering to the European fiscal contract we would face very significant interest rates, perhaps in effect locking us out of the markets again, but this time with no European full-back. While it might be possible to borrow from the IMF this is not a guarantee. So if we do not sign up to the compact, cannot borrow from the European stability mechanism, and do not want to face enormous borrowing costs, we would have no choice but to be running a primary budget surplus by 2014. Given the deleterious effect that the existing “austerity” program is having on the economy, politics, and society, we need to ask whether or not imposing perhaps 50% more is either desirable or feasible? In other words, there is no magic relief from austerity. If we do not sign up for the compact then we are in effect going to have to massively accelerate our movement towards a budget surplus. If we do sign up for compact we’re going to commit ourselves to achieving a budget balance, but over a somewhat slower period.

One way in which we could perhaps begin to square this circle might be if we could get some relief on the money borrowed for the Irish banking recapitalization, now masquerading in most part as promissory notes.  Stephen Kinsella, Karl Whelan and yrs truly  spoke at length to the Oireachtas on the whys and wherefores of the Promissory Notes and how to escape the €3.1b anglo-tross which they represent .Unfortunately, once again the government seem to have ruled out any linkage between the promissory notes (approximately  €31 billion) being relieved from Ireland and a vote in favor of the fiscal compact. This morning the Taoiseach said that the Irish voters would not be bribed… I have a very distinct recollection of a previous Taoiseach returning in triumph from Europe weaving a cheque for the then outstandingly large sum of  £8 billion, prior to a referendum.  If it was good enough then to induce the voters to see the in pocket benefits of being on good terms with Europe then why not now?

Presentation to the Oireachtas Committee on Finance 15Feb2012

Below is a version of the written presentation I circulated to members of the Oireachtas Committee on Finance at our discussions today on ELA and Promissory Notes.

ELA is money. It is not a bond. Dealing with ELA does not involve dealing with bondholder although the money so created was used to redeem (pay off) bondholders. The acronym ELA stands for Extraordinary Liquidity Arrangement, and the name of indicates what it is. It is first and foremost extraordinary, in that it is a facility extended to commercial banks by central banks when ordinary (usually taken to be interbank or regular central bank ) short or medium term funding is not available for whatever reason. It is liquidity, in that it is designed to allow a bank to maintain liquidity to its operations and customers, rather than a solvency arrangement, which is designed to ensure that the organization is well capitalized and able to trade in the longer term. It is a basic tenet of corporate finance that we draw a distinction between these two concepts ; solvency, achieved through capital, is a longterm concept while liquidity is a rolling short-term issue. Liquidity crises, for countries or for companies, can arise when lenders no longer have confidence in the solvency of the borrower. This is what happened in September 2008, the initial focus being on the solvency of Anglo and Irish Nationwide (now collectively known as Irish Bank Resolution Corporation, IBRC).

ELA is money. In the normal course of events in the eurosystem money is created under agreed mechanisms. Central Banks have the power to create money ‘by fiat’ that is to say they can create it from nothing. ELA is not part of the normal operation of this monetary creation but is allowed in extraordinary circumstances. ELA is carried as an asset on the balance sheets of the creating central bank, in the case here the Irish central bank. It is not created by borrowing from other central banks. It is not a bond. It is not money loaned to the central bank of Ireland from the ECB, nor money loaned from the other central banks. It is money, as real as any other form of credit agancy. It is pure money creation, by fiat, allowed in exceptional circumstances. As of end-2011 this domestically created money amounted to some €44billion.

How is this money mobilized? When Anglo/INBS became hopeless and obviously insolvent the Irish government recapitalised them. The largest part of this recapitalisation was via the creation by the irish government of a Promissory Note which was issued to the banks. This was not and is not a sovereign bond. We know that it was not and is not as the ECB refused to accept this for normal liquidity operations, forcing Anglo/INBS to instead go to the central bank of ireland and swap this for money which was then used to finance Anglo/INBS, including paying off senior bondholders, paying staff wages, payment of interest on deposits etc. In effect the Central Bank of Ireland monetized the government IOU. The government have agreed to pay off the Promissory Note over a 15 year period. As there is, to put it mildly, considerable doubt as to whether the remaining assets of IBRC are sufficient to generate income to repay its debts the Minister for Finance in March 2010 as well as creating the Promissory Notes also gave (as of this date secret) letters of comfort to the Central Bank (Sole shareholder, the Minister for Finance) promising repayment of the ELA were IBRC unable to repay. Thus the state in effect is indemnifying itself against its own actions. An analogy might be that we borrow from a bank, put that money into a pocket, then move it to another pocket, then take it out and burn it. The effect is the same. Money is destroyed in the same amount as it was created, in order that the european money supply does not increas

How much is this going to cost us? In essence, through the next 15 years the state will repay the promissory note at a rate of approximately €3.1b per annum.

This repayment is treated in the government accounts as a capital expenditure, and can be found in Note 6 of the 2012 estimates as show above. This expenditure cannot therefore be deployed to other, productive, usage. Each year a capital allocation is made for the repayment of these. This capital must be either raised from taxation or borrowed. The true interest issue therefore of the Promissory Note is NOT the implicit interest rate which is paid on them, rather it is the cost of the funds borrowed to, in effect, recapitalize the banks holding the Promissory Notes. Thus seekingconcessions on the interest rate element of the Promissory Note is seeking the wrong concession.

Another issue as to why this matters and why we are paying is that Eurostat decided that as the Promissory Note was irrevocable it was appropriate to treat this as a €31b increase in the national debt, resulting in a world-beating 32% of GDP deficit in 2010. There is no doubt in my mind that the nature of the note and the consequent realization that it was in fact debt played a large part in the slow but inexorable locking out of Ireland from the regular bond markets and the need to become wards of the Troika.

What can be done about this and who can do it? The essence therefore is as follows: the Central Bank of Ireland has created money, outside the normal course of Eurosystem operations for the creation of money. This it is allowed to do under delegated power. However, this delegated power is circumscribed. In effect the ECB council can veto the action of the national central banks when they act in the manner in which the Central Bank of Ireland has done, but only by a 2/3 majority. Thus the presumption is that in general when central banks act to extend ELA they are doing so in a manner that does not interfere with the normal actions of the ECB.

This is where the crux of the matter lies I submit. While the creation of €40b or so of additional money by the central bank of Ireland is small in the context of a Euro area M3 (broad money supply) of €9800b, amounting less than 1/2 of 1%, the ECB has a mandated inflation fighting role. Add to this the historic antipathy of Germany, the dominant power in european monetary affairs, to any form of inflation and we see that the creation of money in this manner is potentially problematic. Were the Central Bank of Ireland not to require the repayment of the ELA, and the writing down of the money supply, this would represent a permanent increase in the monetary base of the Eurozone. 1/2 of 1% is not much but what if other countries were to commence to refinance their banks in this manner? What if in fact countries were to take up a suggestion made that the debtor countries refinance their sovereign debts in this manner? Ireland issues a €X hundred billion promissory note to IBRC, IBRC swaps that at the Central Bank of Ireland for newly created money, the NTMA issue a €X hundred billion bond for 100 years duration at a low interest rate, and IBRC purchases the bond with the real money which the state now has on hand on deposit to fund itself while we restructure the financial and economic system. What if Greece were to do this? Clearly we could quickly find hundreds of billions of ELA created euros being added. This is what is known as monetising the debt and it is anathema to the ECB for reasons of inflation as well as being a de facto breach of the rule that the ECB is not allowed to finance government deficits directly. Such monetary creation is further anathema to countries such as Germany who have in the past suffered episodes of hyperinflation. I would note that at 3% inflation we are far from hyperinflation. European money supply (M3) has remained within a narrow band of €9.2tri to €9.8tri since the middle of 2008 and in recent months has in fact begun to fall sharply again, having fallen heavily (as might be expected) in the   global financial crisis.  We are a long way from inflationary pressures.

It is highly probable that were countries to seek to do this they would find themselves running a real danger of being cut off from further and ongoing liquidity support, might be accused of having the central banks funding the deficit (deficit financing) and be in breach of treaties. Such a move would only be used in extremis but it does show that ELA has the potential for unlimited monetary creation and should be treated as such. It should be noted that we have had experience of a large currency union breakup in the recent past, with the breakup of the Rouble Zone, which zone lasted after the political union of which it was the currency, the Soviet Union.  . Nonetheless, such debt monetisation while a solution to the immediate liquidity problems of countries would in the long term pose a threat of inflation and would not in any case solve the solvency issues of countries or banks and might in the long term pose more problems than it would solve. However, in the here and now …

There are three ways in which we can deal with the cost of the ELA.

1. One is to extend the term of the ELA repayment from 15 years to a much longer period. Extending by 10 times, to 150 years would reduce the annual cost in the same manner. However, we would be ‘stuck’ with IBRC for potentially that period.

2. Another way we could deal with this cost is to simply write the whole issue off. This is NOT burning bondholders, nor is it burning ourselves. However, the consequence of removing the Promissory Note and associated Letters of Comfort might be to render IBRC technically as opposed to functionally dead. IBRC, if we write off the ELA and the associated Promissory Notes, would have remaining assets (loans not transferred to NAMA) and liabilities (some remaining ELA , some ECB loans, a small amount of deposits and some remaining bonds. If after restructuring the balance sheet IBRC is not able to service its liablities then it can and should be wound up. Again this seems to have been ruled our by successive governments and the ECB over the years, despite that it too would be the effect of saving the state the ongoing drain of €3.1b per annum.

3. A third solution would be to seek to defer, to continue in the kicking of the can at which successive governments and european institutions have excelled. We have already received deferment till 2014 of the implicit interest payment on the Promissory Notes, and if such were to be extended for a number of years the strain would be at least be deferred.

All of these however, of which I prefer the second, would require that the ECB accede to this request. The Irish voice on the ECB is not answerable to either this committee nor any organ of government, which is right and proper. It is in my view highly improbable that Governor Honohan has not raised these or similar proposals at the ECB, but the evidence is that so far there is no will from the ECB to allow movement. Why that is remains unclear as it has recently shown willingness to accept heretofore unpalatable actions in regard to Greece. Removing the burden of the Promissory Notes in some manner would only assist the government. It would assist it politically in terms of implementing the needed closing of the gap between state expenditure and taxation and it would assist in base monetary terms. If the Troika wish to have a ‘good example’ of its policies as opposed to a set of ‘horrible warnings’ they could do worse than quietly monetize the Irish banking debt, making clear that this is (at least in principle) a one off and reflects the reality that in doing so they acknowledge the role the Irish taxpayer has played in preventing contagion into the banking bond market in 2008/9.

The fiscal compact: maybe inevitable, hardly sensible

This is an extended version of a column published in the Irish Examiner, Saturday 4 Feb 2012. http://www.examiner.ie/business/business-features/with-our-fiscal-policies-is-the-compact-right-for-ireland-182591.html

The fiscal compact that we have now seen agreed to, the Not Quite an EU treaty as it has been termed, is a curates egg. At one level, like mom, apple pie, puppies and sunshine, its hard to disagree with the lofty notion aspired to, the notion of government finances being run in a coherent, sensible sustainable fashion. But, like the curates egg, it is good and bad. The bad elements to my mind outweigh the good and for that reason, at this stage, it is not at all clear to me that we should take it on board. The government had an opportunity to take on board a (soft) fiscal compact in the form of a private members bill tabled by Senator Sean Barret which would have addressed many of the concerns of the proposed compact without the hard numeric targets. That they did not kill the bill is testimony to the sense of such a rule being required, but that they did not progress the bill shows that there is no urgent will absent threats and cajoling. Had the barrett bill been progressed it would have strengthened the governments hand in that they could have gone to the treaty meetings with a fiscal rule in hand, and which might then have been able to be used as the basis for discussion.

The basic issue that the compact addresses is that all signatory powers must have a binding rule on how much government debt they are allowed to have, and if this is too much (defined as more than 60% of GDP) they will have to reduce it at a rate of 5% of the balance per annum, and to maintain a balanced or surplus budget. This is not sensible economics. It rules out any countercyclical government spending at least until the 60% balance is reached. To a great extent this is the same as the stability and growth pact, whose terms were breached early and often by Germany and France, now insisting that the rest of Europe swallow the medicine they themselves have persistently rejected without demur or sanction.

The basis of modern economic thinking (since 1930) is that governments should in principle be allowed to engage in countercyclical spending, increasing the relative size of government in bad times and shrinking it in good. In effect however this compact is the obverse of the rightly derided McCreevyism of ‘when I have it I spend it’ and takes economic policy back to the early 1920s. That worked well…

Some argue that the terms of the compact are essentially those that we agreed to under the Maastricht treaty and its attendant stability pact. The main difference here with the stability pact is the speed of adjustment which would imply that Ireland would face up to 20 years of austerity followed by an indefinite period of being unable to borrow regardless of fire flood or famine , and the threat. Instead of carrot and stick it is stick and stickier…The threat is that countries that do not adhere to the terms of the compact will not be able to access further aid from Europe after 2013. This of course should not be a problem for Ireland, if we believe the statements coming out of Merrion Street, as we plan to be back borrowing from the markets and thus will not need a second bailout. In fact, Minister Noonan has stated that it is ‘ludicrous’ to suggest otherwise.

Europe as a whole is significantly over the 60% limit. As of 2010 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 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 it will do nothing for growth, rather the opposite.

A further problem with the compact is that if it succeeds it will gravely damage the sovereign bond market. 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 fulfil that role. The fiscal compact states a maximum permissible deficit of 0.5% of GDP. It is easy to work out that with modest growth of say 3% then the deficit rule will result in a long term debt to GDP ratio of below 20%. 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 have 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 knockon consequences,

The audi adverts from the 1980’s had the tagline “Vorsprung durch Technik“, or competitive edge gained via technology. This treaty should have the tagline “Vorsprung durch Sparmaßnahmen (vielleicht), or progress through austerity, maybe….There is little doubt that Germany has done very well out of the Euro. The german economic model is one where there are relatively low and stable wages and prices, enabling German companies to maintain their production and prices , the rest of the world becoming more or less competitive around them. German exports to the eruo area stand at approx. 40% of their total exports. This has fluctuated surprisingly little over the last decade. It is not credible but appears to be what we see emerging from Germany that they can wish to have a model whereby the rest of the euro area comits itself to ongoing (and perhaps fruitless ) austerity while simultaneously continuing to buy miele washing machines, BMW’s and so on. What is good for the Eurozone as a whole is good for Germany. But this message, if it is being put across in Germany, is not being made clear.
Ireland is only now beginning to really come to grips with the twin financial problems of the banks and the budget deficit. The drag that the banks will have on the state for the next decade is the role which the Anglo Irish bank promissory notes will play. In essence, to ensure that the exceptional liquidity granted to Anglo via its swapping the promissory notes does not become a permanent increase in money, the Central Bank, acting at the behest of the ECB, is requiring the repayment of same. This amounts to €3.1b per annum for the next decade. The ECB rationale is that if they do not do this here then it will set a bad precedent and could result in money supply increasing and this might, eventually, result in inflation. European inflation now is c 3% per annum. Hyperinflation, which destroyed the economy of Weimar Germany and is alleged as a proximate cause of the rise of Nazi Germany, is generally defined as being rates of c 50% per month. The scarring effects of the Weimar experience still scare the Bundesbank and its successor the ECB. But we are literally orders of magnitude away from this problem. In order to prevent the possibility of hyperinflation in Europe, the Irish taxpayer must engage in a money burning exercise. And we must now, under threat of being cut off from funds, engage in a more rapid deflation of the system than would be deemed optimal. We are being asked to pile austerity on absurdity. At the very minimum the state must seek the removal, in toto, of the Anglo promissory note burden. Then and only then can we see where the true trajectory of Irish fiscal policy might be found, and then and only then can we see if the Fiscal Compact makes sense for Ireland.

Understanding Central Banks….

The crisis has shown us that the role of the Central Bank has rarely been more central to global economic welfare. Calls for more, or less, or faster or slower money growth, for new rounds of quantitative easing, for enhancement of the role of Central Banks as lenders of last resort (but to whom?), discussions on the desirable or undesirable role of inflation…. In this context it is essential for any business to understand what a central bank does and does not do.

Taught by Professor Karl Whelan, who has over a decade worth of experience as a central banker in the Federal Reserve and in the Central Bank of Ireland, this course delivered by my Campus Company will  examine among other issues

• If and if so how central banks influence interest rates and the money supply.
• Lender of last resort operations and banking regulation
• Quantitative easing
• How major central banks are structured, their legal limits and how they communicate (and how to decipher this)
• Liquidity traps
• Sovereign debt and central banks.
• MMT (Modern monetary theory).
• Credit risk in the Eurosystem of central banks and the correct interpretation of movements in payment systems and TARGET2.
• The euro area crisis and scenarios for a euro break-up.

Coming when the global cental banking debate intersects with the role of the ECB/Central Bank of Ireland on the issue of the Anglo Irish Bank Promissory Notes, this course should enlighten and provide business context to these issues.

UPDATE

Karl presented a discussion on exceptional liquidity provisions by the Central Bank of Ireland on Friday 27 January. His slides are

here

.