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.

Where is the housing market going in 2012?

This is an extended version of a column published in the Irish Examiner on 7 January 2012.

http://www.examiner.ie/business/uncertainty-over-end-of-fall-in-house-prices-179355.html

In the last week a number of publications have emerged which indicate that far from the house price crash reaching the bottom it appears, at least if you believe Daft.ie, to be accelerating. Daft.ie suggest that the asking prices for houses are now 52% below the peak, showing 18% fall in 2011 alone. Myhome.ie, owned by the Irish Times, is a little less apocalyptic, suggesting that Asking prices are only 43% down. The CSO, and Alsop properties, basing their data to November on paid prices, suggest that the declines are 46 and 67% respectively. Prior to the difficulty in interpreting exactly where we are is that the indices used are based on different constructions. For example the Allsop data reflect distressed properties at auction, while the CSO data represent purchases based on mortgages. We are, in other words, still unsure as to exactly where we stand. And not knowing where we are it is hard to know where we are going.

There is a proposal that in June 2012 we will, if all goes to plan, finally see a official government house price index based on settlement prices. To say that this is long overdue is akin to saying that the Titanic had a slight damp problem. It is arguable that a large part of the crisis which we are in now is as a result of people not knowing where we were, how we got here, and therefore not being able to make an intelligent prediction about where we would likely go. Note that this did not prevent people, including myself, from making predictions, nor did it hamper some form making more cogent and less erroneous predictions. However, I think it reasonable that the absence of an official house price index contributed in large part to the lack of coherent analyses. Moreover, as I understand it, the initial publication of this will only be back to 2010. While there will be data available back to 2001, covering therefore the end of the house price boom and the start of the house price bubble, as well as the crash, it appears as though this will not be published at least not initially. Why this is so is baffling, as giving a full picture of the noughties house price dynamics would be invaluable. There is a plethora of administrative data on house prices available within Revenue. While it is not their job to disseminate it, they do hold it. The CSO have run seminars on using administrative data, but as far as I can see the issue of house price data has not been a topic.

Coming off the reports noted above the consensus is that far from seeing a leveling out, the market reaching the bottom, in 2012 house prices will continue to decline throughout this year and into next year. Indeed, one commentator has suggested that the average house price fall from peak could be as high as 90%. But this perspective is even gloomier, and founded in decent analysis, than the analysis by Morgan Kelly that we could see price drops of up to 80%.

Part of the difficulty in relation to ascertaining when we will see the bottoming out of the market is that the dynamics, both statistical and psychological, of turning points and not particularly well understood. In there is a reasonably large body of research on the dynamics of house price booms. It is a pity that more cognizance was not taken of these reports by the relevant authorities, and indeed by commentators including myself. However, in Ireland we tend not to engage in that foreign continental vice of evidence-based policy making, and therefore one can’t but wonder as to whether or not any amount of analytical evidence into 2004-2007 period would have made the blindest bit of difference to government policy.

Be that as it may the consensus in academia is now that three major elements exist in the dynamics of house price booms.Firstly, these tend to be self-perpetuating, in that rising house prices in one period leads to expectations being formed of house prices rising in the next period. There is a limit to this however, with the not unrealistic finding that as the boom lasts longer and longer it is more likely to collapse.. A recent excellent paper on this is here . Secondly, and this is particularly case in Ireland, the credit conditions are important, with some evidence suggesting that credit laxity can fuel house price booms. This has been discussed here. Thirdly the general economic conditions are of course important, including in particular the conditions and rental market and the overall health of the economy. Income, rental issues, interest rates, unemployment , inflation have all been seen as important drivers. See here for Central Bank analysis on this, here for an analysis of the importance of unemployment. The most recent IMF analysis suggests that deviations from trend national income and a Bundesbank study suggests similar dynamics with deviations from fundementals taking “several years” to correct.

If we then consider all of these we cannot come up with the conclusion other than that house prices will continue to fall through 2012. Daft.ie have noted on a number of occasions that falling house prices are not necessarily a bad thing, if they get house prices back to where they should be based on fundamental economic conditions. I agree with this, but they have also noted that the very self-fulfilling nature of booms also operates for crashes. Expectations of falling house prices will feed into falling house prices, and in the Irish context this is going to be exacerbated by the aggressive deleveraging of banks in general and in particular in relation to mortgage credit. A naive conclusion would be then that we need simply to pull on a happy face and think positive thoughts, and if we really really believe house prices will rise then they will. The reality is that that is both unlikely to happen in an economy grinding to a halt, nor should we want prices to rise until and unless they have reached at or below fundemental value. Outstanding mortgage credit to Irish households is now only 62% of what was at peak, and has continued to decline steadily by 2 to 3% per month. There is no reason to expect that in the near future this will change. The acknowledgement that credit drives the housing market in ireland is evident from the calls for banks to lend more (see same from Sherry Fitzgerald here) and even the astonishing suggestion that the (bankrupt) state should take on board the negative equity of future borrowers.

The evidence is that the longer the boom not only the more severe but also perhaps the longer the crash. There is relatively little research on the macroeconomic determinants associated with house price crashes, and such research as does exist seems counterintuitive, suggesting for example that increases in national income reduced the likelihood of exiting a crash. This may be partially explained by households faced with an increase in disposable income in using these to pay down existing debts rather than to re-enter the housing market. However, much research remains to be done on house price crash dynamics, as opposed to house price boom dynamics. A valuable investment by a mortgage lender would be a couple of postdoctoral researchers focused on this area.

It is quite astonishing that despite the massive wealth created in Ireland over the boom and bubble, from property, there is I would suspect less academic research capacity in property now than there was in 2001. Perhaps in an effort to ensure that this time really is different, and we dont make the same mistakes again and again, one of the estate agencies might consider endowing a lecturer or three in the third level?

A reasonably comprehensive analysis of property bust determinants is given in a 2009 ECB working paper. The determinants of crashes/busts are analysed in the table reproduced below

What can we take from this? That busts are positively associated with short-term interest rates (thankfully low in prospect), increases in property taxes (coming soon) , exchange rate strengthening (hard to call) and banking crises (oh yeah, we have one of them all right…), and are negatively related to the health of the government balance (poor in this case) , monetary growth and credit growth (both poorly here ) , population growth (slowing if for no other reason than due to emigration) and growth in national income (we wont be seeing that for a while). Thus, there is really little cheer from the research such as we have.

Where then might prices go? the CSO data suggest a house price peak of some €331,000 for new houses in Q2 2007. Ronan Lyons uses some relatively simple extrapolations to look at the possible future dynamics and suggests that the market will bottom out in 2014 at approx €150k, representing a fall of 55-60%. In early 2010 I suggested that we could hit €130k region in 2013, a fall of some 60% plus. Cormac Lucey suggests (see his last paragraphs) a fall in average new house prces to perhaps as low as €75k on the basis of overshooting, with a trough perhaps at 2017. Morgan Kelly in his seminal analysis suggested a fall of between 40-60% with a possibility of up to 85%. Recall also that if houses are to fall by say 75% from peak and have already fallen by 60% that does not mean a 15% fall is in prospect: . You are going from 100 at a peak to 40 now and down to 25…. do the math. While NAMA may have declared november 2009 as its valuation date, implicitly suggesting that the crash had then ended (and the ongoing crash has implications for NAMA to which I will return), it seems that in the words of De Bert, when it comes to house price fall, while there is a lot done there is more to do.