Tag Archives: Referendum

What Ireland’s crash tells us about bankers views on Scottish Independence

The next week is going to be fascinating. I have no idea how Scotland will vote, for or against independence. I have no idea how I would vote were I there. Economically, there is probably a somewhat stronger argument for NO than YES, if you believe the politicians promises. But national self determination is not about economics alone. Ireland has seen a massive crash, from its overblown banking system. How bankers and other vested interests responded to that is very instructive for the scottish debate

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Catherine Murphy, Article 27 and the Seanad.

One of the things that must most irk senators and dail members is the way that debates get guillotined. Catherine Murphy TD had proposed to table some amendments in the debate on the Seanad abolition bill, mainly on the issue of Article 27. That this would be futile, as no opposition or independent amendments, no matter how worthy or how much the government agree with them are ever supported. In any case the blade fell and her views were not placed on the record of the house.

Nonetheless, these points that she makes are useful , and show a mechanism to preserve the democratic right of elected officials (local authority members to replace senators) to petition the president on a matter of importance.

Her full document is here.

Note : Im not a ‘supporter’ of Murphy, although she does seem a sensible and coherent independent. She is in my constituency, and I did give her a high preference last time out.

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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.

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The Fiscal Compact and Ireland

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

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

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

Macroeconomic Imbalance Indicators

Estimates of Structural Deficit

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Euro crisis will require some hard choices to be faced.

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

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

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

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

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

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

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

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

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Eolas: Knowledge is power on the Fiscal Compact

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

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

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

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

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

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

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

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

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

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

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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

 

 

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