Sunday, May 13, 2012

13/5/2012: Village Magazine May 2012: Fiscal Rules & actual outruns

This is an unedited version of my article for Village magazine, May 2012.

However one interprets the core constraints of the Fiscal Compact (officially known as the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union), several facts concerning Ireland’s position with respect to them are indisputable.

Firstly, the new treaty will restrict the scope for the future exchequer deficits. This has prompted the ‘No’ side of the referendum campaigns to claim that the Compact will outlaw Keynesian economics. This claim is a significant over-exaggeration of reality. Combined structural and general deficit targets to be imposed by the Compact would have implied a maximum deficit of 2.9-3.0 percent in 2012 as opposed to the IMF-projected general government net borrowing of 8.5 percent of GDP. With the value of the Fiscal Compact-implied deficit running at less than one half of our current structural deficit, the restriction to be imposed by the new rules would have been severe. However, in the longer term, fiscal compact conditions allow for accumulation of fiscal savings to finance potential liabilities arising from future recessions. This is exactly compatible with the spirit of the Keynesian economic policies prescriptions, even though it is at odds with the extreme and fetishized worldview of the modern Left that sees no rational stops to debt accumulation on the path of stimulating economies out of recessions and broader crises.

Secondly, the Fiscal Compact will impose a severe long-term debt ceiling, but that condition is not expected to be satisfied by Ireland any time before 2030 or even later.

One interesting caveat relating to the 60 percent of GDP bound is the exact language employed by the Treaty when discussing the adjustment from excess debt levels. The ‘Yes’ camp made some inroads into convincing the voters to support the Compact on the grounds that debt paydowns required by the debt bond will involve annually reducing the overall debt by 1/20th of the debt level in excess of 60% bound. However, the Treaty itself defines “the obligation for those Contracting Parties whose general government debt exceeds the 60 % reference value to reduce it at an average rate of one twentieth per year as a benchmark” (page T/SCG/en5). Thus, there is a significant gap between the Treaty interpretation and its reality.

Another debt-related aspect f the treaty that is little understood by the public and some analysts is the relationship between deficit break, structural deficits bound and the long-term debt levels that are consistent with the economy growth potential. Based on IMF projections, our structural deficit for 2014-2017 will average over 2.7% of GDP, which implies Fiscal Compact-consistent government deficits around 1.6-1.7% of GDP. Assuming long-term nominal growth of 4-4.5% per annum, our ‘sustainable’ level of debt should be around 38-40% of GDP. Tough, but we have been at public debt to GDP ratio of below 40 percent in every year from 2000 through 2007. It is also worth noting that we have satisfied the Fiscal Compact 60% debt bound every year between 1998 and 2008.

Similarly, the Troika programme for fiscal adjustment that Ireland is currently adhering to implies a de facto satisfaction of the Fiscal Compact deficit bound after 2015, and non-fulfilment of the structural deficit rule and the debt rule any time between now and 2017. In other words, no matter how we spin it, in the foreseeable future, we will remain a fiscally rouge state, client of the Troika and its successor – the ESM.

On the negative side, however, the aforementioned 1/20th rule would be a significant additional drag on Ireland’s economic performance into the future, compared to the current Troika programme. If taken literally, an average rate of reduction of the Government debt from 2013 through 2017, required by the Compact would see our state debt falling to 87.6% of GDP in 2017, instead of the currently projected 109.2%. In other words, based on IMF projections, we will require some €42 billion more in debt repayments under the Fiscal Compact over the period of 2013-2012 than under the Troika deal.

On the net, therefore, the Compact is a mixture of a few positive, some historically feasible, but doubtful in terms of the future, benchmarks, and a rather strict short-term growth-negative set of targets that may, if satisfied over time, convert into a long-term positive outcomes. Confused? That’s the point of the entire undertaking: instead of providing clarity on a reform path, the Compact provides nothing more than a set of ‘if, then’ scenarios.

Let me run though some hard numbers – all based on IMF latest forecasts. Even under the rather optimistic scenario, Ireland’s real GDP is expected to grow by an average of 2.27% in the period from 2012 through 2017. This is the highest forecast average rate of growth for the entire euro area excluding the Accession states (the EA12 states). And yet, this growth will not be enough to lift us out of the Sovereign debt trap. Averaging just 10.3% of GDP, our total investment in the economy will be the lowest of all EA12 states, while our gross national savings are expected to average just 13.2% of GDP, the second lowest in the EA12.

In short, even absent the Fiscal Compact, our real economy will be bled dry by the debt overhang – a combination of the protracted deleveraging and debt servicing costs. It is the combination of the government debt and the unsustainable levels of households’ and corporate indebtedness that is cutting deep into our growth potential, not the austerity-driven reduction in public spending. In this sense, Fiscal Compact-induced acceleration of debt repayments will exacerbate the negative effect of fiscal deleveraging, while delaying private debt deleveraging.

However, on the opposite side of the argument, the alternative to the current austerity and the argument taken up by the No camp in the Fiscal Compact campaigns, is that Ireland needs a fiscal stimulus to kick-start growth, which in turn will magically help the economy to reduce unsustainable debt levels accumulated by the Government.

There is absolutely no evidence to support the suggestion that increasing the national debt beyond the current levels or that increasing dramatically tax burden on the general population – the two measures that would allow us to slow down the rate of reductions in public expenditure planned under the Troika deal – can support any appreciable economic expansion. The reason for this is simple. According to the data, smaller advanced economies with the average Government expenditure burden in the economy of ca 31-35% of GDP have expected growth rates averaging 3.5% per annum. Countries that have Government spending accounting for 40% and more of GDP have projected rates of growth closer to 1.5% per annum. Ireland neatly falls between the two groups of states both in terms of the Government burden and the economic growth rate. So, if we want to have growth above that projected under the current forecasts, we need (a) to accept the argument that growth is not a matter of the stimulus, but of longer-term reforms, and (b) to recognize that for a small open economy, higher levels of Government capture of economy is associated with lower growth potential.

Despite our already deep austerity and even after the Compact becomes operational, Irish Exchequer will continue running excess spending throughout the adjustment period. Between 2012 and 2017, Irish government net borrowing is expected to average 4.7% of GDP per annum, the second highest in the EA12 group of countries. Between this year and 2017, our Government will spend some €47.4 billion more than it will collect in taxes, even if the current austerity course continues. Of these, €39 billion of expenditure will go to finance structural deficits, implying a direct cyclical stimulus of more than €8.4 billion. The Compact will not change this. In contrast, calling on the Government to deploy some sort of fiscal spending stimulus today is equivalent to asking a heart attack patient to run a marathon in the Olympics. Both, within the Compact and without it, the EU as well as the IMF will not accept Irish Government finances going into a deeper deficit financing that would be required to ‘stimulate’ the economy.

The structural problem we face is that under current system of funding the economy and the Exchequer, our exports-driven model of economic development simply cannot sustain even the austerity-consistent levels of Government spending. IMF projects that between 2012 and 2017 cumulative current account surpluses in Ireland will be €40 billion. This forecast implies that 2017 current account surplus for Ireland will be €10 billion – a level that is 56 times larger than our current account surplus in 2011. If we are to take a more moderate assumption of current account surpluses running around 2012-2013 projected levels through 2017, our Government deficits are likely to be closer to €53 billion. Our entire exporting engine will not be able to cover the overspend of this state. In short, there is really no alternative to the austerity, folks, no matter how much we wish for this not to be the case.

Instead, what we do have is the choice of austerity policies we can pursue. We can either continue to tax away incomes of the middle and upper-middle classes, or we cut deeper into public expenditure.

The former will mean accelerating loss of productivity due to skills and talent outflows from the country, reduced entrepreneurship and starving the younger companies of investment, rising pressure on wages in skills-intensive occupations, while destroying future capacity of the middle-aged families to support themselves through retirement. Hardly trivial for an economy reliant on high value-added exports generation, higher tax rates on upper margin of the income tax will act to select for emigration those who have portable and internationally marketable skills and work experience. Given that much of entrepreneurship is formed on the foot of self-employment, high taxation of individual incomes at the upper margin will further force outflow of entrepreneurial talent. In addition, to continue retaining high quality human capital here, the labour markets will have to start paying significant wages premia to key employees to compensate them for our tax regime. All of these things are already happening in the IFSC, ICT and legal and analytics services sectors.

The latter is the choice to continue reducing our imports-intensive domestic consumption, especially Government consumption, and cutting the spending power of the public sector employees, while enacting deep structural reforms to increase value-for-money outputs in the state sectors. This, in effect, means increasing the growth gap between externally trading sectors and purely domestic sectors, but increasing it on demand and skills supply sides, while hoping that corrected workplace incentives will lift up the investment side of domestic enterprises.

Both choices are painful and short-term recessionary, but only the latter one leads to future growth. Anyone with an ounce of understanding of economics would know that the sole path out of structural recession involves currency devaluation. And anyone with an ounce of understanding of economics would recognize that the effects of such devaluation would be to reduce imports, increase differential in earnings in favour of returns to human capital and drive a wider gap between domestic and exporting sectors. The former choice of policies is only consistent with giving vitamins to a cancer-ridden patient – sooner or later, the placebo effect of the ‘stimulus’ will fade, and the cancer of debt overhang will take over once again, with even greater vengeance.

Looking back over the Fiscal Compact, the balance of the measures enshrined in the new treaty is most likely not the right – from the economic point of view – prescription for Ireland today. It is probably not even a correct policy choice for the future. But the reasons for which the treaty is the wrong ‘medicine’ for Ireland have nothing to do with the austerity it will impose onto Ireland. Rather, the really regressive feature of the Treaty is that it will make it virtually impossible for our economy to deal with the issue of private debt overhang and to properly restructure our taxation system to create opportunities for future growth.


Update:  In the above, I reference the 1/20th rule and identify it as 'taken literally'. This can cause some confusion for the readers. To clarify the matter, here is the discussion of the rule as 'taken' literally' as opposed to 'taken as implied' under the Treaty. The article has been filed before the linked discussion took place. Additional material on this can be found on Professor Karl Whelan's blog here.

It is also worth pointing out that I have consistently (until April 26th blogpost) referenced the 1/20th rule as applying to debt portion in the excess over 60% bound. This referencing traces back to my comments on the issue to the Prime Time programme for which I commented on the issue back in late January 2012. However, subsequent reading of the document has shown very clearly that the primary language of the Treaty clearly references one rule in the preamble, while the conditional statement in the Treaty article itself references the other. On the balance, I agree with Karl Whelan, that the implied and valid wording should relate to 1/20th of the excess over 60% bound.

Really shoddy job done by those who wrote this Treaty.

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