Debt Mountain 'Ireland Inc' II

For those who missed yesterday's Irish Times article by Brian Lucey and myself - here is the link. Of course, the followers of this blog would know most of these facts already.

Another article - my quick analysis of the Exchequer figures for January - is in today's Irish Independent (here).

And I actually do mean we are in a soap-opera land when it comes to policy. In fact, in July, I wrote for an investment newsletter a piece that provided a metaphor for our public finances condition as of June 2008 - a metaphor of a Wile E. Coyote frozen over an abyss nanoseconds before a disaster. Memorably, I was informed that the metaphor was taking things too far... Hmmm... was it? Judge for yourselves:If you are still not feeling the wind whistling into your ears as Coyote gains speed, take a look at this...Two facts are apparent:
1) we are witnessing the steepest assent in the unemployment in years, with the speed of unemployment rise shown in the table below; and2) DofF forecast in January 2009 was for the economy to reach 9.2% unemployment this year. Just a month into 2009, we are already there in standardized unemployment terms. DofF 2010 target for social welfare spending is based on the projection that unemployment will reach 10.5% or a notch over 372,000 in today's labour force terms. 2009 Live Register average was assumed to be at 290,000 in the Budget. In other words, at the rate of jobs losses in January, we are less than 2 months away from blowing through 2010 assumption, never mind the 2009 estimate!

Whiiiishshsh! Goes Coyote...

2009 budgeting in October assumed unemployment at 7.3% 2009 (I wrote before about the abysmal quality of our boffins' forecasts here). The €2bn spending cuts were also based on this figure as a part of budgetary estimates. It is now crystal clear that DofF has grossly missed the estimate on social welfare and unemployment benefits. By how much? I will leave budgetary eggheads to do all the math, my guess is ca €2bn.

.... Splat!

But it can be more. Why? Well, last year an unknown, but potentially significant number of foreign workers have left Ireland. This undoubtedly kept Live Register somewhat lower. But as the best and most employable workers leave first - because they have better prospects of gaining a job elsewhere - adverse selection will most certainly see marginal and poor foreign workers remaining. These workers face much lower prospects of gaining a job elsewhere, so on the margin, Irish unemployment benefits are much more lucrative an incentive for them to stay here. In other words, if emigration was keeping Live Register below what it might have been in 2008, the same is unlikely to happen in 2009 and 2010.

Good luck to all who bought rental apartments in the outlying areas of Dublin and across the country. With Poles and others heading either for the airport or to the dole office, the rents are going to follow land values - into agricultural pricing territory...

P.S. Given that our banks spent 2008 busy converting development loans into investment loans by forcing developers to turn completed properties into rentals, what does this mean for our banks' impairment charges? BofI at €0.30 and AIB at €0.50 after the recapitalization?.. The answer is unpalatable, but I will leave the numbers as an exercise for Ireland's best banking sector analysts...

Falling from disgrace

Ah, another day, another screw up in the Biffoland – the veritable emporium of economic policy oddities and quaint Boggerista collectibles. So much drama, RTE’s / ESRI’s tax-everyone-to-death crowd is getting all excited. In reality, if 2008 was the year Biffo & Co have fallen from grace, 2009 is shaping up to be the year when they will fall through the bottom of hell itself.

The 'savage cuts' were announced at last – ‘adding to just under €2.1bn’ in RTE’s official interpretation. In the mean time, the Exchequer results get sidelined by David Begg’s and Jack O’Connor’s pleading poverty for the public sector workers.

Let’s cut through the fog, shall we?

In the entire ‘package’ announced by Cowen the only hard budgetary measure was the pension levy. But even here, Mr Cowen fails the reality test. If the pensions levy is tax deductible – and all indications are that it is – the alleged €1.4bn in savings will shrink to ca €800mln.

The only announced economic rescue measure – some two-years old capital spending programme slightly neutered by the second-largest ‘cut’ of the day. But give it a second to take the perverse 'logic' of this Government's thinking in. If capital spending programme under the NDP is a stimulus package today - in the recession - what on earth was it enacted for some two years ago? To boost rabid inflation to Zimbabwean levels?

The rest of this 'new' package is pure hot air.

Cuts in professional fees and administrative savings?.. This beggars a question why these were not cut by Biffo when he was the Minister for Finance? So, either Biffo was an inept Minister for Finance (in which case he has some room to cut these lines of spending today) or he is an inept Taoiseach (in which case he has no room to cut these). Take your pick.

Child benefit restriction – aiming to save €75mln – is another hit at the same soft target. Remember Budget 2009 – children already got some whacking from our Biffo ‘The Gruffalo’. How much more can he milk out of them, should more ‘adjustments’ be needed in the near future (see below)? Lots! He can tax the un-born off-springs of the rich (income in excess, of oughh, say €150K pa) household.


But all of this pales in comparison with what should have been done by the Government in today’s announcement. As my earlier posts (here and here) estimate, in 2009 we are going to face “a shortfall of up to €7,080mln on 2008 revenue, not €3,898mln as DofF forecast in January. My previous post forecast €7,698mnl shortfall, so January figure appears to be generally supportive of this.”

The latest Exchequer results have just run over my correction – given the latest figures and the dynamic of different tax lines deterioration, we are now facing at the very least a ca €8bn shortfall on 2008 figures. Belatedly, some economists are coming to a realization that this indeed is the case (see here and scroll to Niall Says: February 3rd, 2009 at 7:50 pm comment). We are back to that original estimate of mine and things are likely to get even worse from here on, implying today's cuts should have been in the neigbourhood of €4-5bn!

In the end, Brian Cowen has loudly and publicly declared tonight that anyone expecting him to govern this economy out of the recession is a fool. He hasn’t got the balls, he hasn’t got the ideas and he hasn’t got the Cabinet to do the job. Full stop.

Someone, dial Trichet’s private secretary. We will need his money very soon!

P.S. Here is a problem no one noticed for now. If the basket cases Ireland, Greece and Italy are weighing heavily on the reputation of the Euro, then the lack of an immediate adverse reaction to today’s announcement by the bond markets might suggest that the Magnificent Three are now creating a drag on German bunds. In other words, Irish, Greek and Italian mess is now costing real money to German taxpayers through elevated spreads on the bund. I’d venture to say that Mrs Merkel might be a bit concerned about Brian’s economic flops.

S&P's visit: Pints!

S&P gang is in town (hat tip to P.O.) making rounds, sniffing out the need to slam the book on Irish bonds AAA rating. Better late than never, I'd say.

This blog has argued on numerous occasions (here and here) that Irish credit ratings should fall from their current AAA rating to at least AA-/A- levels. In fact, I called for S&P to climb down from its ivory tower of 'Ireland's low public debt...' myth and produce a more realistic assessment of the risks inherent in our borrowings (here).

This, of course, was predicated on:

• Irish Government's exposure to toxic banks debt (here);
• Irish Government's exposure to its own reckless spending (here);
• Irish Government's inability to carry out necessary economic policy adjustments to address the real crises in this economy: corporate and household debt (here), and public sector excessive cost to the rest of the economy (here and here);
• Irish Government's lack of realistic understanding of how economy works (here and here);
• Irish Government's wobbling on various aspects of economic policy (see all the Mushroom Cloud posts in January 2008 archive)...

...and so on. I can go on listing more reasons as to why this is no longer an economy warranting a gold-standard AAA rating, but let me put three facts in front of you:

Fact 1: Despite having (belatedly) recognized the need for some sort of crisis management solutions in July 2008, the Government has yet to produce any realistic plan for dealing with the above problems.

Fact 2: Courtesy of FT (hat tip to B.) there is a self-explanatory chart below (corrected per Anonymous update, the number for Irish bank liabilities should be at 396% of GDP). Of course, those of you who are regular readers would recognize this as something I have written about ages ago (here), but FT's authority helps.
Fact 3: Finally, another chart illustrates the fact that no one in the market actually believes that our bonds offer AAA protection from default.
Pretty conclusive, then? So what's the point of sending a team over to Dubs, S&P? To have a few pints with our BB&M Trio and listen to their assurances that our 'greenish knowledge innovation' errr... economy-thingy is steaming ahead?

To the icebergs, then, Captain Brian!

PS: I am currently working on preparing a comprehensive compendium of comparisons per our debts (across various sectors and maturities) to the rest of the Eurozone, so keep watching the blog...

DofF Forecast: Update I

According to today's reports, the y-o-y tax take in January is down 15% (hat tip to B.).

My personal projection, given the dynamics of 2008 tax intake (remember, Q1 2008 was still positive growth territory and lagged tax revenue was rolling in) is that we are going to finish 2009 with ca 15-17% down on 2008. 2007-2008 decline was 9.4%, implying we are going to collect €34,550-35,380mln in 2009 or a shortfall of up to €7,080mln on 2008 revenue, not €3,898mln as DofF forecast in January. My previous post forecast €7,698mnl shortfall, so January figure appears to be generally supportive of this.

As B. mentioned, this will bring our revenue to 2005 level - 'four years lost' as he puts it. This is about right - fundamentals (productivity, wages, costs inflation) all point to ireland having abandoned growth path around 2003-2004 which means a return - in nominal terms (using Eurozone average inflation rate) - to 2002-2003 levels by the end of 2011 will be mean reverting (with downward overshoot, of course) for underlying growth fundamentals.

P.S. Meanwhile - our Vacuum-Head in Politics Watch has spotted the following idea from Gay Mitchell (FG MEP). Surely, the nation falling off the cliff into an abyss of a severe recession and fiscal insolvency has nothing better to do than engage its MEPs in advocating Gaelic subtitles in cinemas. Too bad Gay's brain power never stretched to imagine watching a French or a German film with Irish and English subtitles littering the same screen. Oh, dear...

European v American Model: Labour and Leisure

Recently, I was invited to adjudicate TCD's Hist annual debate with Yale. It was, as such nights always are, a really great exchange of good-spirited fun and youthful energy. The topic of the debate was the clash of two values systems: the so-called American Model of economic development against the caring social-economy model this side of the Atlantic.

Great fun aside, neither Yale, nor TCD team produced much of earth shattering factual evidence to defend their arguments. Instead, several commonly held cliches, became the focal points fo the entire discourse.

One of these was the argument advanced by the TCD side that Americans enjoy lower quality of life than Europeans because the former work longer hours than the latter. It was frustrating watching the Yale team inventing epicycles to by-pass the thorny issue. In reality they did not have to do this, since the claim is simply not true.

Some years ago I worte about the matter in several articles (see an example here). But all comparisons between the quality of hours spent outside paid work enjoyed by Americans and Europeans are somewhat qualitative. 'Sure, maybe Americans do less own work at home, but what if Europeans actually enjoy house work?' goes an argument from the Eurofans side.

Ok, so Americans do indeed work longer hours than Europeans do. The question then becomes as to why these differences arise? Economics distinguishes two sources of greater aggregate hours worked in any economy:

• the extensive margin - differences in hours worked due to differences in employment and labour force participation rates; and
• the intensive margin - the number of hours worked per person employed.

A paper, published in November 2008 by the German Institute for the Study of Labor (IZA Discussion Paper No 3846, Langot, F. and C. Quintero-Rojas "European vs. American Hours Worked: Assessing the Role of the Extensive and Intensive Margins") shows very interesting results:

• Concerning the impact of the extensive margin, the authors show that "the two dimensions of the extensive margin, the employment rate and the participation rate, explain the most of the total-hours-gap between regions. Moreover, both ratios have similar weight." In other words, Americans work longer hours than Europeans primarily because more Americans than Europeans are in employment and in the labour force. To say that Europeans 'enjoy' less work and more leisure is, according to this finding, equivalent to say that Europeans enjoy being unemployed and having no prospect of ever gaining a job in the future.
  
• "Conversely," say the authors, "the intensive margin, measured by the number of hours worked per employee, has the smallest role."

The paper looks at data for Belgium, Spain, France, Italy, UK and US over 1960-2003. Here are few more details from their findings:

"We observe that in most countries the role of the intensive margin seems to be important before the mid 1970s" [which implies that American workers, on average, tended to work longer hours per person than their European counterparts not in the years of heartless Reganomics, but in the years of liberal Democrats - Kennedy, LBJ and Jimmy 'The Peanut' Carter].

"Thereafter, the contribution of the average hours per employee is very poor... In general, the two dimensions of the extensive margin have a minor impact before the 1970s. Thereafter, in all countries the relevance of the three variables is quite similar." [This shows that consigned to long term unemployment, Europeans are working less since the onset of the 1980s - precisely when Europe decided to depart from the 'American' model of flexible labour markets in favour of the socialist/welfare state model of employment].

And so, "about 2/3 of the observed fall in the total hours of market work in European countries, relative to the US, is mostly explained by the dynamics of the extensive margin (that is, by the employment and the participation), and roughly 1/3 by the dynamics of the intensive margin (the hours worked per employee), particularly after the 1980s."

I rest my case...

DofF Forecast: does it hold any water?

I have a serious question to ask of our Government: Do budgetary projections by the DofF in (e.g those contained in their January 2009 Addendum covered here) hold any water?

In particular, no one has yet taken the DofF forecasters to a task of explaining how on earth, with projected:

• shrinking GDP (-€7.6bn in 2009 in nominal terms relative to 2008) and GNP,
• negative inflation (-1%),
  
• rising unemployment (+2.9 percentage points on 2008) and falling employment (-4%), and
• rising, not falling, Net Current Expenditure (+4.3bn in 2009),
  

does DofF come up with a revenue fall-off of just €3.9bn for 2009 relative to 2008 and total revenue as a percentage of GDP actually rising from 33.6% in 2008 to 33.7% in 2009? (Those of you who are impatient enough, see one potential answer at the end of this post)...

These numbers - the backbone of Irish Government plans for the year - are suspiciously incongruous. Not only because they do not seem to add up. But also because we have no reason to trust DofF forecasts on the basis of their historical accuracy.

Do Government numbers hold up to scrutiny?
This week, it came to media attention that the entire Department of Finance employs only one PhD-level economist. As far as I am aware, we do not know:

1. Where and when did this person obtain her/his degree?
2. Was her/his degree in the field of macroeconomic modeling?
3. Has he/she ever published peer-reviewed research in the areas of taxation and/or macroeconomic forecasting?

In other words, we have no idea how qualified this economist is to carry out macroeconomic forecasting, policy evaluations and risk analysis.

Furthermore, per my knowledge, no one knows who exactly is responsible for supervision and execution of forecasting in DofF and what model is being used. Searching DofF website for Chief Economist reveals no such person. We do not know whether forecasting function is, indeed, an established and managerially resourced function of the Department. Ditto on the Risk Analysis side, which requires both an expert in microeconomic risk modeling and macroeconomic risk specialist.

It is simply not sufficient to say that accountancy or previous budgetary experience, potentially possessed by some DofF employees (how many?) qualifies the Department to deliver any sort of economic analysis or projections. Certainly not the ones which can used by the Government to argue about the need for one reform or another.

In fact, to see the absolute poverty of economic policy research output produced by DofF one should go straight to the source: here. They might as well publish these reports in Gaelic only, for no serious economist would recognize this as proper economics.

One example: in the sole document relating to economic reviews and outlook for 2008, titled Irealnd's Contribution to the Public Consultation Process on the Review of the EU Budget (I am not kidding - they couldn't even spell Ireland correctly). Here, DofF's 'Research' team devotes only 4 pages to the entire analysis of a vital fiscal policy process. The issue of EU-wide tax - something that was a hot topic of debate in Ireland throughout 2007-2008 is given 148 words! Of course, DofF gives five times this much to the discussion of CAP - suggesting, perhaps, our Finance boffins are more comfortable in the cow sheds than in the world of macro-finance and macroeconomics.

Getting basic research wrong - something that is being done by virtually all Irish Government departments on a routine basis - is a serious issue. Brandishing as a major reform a promise to get policies onto an 'evidence-driven' platform, as our Government did last week (see here: 3rd bullet point under Taxation heading), while having no capability to prepare proper economic analysis is hardly a responsible way of governing.

When even the mighty fail by poor research
Few months back, I was sent a research note from PIMCO's cult giant, Bill Gross. Gross is an archetypal salesman, in my view, who has fantastic intuitive understanding of the market (which is way more than our public sector mandarins and politicians have). This is, in most instances, sufficient to earn high rates of return and to contain downside risks.

But, it is not enough to do two things -
(a) provide rigorous analysis of your position in the market at any point in time - past, present, or future; and
(b) explain to others why your intuitive searchlight is capable of picking the right opportunities out of the mass of potential investment strategies.

Published in June 2008 (see here: those of you who attended my class last Fall in TCD's MSc in Finance would recognize it) the note contained a rant about US inflation indices. Specifically, Gross expended some 4 pages of small print arguing that

1. US inflation has been historically higher than measured by the CPI;
2. True US inflation should be much closer to the 'global' average (including such economically stable and developed countries like Venezuela, Indonesia, Brazil, Philippines, Thailand, Columbia, Turkey, Ecuador and Vietnam - out of a sample of 24 countries chosen, seemingly, to deliver Gross' point).
   

All of this led to the following conclusion:
"What are the investment ramifications [of the 'fact' that U.S. inflation is closer to worldwide levels than previously thought]? With global headline inflation now at 7% there is a need for new global investment solutions, a role that PIMCO is more than willing (and able) to provide. In this role we would suggest: 1) Treasury bonds are obviously not to be favored because of their negative (unreal) real yields. 2) U.S. TIPS, while affording headline CPI protection, risk the delusion of an artificially low inflation number as well. 3) On the other hand, commodity-based assets as well as foreign equities whose P/Es are better grounded with local CPI and nominal bond yield comparisons should be excellent candidates. 4) These assets should in turn be denominated in currencies that demonstrate authentic real growth and inflation rates, that while high, at least are credible. 5) Developing, BRIC-like economies are obvious choices for investment dollars."

Lacking:

• serious analysis - Gross tweaked the evidence to support his own premise;
• proper investigation of academic and practitioner research - Gross ignored the fact that several Congressional and academic investigations since the early 1990s have concluded that CPI actually overestimates the true extent of inflation in the US by between 0.5% and 1% pa,

he produced a call to arms for investors that cost PIMCO and those who follow its strategy an arm and a leg. How? Gross' advice - issued in June 2008 -

• has missed a significant H2 2008 rally in Treasuries, Munis and TIPS;
• calling for heavier weighting for commodities-linked economies came at the time of extreme valuations of these economies (e.g Russia and Brazil both have peaked in June-August 2008), before they fell off the cliff in H2 2008;
• led to an unprecedented cancellation of dividends by several PIMCO munis funds - the first time in known history any fund suspended payouts for what is, in effect, a monthly yield-generating securities class.

I do enjoy the fact that, being criticised at the time for arguing against Gross' June note, I did turn out to be right about both his call on inflation (he was concerned with hyper-inflation as the world was teetering on the verge of deflation) and on emerging markets.

Back to DofF numbers
But I am not telling this story with some malice towards Gross or PIMCO in mind. At the very least, the man can spell Ireland better than our DofF boffins can. Instead, I am using it as an illustration as to the importance of proper research in backing any strategy - investment and/or policy-related. PIMCO's operations are much more superior to what is going on in our DofF and the rest of civil service when it comes to the quality of research and analysis. This implies that if people like Gross can get things spectacularly wrong, people that occupy our DofF - quipped with one token PhD level economist - simply have no chance at getting anything right.

Remember their latest numbers:

• shrinking GDP (-€7.6bn relative to 2008),
• negative inflation (-1%),
  
• rising unemployment (+2.9 percentage points on 2008) and falling employment (-4%),
• a revenue fall-off for the Exchequer of just €3.9bn for 2009 relative to 2008, and
  
• a total revenue as a percentage of GDP actually rising from 33.6% in 2008 to 33.7% in 2009

Well, of course to get these things to add up, one has to assume that tax increases passed in the Budget 2009 will not reduce tax revenue. In other words, that the Laffer Curve does not work. We shall see, of course, but empirical studies provide little comfort that such an assumption is a reasonable one. Ditto the numbers on retail spending in the NI and South of the border, SuperQuinn's plan to shut down supermarket located near Newry and loads of anecdotal evidence showing that Irish shoppers are fleeing the Republic for that VAT heaven of NI.

This spells serious trouble for the Government. Suppose that due to increases in the income tax, VAT and other taxes, the revenue were to decline by, say, 2.1% of GDP - as it did in less recessionary 2008. This would imply that tax increases will still be contributing positive revenue growth for the Exchequer, although on a much smaller scale. In such a scenario,

• the net Exchequer borrowing will jump from 6.3% of GDP to 8.4% of GDP,
• the General Government Deficit will rise by €3.8bn in 2009 - from 9.1% of GDP projected by DofF assuming €2bn in savings goes through, to over 12%.

Now, suppose tax increases wipe out any revenue gains by 2010 - the deficit will then rise to above 13% of GDP in 2009 and 15% in 2010.

Add to this the fact that while DofF was basing its numbers on -4% growth rate in GDP for 2009, the economy quite probably will contract by at least 5% - balooning potential deficit to 15-16% this year.

A scary thought, indeed, because even the IMF will not lend Mr Cowen a penny with such financial performance on the plans. So much for Brian, Brian&Mary's 'evidence-based' policies...