Sunday, October 31, 2010

Economics 31/10/10: €15bn in cuts will not be enough

This is an unedited version of my article in yesterday's Irish Examiner.

The last three days have seen dramatic volatility and extreme upward pressures on Irish, as well as Greek and Portuguese Government bonds. Briefly, early on Thursday morning, Irish 10 year bonds have set a new all-time record with yields reaching North of 7.07%. Much of these changes have been driven by the budgetary news from all three countries.

First, Greece and Portugal have shown the signs of increasing uncertainty about projected tax revenues and ability to deliver on ambitious austerity programmes.

Then, Ireland came into the line of fire.

Back in December 2009, the Government outlined a plan for piecemeal cuts in deficits over 2011-2014 that added up to a gross value of €6.5 billion (with at least €3 billion in tax measures). This was supposed to get us from having to borrow €18.8 billion in 2010 to a deficit of ca €9 billion in 2014. All courtesy of robust economic growth of more than 4% per annum penned into the Department of Finance rosy assumptions for 2011-2014.

This week, the Minister for Finance had to come down from the lofty heights of the “now you see the deficit, now your don’t” estimates by his Department. Courtesy of continuously expanding unemployment, declining tax revenues, plus ever-growing interest bills on Government debts, the headline gross savings target for 2011-2014 has been increased to €15 billion.

Dramatic as it might be, this figure is still far from being realistic – the fact that did not escape the bond vigilantes and some analysts. More than that, it represents the very conservative ethos of the Department of Finance and the Government that got us into a situation where three years into the crisis Ireland is still light years away from actually doing anything serious about correcting its fiscal position.

Let me explain.

First of all, take the actual announced plans for cuts in public spending. Over two months ago I have argued in the media that to get us onto the track toward reaching the goal of 3% to GDP deficit ratio, we need ca €7 billion in cuts in 2011, followed by €5 billion in 2012. The grand total of gross deficit reductions from now through 2014 adjusting for the effects of these cuts on our GDP and unemployment, plus steeper cost of financing Government debt, excluding new demand for funding from the banks is not the €15 billion, but €19-20 billion. In other words, once fiscal stabilizers (automatic clawbacks on Government spending) are added in, to achieve 3% target requires more than 33% deeper cuts than Minister Lenihan announced this Wednesday.

The markets know this. Just as they know that given the Government record to date there is very little chance that even €15 billion in cuts will be delivered. This mistrust in Government’s capacity to actually administer its own prescription is manifested most explicitly by the Croke Park agreement that effectively put one third of the current public expenditure out of reach of Mr Lenihan’s axe. It is further highlighted by the fact that this Government has failed to
substantially reduce public spending bills from 2008 through today. Back in 2008, net government spending stood at €55.7 billion. This year, we are likely to post a reduction of just €2.4 billion on 2008, all of which is accounted for by cuts in capital investment programmes.

Third, the markets also understand long-term implications of deficits. Even if the Irish Government manages to bring 2014 deficit close to 3% target, our Sovereign debt will grow by over €5 billion in that year. At this pace, Irish Exchequer is likely to be on the hook for a debt to GDP ratio of 125% by the end of 2014 reaching over 140% if expected additional banks liabilities materialise in 2011-2014. And all of this after we account for Mr Lenihan’s €15 billion cuts planned for 2011-2014.

Fourth, Government budgetary arithmetic falls further apart when one considers economics of the proposed deficit reduction measures. So far, the Government has planned for €3 billion increase in taxes on top of tax revenues gains due to rosy economy growth expectations between now and 2014. €15 billion target announcement raises this most likely 2-fold.

I have severe doubts that this economy has capacity left for tax revenue increases. Signs are, households are struggling with personal debts and their disposable after-tax incomes are barely sufficient to cover day-to-day spending. Credit card debts and utilities arrears are rising, savings are falling – all of which points to growing stress. Weakening sterling is pushing more retail sales out into the North just in time for Christmas shopping season. Cash economy – judging by
anecdotal evidence and corporate tax revenue in light of booming exports sectors – is expanding. The tax base is shrinking due to unemployment, underemployment and falling earnings.

Again, any rational investor will look at this as the evidence that the Government has run out of capacity to tax itself out of the fiscal corner.

But wait, this is only half of the story. The other half relates to the banking side of consumer affairs. In 2011 we can expect significant increases in mortgages costs as Irish banks once more go rummaging through the proverbial couch in search for a new injection of pennies. Bank of Ireland’s bond placing this week, with a yield of 5.4%, suggests a bleak future for lending markets. Any increases in mortgages costs will hike Government expenditure (by raising the cost of interest subsidies), hammer revenues (by reducing household consumption) and trigger new demands from banks for capital (to cover defaulting mortgages).

None of which, of course, appears to be attracting much attention from the Upper Merrion Street. At least judging by the budgetary projections released so far. At the same time, these numbers are impacting our long term growth potential and increasing the probability that Ireland, in the end, will have to restructure its public debt.

This week, similarly brutal arithmetic concerning Greek fiscal situation has prompted Professor Nouriel Roubini to make a dire prediction of the inevitable default by Greece on its Sovereign debt. Given Minister Lenihan’s recent statements and his boss’ staunch unwillingness to scrap the Croke Park agreement, it is hard to see how the forthcoming budgetary framework for 2011-2014 can get us out a similar predicament.


Dublinurbanite said...

Excellent article.

Anonymous said...

Thanks again for your excellent analysis

jjsalmo said...

An excellent article which once again exposes the breath taking ignorance not say to folly of our 'Government' and Dept of Finance. The real growth in the economy will most likely not exceed 2% annually and that's being generous. Based on that, the long term debt position will get progressively worse compounded by increasing unemployment and a consequent lower tax take. Like it or not debt restructuring and write off at a sovereign and personal level is the only option left. Better that we swallow our pride and accept that we now need to access the ECB rescue fund than continue this death spiral. This morning our our borrowing costs hit 7.29%, the markets so beloved of Lenihan et al have spoken...You've got no bloody clothes Minister

Ed said...

Good analysis.
Will Ireland (and Europe and US economies) follow the Japanese example of long term deflation over the next 2 decades? Their government increased spending, lowered interest rates and printed money, but people kept on saving and the domestic economy kept on shrinking, even if exports increased. Maybe the bursting of their housing bubble is an indication of where we are heading?
Keep up the goof work.