Monday, December 5, 2011

5/12/2011: Sunday Times, December 4, 2011

For those of you who missed it - here is an unedited version of my article for Sunday Times, December 4, 2011.

Comes Monday and Tuesday, the Government will announce yet another one of the series of its austerity budgets. Loaded with direct and indirect taxation measures and cuts to middle class benefits, Budget 2012 is unlikely to deliver the reforms required to restore Irish public finances to a sustainable path. Nor will Budget 2012 usher a new area of improved Irish economic competitiveness. Instead, the new Budget is simply going to be a continuation of the failed hit-and-run policies of the past, with no real structural reforms in sight.

Structural reforms, however, are a must, if Ireland were to achieve sustainable growth and stabilize, if not reverse, our massive insolvency problem. And these reforms must be launched through the budgetary process that puts forward an agenda for leadership.

Firstly, Budgetary arithmetic must be based on realistic economic growth assumptions, not the make-believe numbers plucked out of the thin air by the Department for Finance. Secondly, budgetary strategy should aim for hard targets for institutional and systemic improvements in Irish economic competitiveness, not the artificial targets for debt/deficit dynamics.

Let’s take a look at the macroeconomic parameters framing the Budget. The latest ESRI projections for growth – released this week – envision GDP growth of 0.9% and GNP decline of -0.3% in 2012. Exports growth is projected at 4.7% in 2012, consumption to fall 1.5% and investment by 2.3%. Domestic drivers of the economy are forecast to fall much less in 2012 than in 2011 due to unknown supportive forces. This is despite the fact that the ESRI projects deepening contraction in government expenditure from -3% in 2011 to -4% in 2012. ESRI numbers are virtually identical to those from the latest OECD forecasts, which show GDP growing by 1.0% in 2012, but exports of goods and services expanding by 3.3%. OECD is rather less pessimistic on domestic consumption, projecting 2012 decline of just 0.5%, but more pessimistic on investment, predicting gross fixed capital formation to shrink 2.7%.

In my view, both forecasts are erring on optimistic side. Looking at the trends in external demand, my expectation is for exports growing at 2.9-3.2% in 2012, and imports expanding at the same rate. The reason for this is that I expect significant slowdown in public sector purchasing across Europe, impacting adversely ICT, capital goods, and pharmaceutical and medical devices sectors. On consumption and investment side, declines of -1.5-1.75% and -4-4.5% are more likely. Households hit by twin forces of declining disposable incomes, rising VAT and better retail margins North of the border are likely to cut back even more on buying larger ticket items in the Republic. All in, my forecast in the more stressed scenario is for GDP to contract at ca 0.6% and GNP to fall by 1.7% in 2012. Even under most benign forecast assumptions, GDP is unlikely to grow by more that 0.3% next year, with GNP contracting by 0.5%.

Under the four-year plan Troika agreement, the projected average rate of growth for GDP between 2012 and 2015 was assumed to be 3.1% per annum. Under the latest pre-Budget Department of Finance projections, the same rate of growth is assumed to average 2.5% per annum. My forecasts suggest closer to 1.5% annual average growth rate – the same forecast I suggested for the period of 2010-2015 in these same pages back in May 2010.

Using my most benign scenario, 2015 general government deficit is likely to come in at just above 4.0%, assuming the Government sticks to its spending and taxation targets. Meanwhile, General Government Debt to GDP ratio will rise to closer to 120% of GDP in 2015 and including NAMA liabilities still expected to be outstanding at the time, to ca 130% of GDP.

In brief, even short-term forecast changes have a dramatic effect on sustainability of our fiscal path.

Yes, the Irish economy is deteriorating in all short-term growth indicators. The latest retail figures for October, released this week show that relative to pre-crisis peak, core retail sales are now down 16% in volume terms and 21% in value terms. In the first half 2011, nominal gross fixed capital formation in the Irish economy fell 15% on H1 2010 levels and is now down 38% on pre-crisis peak in H1 2007. And exports, though still growing, are slowing down relative to imports. Ireland’s trade balance expanded 5% in H1 2011 on H1 2010, less than one fifth of the rate of growth achieved a year before. More ominously, using data through August this year, Ireland’s exports growth was outpaced by that of Greece and Spain. Ireland’s exporting performance is not as much of a miracle as the EU Commissioners and our own Government paint it to be.

However, longer-term budgetary sustainability rests upon just one thing – a long-term future growth based on comparative advantages in skills, institutions and specialization, as well as entrepreneurship and accumulation of human and physical capital. Sadly, the years of economic policy of hit-and-run budgetary measures are taking their toll when it comes to our institutional competitiveness.

This year, Ireland sunk to a 25th place in Economic Freedom of the World rankings, down from the average 5-7th place rankings achieved in 1995-2007. In particular, Ireland ranks poorly in terms of the size of Government in overall economy, and the quality of our legal systems, property rights and regulatory environments. The index is widely used by multinational companies and institutional investors in determining which countries can be the best hosts for FDI and equity investments.

In World Bank Ease of Doing Business rankings, we score on par with African countries in getting access to electricity (90th place in the world), registering property (81st in the world), and enforcing contracts (62nd in the world). We rank 27th in dealing with construction permits and 21st ease of trading across borders. Even in the area of entrepreneurship, Ireland is ranked 13th in the world, down from 9th last year. This ranking is still the highest in the euro area, but, according to the World Bank data, it takes on average 13 times longer in Ireland to register a functional business than in New Zealand. The cost of registering business here amounts to ca 0.4% of income per capita; in Denmark it is zero. In the majority of the categories surveyed in the World Bank rankings, Ireland shows no institutional quality improvements since 2008, despite the fact that many such improvements can reduce costs to the state.

I wrote on numerous occasions before that despite all the talk about fiscal austerity, Irish Exchequer voted current expenditure continues to rise year on year. Given that this segment of public spending, unlike capital expenditure, exerts a negative drag on future growth potential in the economy, it is clear that Government’s propensity to preserve current expenditure allocations is a strategy that bleeds our economy’s future to pay for short-term benefits and public sector wages and pensions.

Similarly, the new tax policy approach – enacted since the Budget 2009 – amounts to a wholesale destruction of any comparative advantage Ireland had before the crisis in terms of attracting, retaining and incentivising domestic investment in human capital. Continuously rising income taxes on middle class and higher earners, along with escalating cost of living, especially in the areas where the Irish State has control over prices, and a host of complicated charges and levies are now actively contributing to the erosion of our competitiveness. Improvements in labour costs competitiveness are now running into the brick wall of tax-induced deterioration in the households’ ability to pay for basic mortgages and costs of living in Ireland. Year on year, average hourly earnings are now up in Financial, Insurance and Real Estate services (+3.1%) primarily due to IFSC skills crunch, unchanged in Industry, and Information and Communications, and down just 2.6% in Professional, Scientific and Technical categories. In some areas, such as software engineering and development, and biotechnology and high-tech research and consulting, unfilled positions remain open or being filled by foreign workers as skills shortages continue.

By all indications to-date Budget 2012 will be another failed opportunity to start addressing the rapidly widening policy reforms gap. Institutional capital and physical investment neglect is likely to continue for another year, absent serious reforms. In the light of some five years of the Governments sitting on their hands when it comes to improving Ireland’s institutional environments for competitiveness, it is the Coalition set serious targets for 2012-2013 to achieve gains in Ireland’s international rankings in areas relating to entrepreneurship, economic freedom and quality of business regulation.


Amidst the calls for the ECB to become a lender of last resort for the imploding euro zone, it is worth taking some stock as to what ECB balance sheet currently looks like on the assets side. As of this week, ECB’s Securities Market Programme under which the Central Bank buys sovereign bonds in the primary and secondary markets holds some €200 billion worth of sovereign debt from across the euro area. Banks lending is running at €265 billion under the Main Refinancing Operations and €397 billion under the Long-Term Refinancing Operations facilities. Covered Bonds Purchasing Programmes 1 and 2 are now ramped up to €60 billion and climbing. All in, the ECB holds some €922 billion worth of assets – the level of lending into the euro area economy that, combined with EFSF and IMF lending to peripheral states takes emergency funding to the euro system well in excess of €1.5 trillion. Clearly, this level of intervention has not been enough to stop euro monetary system from crumbling. This puts into perspective the task at hand. Based on recently announced emergency IMF lending programmes aimed at euro area member states, IMF capacity to lend to the euro area periphery is capped at around €210 billion. The EFSF agreement, assuming the fund is able to raise cash in the current markets, is likely to see additional €400-450 billion in firepower made available to the governments. That means the last four months of robust haggling over the crisis resolutions measures between all euro zone partners has produced an uplift on the common currency block ‘firepower’ that is less than a half of what already has been deployed by the ECB and IMF. Somewhere, somehow, someone will have to default big time to make the latest numbers work as an effective crisis resolution tool.

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