6/9/16: The Pain in Spain: Growth vs Structural Deficits

FocusEconomics have published an interesting research note on Spanish economy. 

The country has been muddling through 

1. An ongoing political crisis - with already two elections failing to produce a Government and the latest failed efforts at forming one last week suggesting there is a third round of voting ahead - and 
2. The long-running fiscal crisis - with the EU Commission initiating series of warnings about Spain's failure to comply with the Fiscal Compact criteria and warning that the country is falling behind on deficit targets

Yet, despite these apparent macro risks, the economy of Spain has been expanding for some time now at the rates that are ahead of its other EURO 4 peers (Germany, France and Italy). 

In a guest post below, FocusEconomics shared their research with Trueeconomics readers:

The Pain in Spain: Robust GDP growth cannot mask the persistent structural deficit

Spain’s robust GDP growth despite the ongoing political impasse has made the headlines time and time again. The panel of 35 analysts we surveyed for this month’s Consensus Forecast expect GDP to expand 2.8% in 2016, one of the fastest rates in the Eurozone this year, before decelerating to 2.1% in 2017. 

And yet both Spain’s Independent Authority for Fiscal Responsibility (Airef) and the European Commission have warned in recent months that Spain is relying too heavily on GDP growth to reduce its deficit while neglecting much-needed progress with structural reforms to reduce its sizeable structural deficit (the part of the overall deficit which is adjusted for temporary measures and cyclical variations). This leaves it vulnerable to its deficit increasing in the future should economic conditions become unfavorable again. 

According to the Airef, without further reforms, a structural deficit of approximately 2.5% will still persist in Spain in 2018. 

Meanwhile, the European Commission predicted in its updated spring forecast that the structural deficit will reach 3.2% that year—well beyond the new 2.1% revised structural deficit target for 2018 (as part of an overall 2.2% deficit target) that it recently announced in July. Spain’s general government deficit is the sum of the deficits of the central government, the regional governments, the local authorities and the social security system, and most of the overshoot is expected to come from the underperformance of the regional governments and social security. Spain has gradually been reducing its overall general government deficit in recent years, albeit not at the speed stipulated by the European Commission, but it is the persistence of the structural part of the deficit that is the main cause for concern.

After deciding last month to waive the budgetary fine on Spain for missing its targets, the European Commission set a new series of targets up until 2018 in order finally to bring Spain’s overall deficit below the long-targeted 3% that year. In 2016 it expects Spain to meet an overall general government deficit target of 4.6%, not more than 3.1% of which is expected to be a structural deficit. This is in line with the European Commission’s updated spring forecast for the country, since it has decided not to impose additional adjustment requirements on Spain this year (attributing this in part to the fact that lower-than-expected inflation, which is out of the government’s control, has hindered deficit reduction efforts this year). In 2017 and 2018, however, the Spanish government will have to implement structural reforms to make savings equivalent to 0.5% of GDP each year to bring its structural deficit down to 2.6% in 2017 (as part of an overall deficit target of 3.1% that year) and 2.1% in 2018 (as part of an overall deficit target of 2.2%). Achieving this will require a strong government able to press ahead with a reform program—something which currently looks rather a panacea. Spain’s ongoing failure to form a new government since the first inconclusive elections in December last year may not have impacted the current resilience of its GDP growth, but it certainly puts its fiscal compliance in jeopardy and prolongs the structural problems of its economy.

The agenda ahead is tight. Under the Spanish Constitution, 1 October is the deadline for the government to present its proposed 2017 budget to the Spanish Parliament. And under the EU’s rules, the European Commission must receive the budget (which must, of course, indicate how Spain will meet the required 2017 targets) by 15 October, or Spain faces a fine. Spain is still struggling to form a government after two elections in the last nine months and looks highly unlikely to have a new government in place by October that is able to push through a budget with the requisite reforms. Mariano Rajoy, who heads the current caretaker Popular Party (PP) government and is seeking to be sworn in as prime minister again, failed to garner sufficient support at both his first investiture attempt on 31 August (for which he would have needed an absolute majority in his favor) and his second attempt on 2 September (at which a simple majority would have sufficed). He might have another attempt at being appointed after the regional elections in the Basque Country and Galicia at the end of September if by chance the circumstances look more favorable by then, but otherwise Spain will probably be going to the polls again on 25 December, in what would be an unprecedented event. Even if a new government is formed by some miracle, it looks highly likely to be a weak one that might not manage to last long, let alone implement a convincing reform program.

Click on the image to enlarge

A closer look at the political turmoil

Spanish parties are simply not used to formal coalition politics at central government level, and don’t seem to be willing to adapt to the times in a hurry. Since 1982, either one or other of the two main parties, the conservative PP and the Socialist Party (PSOE), had always managed to form either a majority government or alternatively a strong minority government, in the latter case achieving working majorities by striking mutually beneficial deals with regionally-based nationalist parties—especially in the Basque Country and Catalonia—to secure their support in the Spanish Parliament (a classic case of “I’ll scratch your back if you scratch mine”). Neither party was prepared for two quite successful newcomers—the populist left-wing Podemos (“We Can”) and the centre-right Citizens party (C’s)—coming along to break up their longstanding dominance, at the same time as the pro-independence wave in Catalonia makes reviving the traditional mutual support arrangements with the Catalan nationalist parties impossible. 

The re-run elections held on 26 June have so far simply resulted in another stalemate. The PP won again and this time managed to increase its seats from 123 to 137, but it still fell far short of an absolute majority of seats (176) in Spain’s Parliament. The only plausible option for Rajoy in the circumstances is to form a minority government, since both the PSOE and C’s ruled out the possibility Rajoy had initially advocated of a “grand coalition” comprising the PP, the PSOE and potentially C’s too—an option which market participants had considered the most likely to deliver the structural reforms Spain needs, but which would not have provided the “government of change” that so many Spanish citizens voting for new parties seek. Rajoy had managed to reach an agreement with C’s (32 seats) for it to support his investiture attempts on 31 August and 2 September, as well as the commitment of the one MP from the Canary Coalition (CC) to do the same, but he failed to secure the 11 abstentions he would also have needed to be voted in on the second attempt with a simple majority. This would have required some of the PP’s arch rival the PSOE to abstain, and PSOE leader Pedro Sánchez remains absolutely adamant that his party will continue to vote against Rajoy instead. Sánchez is in a weak position since the PSOE declined at the re-run elections and is under pressure from Unidos Podemos (an electoral coalition between Podemos, the United Left party and some other smaller left-wing forces), so he is not in a strong position to try and form a government himself, but he does not want to lose yet more voters to Unidos Podemos by being seen to allow or to prop up a conservative government either. It looks like only an internal crisis within the PSOE could possibly change the circumstances.

There is an outside chance that Rajoy could attempt an investiture vote again after the Basque regional elections on 25 September, if it looks like he might be more likely to get the Basque Nationalist Party (PNV)—which has 5 seats in the Spanish Parliament—on board then, to continue to boost his numbers and up the pressure on the PSOE to deliver the final few abstentions. The only plausible circumstance in which the PP might stand any chance of getting the PNV on side is if, after the Basque regional elections, the PNV itself finds it needs the PP’s support to be able to govern in the Basque region. This is not totally beyond the realm of possibility, since the PNV is likely to win the Basque elections with a minority of votes and could struggle to form a working majority, especially if its traditional ally, the Basque Socialist party (PSE)—the Basque federation of the PSOE—declines as expected amid the rise of Podemos, which could potentially build alliances with other left-wing forces including the Basque anticapitalist and secessionist EH Bildu coalition of parties. Podemos is proving particularly attractive in the Basque Country (and Catalonia too) given that it is the first Spanish party to support the idea of self-determination for Spain’s constituent territories. Indeed, the PNV itself, a traditionally centre-right party which is struggling to attract the younger generations of Basque voters, is far from immune to the risk of losing some of its voters to the populist party: at the Spanish general election re-run in June, it was significant that Unidos Podemos beat the PNV not only in terms of votes but also seats in the PNV’s traditional Basque stronghold of the province of Vizcaya (one of the three provinces making up the Basque region). In these changing circumstances, the PNV could possibly end up needing the support of the PP in the Basque Parliament in order to govern, which would inevitably require it to return the favour in the Spanish Parliament, but this is only one of various possible outcomes at this stage and the PNV certainly looks highly unlikely to contemplate this option as anything but a very last resort.  

Summing up

Overall, the political impasse thus looks set to continue for the foreseeable future—though if we’re looking for silver linings, at least Spain’s nearly nine-month hiatus is still nowhere near Belgium’s 2011 record of 19 months without a government. Spain faces unprecedented challenges as it undergoes a fundamental political transformation stemming from the widespread disillusionment with existing political institutions and actors and the emergence of new players, not to mention the territorial crisis due to the Catalan challenge to the integrity of the Spanish state. While Spain’s GDP growth has remained remarkably resilient in recent quarters, there is no room for complacency. The country’s persistent structural deficit—which cannot be effectively addressed during the current political deadlock—still renders its economy particularly vulnerable to future changes in economic climate and puts the country on a collision path with Brussels over the required fiscal consolidation trajectory. 

Author: Caroline Gray, Senior Economics Editor, FocusEconomics

29/5/2012: Quick note on Structural Deficits and Growth

Per someone request: can growth result in larger structural deficit?

Answer is yes, it can. Here's how.

Equation 1:
Structural Deficit = Total Government Deficit -- Cyclical Deficit -- One-off Measures

(One-off Measures are emergency spending, one-off banks recaps etc)

So Structural Deficit = Government Deficit that would have prevailed if economy operated at 'full employment' (full capacity)

What is Cyclical Deficit in the above?
Equation 2:
Cyclical Deficit = Output Gap * Elasticity of Fiscal Balance
where
Output Gap = Potential (Full-Employment) Output of Economy -- Actual (realised) Output of Economy
Output Gap is expressed in % terms difference.
Elasticity of Fiscal Balance = 0.38-0.4 for Ireland and captures the percentage change in (Government expenditure net of Government revenue) per 1% change in output gap. DofF estimates this to be 0.4 and EU Commission estimates it to be 0.38 for Ireland.

Thus, from Equation 2 above:
Equation 3:
Cyclical Deficit  = [Potential GDP -- Actual GDP]*0.38     
for EU Commission, or replacing 0.38 with 0.4 above gets you approximation for DofF model.

Now, economic growth can happen at the point above 'Full Employment', in which case Output Gap will be negative, as potential GDP will exceed actual GDP, giving positive output gap - consistent with economy overheating.

Alternatively it can happen at 'Below Full Employment', so that output gap is negative (economy growing without overheating).

If growth happens when economy is overheating, in the equations above, cyclical deficit becomes positive, in other words, there is actual deficit. If it is happening in the economy that is not overheating, then cyclical deficit is negative, so there is cyclical surplus.

Now's for an interesting bit: both the EU Commission and the DofF estimate that in 2014, despite the fact that we are expected to run double-digit unemployment, Irish economy will be technically in 'overheating' or 'above full-employment' mode. This explains why even with shallow growth, in 2015 Ireland is still forecast to run 3.5% structural deficit (DofF forecast, which is ahead of 2.5% structural deficit forecast for the same year by the IMF).

In other words, if we hike growth even more, in 2015 over and above currently assumed by the DofF, so that our output gap will rise by 1% in 2015, this will result in an increase in Cyclical Deficit of 0.4%. This will result in subtracting a larger negative number in computation of Structural Deficit in the first equation above, thus increasing Structural Deficit.

In other words, if growth happens when economy is considered 'overheating' and that growth does not increase potential output of the economy, but only transient output, then such growth will increase, not decrease Structural Deficit, unless the state somehow taxes entire growth*0.4 out of the economy and does not spend the collected amounts. This can be done if we were to run a cash-based sovereign wealth fund that will not invest any of its proceeds back into the economy.

Logic? Who said economics supposed to have real world logic? Not me...

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 1/20^th 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 1/20^th 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.

CHARTS:

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.

4/5/2012: Sunday Times - 29/4/2012: Fiscal Compact

My Sunday Times article from April 29, 2012 (unedited version).

When first published, the Fiscal Compact (formally known as the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union) was billed as a ground-breaking exercise in European legislative activism. The main innovation of the treaty was not its content (which largely regurgitates already existent fiscal constraints established under the Maastricht Treaty), but its compact size and designed-to-be-digestible language.

Few months down the road, and the Fiscal Compact has become a subject to numerous conflicting claims and interpretations, thanks to both side of the referendum debate in Ireland. Mythology that surrounds the Fiscal Compact is impressively wide and growing. The fog of politicised sloganeering and scaremongering on the ‘Yes’ side is well matched by the clouds of emotive and quasi-economic nonsense from the ‘No’ camp.

The main alleged problem with the Compact is that its core rules – the 60% debt/GDP limit for Government borrowings, the 1/20 adjustment rule for dealing with excess public debt, the 3% deficit ceiling and the 0.5% structural deficit break – amount to prohibiting of the Keynesian economic policies in the future. This argument is commonly advanced by the Fiscal Compact opponents and implies that in the future crises, Ireland will not be able to use stimulative Government spending to support its economy.

In practice, however, Fiscal Compact restricts, but not eliminates the room for deficit financing. In the current economic conditions, under full compliance with the deficit rules, Irish Government would have been able to run a deficit of at least 2.97% of GDP – much lower than 8.6% targeted under Budget 2012, but close to 3.2% deficit forecast for 2012 for the euro area.

Far from ‘killing Keynesianism’, the Fiscal Compact induces in the longer run fiscal policies that are consistent with Keynesian economics. Any state that wants to secure a ‘fiscal stimulus’ cushion for future crises should accumulate surplus resources during the times of economic expansions, not rely on the goodwill of the bond markets to supply debt financing to the Governments when their economies begin to tank.

The treaty does limit significantly the state capacity to accumulate debt in the future. In the long run, debt to GDP ratio should converge to the ratio of average deficits to the long-term growth potential. Based on IMF projections, our structural deficit for 2014-2017 will average over 2.7% of GDP, which implies Fiscal Pact-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 36-40% of GDP. Although no one expects (or requires) Ireland to draw down our public debt to these levels any time soon, over decades, this is the level we will be heading toward if we are to comply with the Fiscal Compact rules.

On the ‘Yes’ side, the biggest myth concerning the Fiscal Compact is that adopting the treaty will ensure that no more fiscal crises the likes of which we have experienced since 2008 will befall this state.

In reality, the collapse of exchequer finances in Ireland has been driven by a number of factors, completely outside the matters covered by the Fiscal Compact.

Firstly, significant proportion of our 2008-2011 deficits arises from the state response to the banking sector implosion and closely correlated property sector collapse. The latter was also a primary driver for the decline in tax revenues. The former was a policy choice. Thirdly, our deficits were driven not just by the fiscal performance itself, but also by the unsustainable nature of our government spending and taxation policies. For example, during the boom, Irish Governments consistently acted to increase automatic payments relating to unemployment and social welfare financed on the back of tax revenues windfall from property transactions. Property revenues collapse coincident with increases in unemployment has led to an explosion of unfunded state liabilities.

None of these shocks could have been offset or compensated for by the Fiscal Compact-mandated measures. In fact, during the 2000-2007 period, Irish Governments’ fiscal stance, on the surface, was well ahead of the Fiscal Compact requirements. Ireland satisfied EU Fiscal Compact bound on structural deficits in all years between 2000 and 2007, with exception of two. Of course, in all but one year over the same period, we also failed to satisfy the very same bound if we were to use the IMF-estimated structural deficits in place of those estimated by the EU, but that simply attests to the difficulty of pinning down the exact value of the potential GDP, required to estimate structural deficits. We also satisfied EU-mandated debt break in every year between 2000 and 2008. In fact, between 2000 and 2007 our debt to GDP ratio was below 40% - the benchmark consistent with long-term compliance with the Fiscal Compact. More than fulfilling the requirement for a 3% maximum Government deficit, Irish Exchequer run an average annual net surplus of 1.97% of GDP, accumulating 2000-2007 period surpluses of €11.3 billion and the NPRF reserves which peaked in Q3 2007 at €21.3 billion.

In short, the Fiscal Compact is not a panacea to our current crisis, nor is it a prevention tool capable of automatically correcting future imbalances, especially given the difficulty of forecasting future sources of risk.

Instead, Ireland needs a combination of institutional reforms to enhance our domestic capacity to identify points of rising risks and to deploy policies that can address these risks in advance. A flexible and highly responsive early warning system, such as a truly independent Fiscal Advisory Council, coupled with reformed Civil Service, aiming at achieving real excellence and accountability within the key Departments and regulatory offices can help. Furthermore, abandonment of the consensus-focused systems of governance, eliminating the expenditure-centric Social Partnership and the Dail whip system, and reformed legislative and executive systems to increase the robustness of the checks and balances on local and central authorities, are needed to develop capacity to respond to emerging future crises. Legal reforms, to address the imbalances of power of the vested groups, such as bondholders or state monopolists, vis-à-vis the taxpayers, are required to prevent future bailouts of private and semi-state enterprises at the expense of the Exchequer. Local authorities reforms are required to ensure that the madness of over-development and land speculation do not build up to a systemic crisis. Taxation reforms are needed to stabilize future revenues and develop an economically sustainable tax system.

The Fiscal Compact is a wrong policy for all of the above because it risks creating a confidence trap, which can replace or displace other reforms. It represents a wrong set of objectives, as it diverts state attention from considering the nature of underlying imbalances. It also re-directs much of the fiscal responsibility away from Irish authorities, potentially amplifying the reality gap between the real economy and the decision-makers. By endlessly blaming Europe for tying Government’s hands, the Compact will continue building up voters’ perception disenfranchisement, fueling stronger local political orientation toward parochialism and narrow interests representation, while alienating voters from European institutions.

In short, the Compact is not an end to the politics as usual. This, perhaps, explains why no independent analyst or politician is prepared to vote in favour of the new Treaty except under the threat of the Blackmail Clause contained not in the Fiscal Compact itself, but in the forthcoming ESM Treaty and which requires accession to the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union as a pre-condition for gaining access to the ESM funds. Not exactly a moment of glory for either Europe or Ireland.

  

Box-out:

By now, we have become accustomed to the endless repetition of the boisterous claims that the continued declines in Government bond yields since mid-2011 signal the return of the markets confidence in Ireland. Alas, based on the last two months worth of data, things are not exactly going swimmingly for this school of thought. Based on weekly data, Irish benchmark 9-year bond yields spreads over Germany have contracted sharply in year on year terms, falling on average 1.30 percentage points since March 1, 2012 and 1.26 percentage points in April. The former is the second best performance in the euro zone after Italy, and the latter marks the third best performance after Italy and Portugal. Alas, weekly changes have been much less impressive. Since March 1, our yields have actually risen, in weekly terms, with an average rate of increase of 0.02 percentage points. For the month of April, the same metric stands at 0.05 percentage points. The same performance pressure on Ireland is building up in the Credit Default Swaps markets, with our 5 year benchmark CDS spreads declining just 0.24 percentage points compared to Portugal’s 5.2 percentage points drop since a month ago. Overall, European CDS and sovereign bonds markets are now signalling the exhaustion of the positive momentum from the December 2011 and February 2012 LTROs. Ireland’s bonds and CDS are no exception to this rule, suggesting that the ‘special relationship’ that we allegedly enjoy with the markets might be now over.

4/5/2012: Irish Examiner 26/4/2012: Is there an alternative to austerity?

This an unedited version of my article that appeared in the Irish Examiner, April 26, 2012.

However one interprets the core parameters of the fiscal discipline to be imposed under the Fiscal Compact, several facts concerning the new treaty and Ireland’s position with respect to it are indisputable. Firstly, the new treaty will restrict the scope for future exchequer deficits. Combined structural and general deficit targets to be imposed imply a maximum deficit of 2.9-3.0 percent in 2012 as opposed to the IMF-projected general government net borrowing of 8.5% of GDP. Secondly, it will impose a severe long-term debt ceiling, but that condition will not be satisfied by Ireland any time before 2030 or even later.

At the same time, 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 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.

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, 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.

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 of 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.

Despite the already deep austerity, 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. Put differently, 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. 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 exports-driven economy of Ireland 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.

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 to 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. The latter is the choice to continue reducing our imports-intensive domestic 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. Both choices are painful and short-term recessionary, but only the latter one leads to future growth. The former choice 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.

26/4/2012: One interesting point on Fiscal Compact 1/20 rule

One interesting point on Fiscal Compact, folks. The 1/20th adjustment rule has been interpreted widely as the rule requiring states with debt/GDp ratio in excess of 60% to reduce their debt levels by 1/20th of the gap between their existent debt level and the 60% bound. However, the Treaty itself states: "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). In other words, there is a big gap between interpretation and reality.

Hat-tip for this discovery goes to Peter Mathews, TD.

Say, Ireland's debt/GDP ratio peaks at 120% GDP (I am rounding up the actual forecasts here). Under 'interpreted' adjustment mechanism, we would be expected to reduce the overall debt by 1/20th of 120% minus 60% or by 3% of GDP in year one. Under the actual Treaty, we are expected to reduce it by 1/20th of 120% or 6% of GDP in year one. Say our GDP is 175 billion in that year. Under interpreted rule, we have to find €5.25 billion to reduce debt levels, under actual Treaty language, we are expected to come up with €10.5 billion. To put this into perspective, the average level of gross investment in the Irish economy is forecast by the IMF to be around 10%pa between 2012 and 2017 or ca €17.5 billion under above assumptions. This means that the Fiscal Compact adjustment path would take out 60 percent of the entire annual investment in the economy. That is hardly a chop-change of a difference.


Updated: Thanks to Prof Karl Whelan for pointing this:

Applying the 1/20^th to the full amount is not consistent with the Treaty.

Article 4 ...makes reference to  “as provided for in Article 2 of Council Regulation (EC) No. 1467/97 of 7 July 1997 on speeding up and clarifying the implementation of the excessive deficit procedure, as amended by Council Regulation (EU) No. 1177/2011 of 8 November 2011”

And Regulation 1177/2011 states: “When it exceeds the reference value, the ratio of the government debt to gross domestic product (GDP) shall be considered sufficiently diminishing and approaching the reference value at a satisfactory pace in accordance with point (b) of Article 126(2) TFEU if the differential with respect to the reference value has decreased over the previous three years at an average rate of one twentieth per year as a benchmark, based on changes over the last three years for which the data is available.”

http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2011:306:0033:0040:EN:PDF

So it’s the gap to 60%.

25/3/2012: Irish GDP and Structural Deficits - forecasting unpredictable?

The pitfalls of forecasting Irish GDP and structural deficit in handy charts...

First - the range of forecasts and outruns for annual GDP growth in constant prices:

Not only the range of forecasts is wide (exclude the 2008-2009 period for obvious reasons), but what is worse is that there is virtually no agreement within the WEO database on past rates of growth. For example, take year 2000:

• WEO September 2011 claims 2000 saw growth of 9.298%
• WEO April 2011 and September 2010 state it was 9.665%
• WEO April 2010 and October 2009 claimed it was 9.447%
• WEO April 2009 and October 2008 set it at 9.237%
• WEO April 2008 at 9.15%
• WEOOctober 2007 at 9.1%
• WEOApril 2007 reported it to be 9.4%
• WEOOctober 2006 and April 2006 showed 9.2%

So which is the real growth rate, then? And how long do we need to wait to confirm it? Of course, much of the above is due to referencing to different prices bases - in other words, inflation 'target' changes' but you do get the point - even past rates are changing over time, implying the difficulty of actually comparing past performance.

Meanwhile, the range of forecasts is outright massively all over the place. Take this year forecasts (and we exclude the fact that between WEO database releases twice a year, we have intermediate updated forecasts published in separate documents without actually updating the database. So back in 2009 the IMF predicted 2012 rate of growth to be 2.325% to 2.337% (April-October versions). By April 2010 it was 2.306% and by October 2010 it was 2.446%. InApril 2011 the forecast for 2012 was revised to 1.908% and in September 2011 it was revised to 1.484%. So much for planning: the range over just 1.5 years is 2.446% to 1.484%.

Structural deficits - the reverse is true. Forecasts are tighter (as potential GDP assumes away cyclical effects) and outrun estimates are all over the place instead:

There is also a strangely strong correlation between conservative estimates of the structural deficits and the average estimates of the structural deficit and the IMF reported and forecast GDP growth rates. In other words, the models used by the IMF appear to produce more consistent lower end deficit estimates.

Which, of course, begs a question. You see, per IMF, Ireland's structural deficits were on average and at the minimum levels strongly outside the fiscal sustainability in 2000-2006 and well outside the Fiscal Compact bound of -0.5%. Over the same period of time, EUCommission reported structural deficits were actually within the parameter bounds for Fiscal Compact. Given that the IMF min and average estimates closely reflect the growth estimates and reported outruns, it appears that the IMF metric is probably a more reasonable reflection of the fiscal realities than that of the EUCommission.

Which is not exactly the great news for the Fiscal Compact as far as the treaty expected ability to achieve any real impact on fiscal discipline goes.