26/02/2012: What happens when debt is too high and taxes are distortionary?

An interesting paper: Public Debt, Distortionary Taxation, and Monetary Policy by Alessandro Piergallini and Giorgio Rodano from February 7, 2012 (CEIS WorkingPaper No. 220 ).

In traditional literature, starting with Leeper’s (1991):

• if fiscal policy is passive (so that it simply focuses on a guaranteed / constitutionally or legislatively mandated public debt stabilization irrespectively of the inflation path), 
• then monetary policy can independently be set to focus solely on inflation targeting (ECB) ignoring real economy objectives, such as, for example, unemployment and growth targeting. 

The twin separate objectives of fiscal and monetary policy can be delivered by following the Taylor principle. This means if the monetary authorities observe an upward rise in inflation, they can hike nominal interest rates by greater proportion than the rise in inflation. This is feasible, because in the traditional setting, fiscal policy objective of sustaining public debt at stable levels can be achieved - in theory - by raising non-distortionary taxes that are not linked to inflation (for example, distortionary VAT and sales taxes yield revenues that are linked to inflation, so monetary policy to reduce inflation will lead to reduced economic activity and reduced revenues for the Government at the same time; in contrast, non-distortionary lump sum taxes yield fixed revenue no matter what income or price level applies, so that anti-inflationary increase in the interest rates is not going to have any impact on tax revenue).

Of course, if fiscal policy is active (does not focus on debt stabilization), monetary policy under Taylor rule should be passive (so interest rates hikes should of smaller percentage than inflationary spike). Such passive monetary policy will allow Governments to inflate their tax revenues without raising rates of distortionary taxation and

In many real world environments Governments, however, can only finance public expenditures by levying distortionary taxes (progressive taxation). So in this environment, the question is - what happens to the 'passive fiscal - active monetary' policies mix? According to Piergallini and Rodano, "It is demonstrated that households’ market participation constraints and Laffer-type effects can render passive fiscal policies unfeasible. For any given target inflation rate, there exists a threshold level of public debt beyond which monetary policy independence is no longer possible. In such circumstances, the dynamics of public debt can be controlled only by means of higher inflation tax revenues: inflation dynamics in line with the fiscal theory of the price level must take place in order for macroeconomic stability to be guaranteed. Otherwise, to preserve inflation control around the steady state by following the Taylor principle, monetary policy must target a higher inflation rate."

Ok, what does this mean? It means that if you want passive rules (public debt targeting - e.g. fiscal compact EU is trying to legislate) you need inflation (to transfer funds to the Government from the private individuals and companies).

Per authors: "The analytical results derived in this paper give theoretical support to the argument recently advanced by Cochrane (2011) and Davig, Leeper and Walker (2011) that the large fiscal deficits decided by governments to offset the crisis can lead to the “Laffer limit” beyond which inflation must endogenously jump up according to the fiscal theory of the price level."

Now, we often hear the arguments that in the near term there will be no inflation as slow growth will prevent prices from rising. Sure, folks. Good luck with that.

11/02/2012: Globe & Mail 9/02/2012

Here's the link to my latest article for Economy Lab with Canada's Globe & Mail.

6/2/2012: Fiscal Compact Treaty - Sunday Times 05/02/2012

This is an unedited version of my Sunday Times article from February 5, 2012.

In medical analogy terms, this week’s Fiscal Pact signed by the 25 EU Member States, is equivalent to a misdiagnosed patient (the euro area economy) receiving a potent cocktail of misprescribed medicines.

In other words, the Fiscal Pact is neither a necessary, nor a sufficient solution to the ongoing crisis of the euro area insolvency. Moreover, it saddles the euro area with a choice of only two equally unpalatable alternatives. The first choice is compliance with the Pact that will lead to a situation whereby a one-policy-fits-all monetary framework will be coupled with an equally mismatched one-policy-fits-all fiscal framework. The second choice is business as usual, with continued reckless borrowing, internal and external imbalances and ever deepening links between the sovereign finances, the ECB and the banking sector balancesheets. In other words, there is a choice of either pushing Euro area down the deflationary, stagnation-inducing deleveraging spiral, or leaving it in the current modus operandi of reckless borrowing.

Both alternatives are internecine for Ireland, and both increase the probability of an eventual collapse of the euro over the next 5-10 years.

Suppose the EU member states, opt for the first alternative. As a whole, to comply with the Pact parameters, the Euro area economy will have to shrink by some €535-540 billion every year between now and 2020 – an equivalent of reducing euro area growth by a massive 3.9% annually. Just for the purpose of comparison, during the 2009 recession, Euro area experienced a real decline of overall income of 4.25%.

Ireland will be one of the worst impacted economies in the group courtesy of our excessively high structural deficits, debt to GDP ratio and cyclical deficits. In 2012, Ireland is forecast to post a structural deficit in excess of 5.5% of potential GDP – the highest structural deficit in the entire Euro area. To cut our structural deficit to 0.5% will require reducing annual aggregate demand in the economy by some  €7-8 billion in today’s terms. Debt reductions over the period envisioned within the pact will take an additional €12 billion annually. For an economy with huge private sector debt overhang, paying some 12% of its GDP annually to adhere to the Fiscal Pact is a hefty bill on top of the already massive interest bill on public debt.

Ireland’s fiscal performance under the Fiscal pact constraints, 2012

Sources: author estimates based on the combination of data from the Department of Finance, Budget 2012, IMF World Economic Outlook database, and author own forecasts

Crucially, the idea of the Fiscal Pact as a tool for resolving the structural crisis faced by the Euro area is equivalent to doing more of the same and expecting a different outcome.

The crisis arose because the Euro area combined vastly heterogeneous and complex economies under a one-policy-fits-all monetary umbrella. This has meant that no matter what policy the ECB pursued, interest rates and money supply will never be in synch with all economies within the Euro. The modern economic theory suggests that fiscal transfers can act as automatic stabilizers, correcting for monetary policy disequilibrium.

In European case, this theory is a pipe dream. Firstly, fiscal transfers cannot happen with the same timing as monetary policy changes, especially given the bureaucratic nature of the EU and its institutions’ detachment from the member states’ realities. Take one example – Ireland and other euro areas have been experiencing severe unemployment problems since 2009. Yet, only this week did the EU wake up to the problem and thus far, there are no tangible plans for dealing with it. Automatic stabilizer of fiscal policy will never be timely and responsive enough to undo damages caused by the unsuitable monetary policy. Secondly, fiscal transfers are an imperfect substitute for private sector adjustments to dislocations that monetary policy generates. No need to go beyond the current crisis to see this with aggressive monetary policy interventions since 2008 yielding not an ounce of real economic impact on the ground. Which means that the theoretical stabilizers are not really that effective in stabilizing the economic disruptions caused by monetary policy misfiring. Lastly, neither the current Pact, nor any other institutional arrangements within the Union provide for any automatic fiscal transfers.

Yet, when it comes to the penalties that apply to member states breaching the Pact conditions the new agreement are automatic and very tangible. This imbalance – with the Pact being all stick and no carrot – risks destabilizing economic systems struggling with shocks.

Take for example a country like Ireland. Suppose ECB policy in the future leads to high interest rates – a scenario consistent with the current monetary policy developments. This would imply that our terms of trade will deteriorate, reducing our exports and driving our economy into an external deficit. Simultaneously, slowdown in the economy will put pressures on our fiscal balance. This deterioration will not be consistent with a cyclical recession, implying that we are likely to simultaneously breach the twin deficits targets under the Fiscal Pact, triggering automatic penalties. Economy brought to its knees by the monetary policy mismatch will be forced to pay additional price through fiscal penalties.

In other words, the Pact is now attempting to create another policy system that will risk further detaching fiscal policies within the Euro area from the monetary policy.

When it comes to dealing with the current crisis, the new Pact contains no tools for achieving structural reforms required to arrive at sustainable public finances. Paying down the debts and cutting back deficits requires simultaneously running surpluses on the Exchequer side and the current account side. In other words, both external and internal surpluses must be achieved simultaneously. As international research shows, the likelihood of any state moving from long-term external imbalances to a sustainable current account surplus is extremely low.

Matters are worse when it comes to both fiscal and external balances. My own research based on the Euro area data shows that during 1990-2008, only two euro countries – Finland and Malta – have complied with the Fiscal pact criteria more than 50% of the time. The rest of the member states, including Germany and France, have run sustained deficits more than 60% of the time. Once a euro state found itself stuck in twin current and fiscal deficits in one decade (the 1990s), transitioning to a twin current account and fiscal surplus in the next decade (the 2000s) was virtually impossible. For example of all states in EA17 who were in current account deficit throughout the 1990s, only 2 have managed to achieve current account surpluses during the following decade. Only one country that experienced fiscal deficits in the 1990s has managed to generate fiscal surpluses over the following decade. No country has been successful in restoring fiscal and external balances after a decade of twin deficits.

The Fiscal Pact implies even less flexibility in adopting structural reforms necessary to achieve an already highly unlikely economic transition to the long-term sustainability path for many euro area states, including Ireland.

Consider for example two economies currently in a crisis – Ireland and Portugal. Portugal requires severe and substantial cuts in all public spending and then deep reforms in the private sectors of its economy. The country does not need a debt restructuring, but it needs huge capital injections to put it onto the path of capital investment convergence with the euro area average.

In contrast, Ireland needs restructuring of the private sector debts, deep reforms on the current expenditure side of the Irish exchequer, and more gradual reforms in the private sectors. Ireland has a functional exports generating economy, it has achieved current account surpluses on external side and balance on its Government spending side in the past. During the adjustment, Ireland needs structural reductions in the current spending best timed to start concurrently with the pick up in private sector jobs creation to offset adverse effects of these reforms on the most vulnerable – the unemployed. Ireland also needs to boost its after tax returns to human capital in the medium term – something that Portugal has no need for at this point in time.

There is nothing within the Pact that would facilitate either Portuguese or Irish economic stabilization and recovery. Neither will the Pact improve the chances of Spain, Belgium and Italy ever reaching real growth paths that imply sustainability of fiscal and external balances. In short, the Pact our Government so eagerly subscribed to is at the very best a continuation of the status quo. At its worst, Ireland and other member states of the Euro are now participants to a fiscal suicide pact, having previously signed up to a monetary straightjacket as well.

Box-out:

Last two weeks marked two significant milestones on Ireland’s economic performance front. Despite the adverse newsflow on the real economy side, Irish bond yields for 5 year bonds have dipped below 6% mark last week for the first time since the beginning of the crisis. This week, spreads on the 5 year Credit Default Swaps (the cost of insuring Irish bonds) also fell below 6% mark. For the first time since the crisis began our implied cumulative probability of default (CPD) – the probability that the Irish Government will default on its debt at some point over the next 5 years has touched 40%, down from over 46% at the end of 2011. Although the CPD is a mechanical function of CDS yields and not a statistical estimate of the true risk of the Government default, the CPD is an important metric for the markets. The significant decline in our CDS spreads this week, was prompted by the Irish banks buying into longer maturity bonds in the recent NTMA-led bond swap, plus the overall improving sentiment for sovereign debt in the euro area markets. The later itself was driven by the artificial forces, such as the ECB extending €497 billion to the banks in 3 year money. Nonetheless, our bond yields and CDS spreads declines are starting to show some improvement in overall markets risk-pricing for the Irish Government debt – a much needed stabilization and a moment of respite from the relentless crisis dynamics of the recent past.