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.

21/12/2011: Sunday Times December 18, 2011 article

This is an unedited version of my Sunday Times article for December 18, 2011.

Last week’s EU Summit was billed as offering long-term solutions to the fiscal stability in the euro area and setting out the tools for dealing with the immediate threats. Just a week after the summit, however, the euro zone finds itself in the midst of an ever-deepening crisis once again.

This, of course, is a logical conclusion to the meeting that not only failed to present any new measures, but went on to undermine credibility of the previously deployed solutions, such as the EFSF, the ESM, Private Sector Involvement in bondholders haircuts in Greece, the expanded IMF engagement in lending to the euro zone member states, and the ECB deployment of aggressive quantitative easing programmes.

Let’s take a look at the hard numbers that emerged from the summit.

Post-July 2011 plan was to enhance EFSF lending capacity to €1.5-2 trillion either by raising new funding or by running €500 billion EFSF concurrently with €1 trillion ESM. Post-December summit we have: no increase in EFSF, no concurrent schemes and a vague promise of a €1 trillion target for ESM. This means that the effective lending capacity of the long-term funds in euro zone will be less than one half of what was expected.

That, of course, assumes that EFSF and ESM will carry on borrowing under AAA rating status and that funding markets will be receptive to new issuance of debt. The former is now jeopardized, courtesy of the summit failure, leading to France downgrade. The latter has been under severe questions for weeks now, since the EFSF failed to raise €3 billion in the last auction earlier this month. In fact, things are now so desperate, that this week EFSF was forced to issue 91 days bills. A fund that is lending under 7.5-10 year mandate now runs short term funding schemes that imply a massive maturity mismatch risk.

In order to by-pass ECB’s statutory restriction on financing the member states, for months prior to the December summit, EU leaders were voicing the idea of lending funds to the IMF so that the IMF can re-lend these same funds, leveraged ca 4-5 times back to the euro member states. This too now appears completely out of reach. Following the summit, the US, Canada and Japan stated unequivocally that they will not support targeted funding by the IMF. In addition, Russia, Brazil, China and India have in the past said no to matching euro area loans, meaning that the scheme cannot come into existence as a general fund allocation. Of course, in all the excitement surrounding the Summit, everyone forgot to ask a simple question – where will the EU governments find the said €200 billion if they can’t raise the money to fund the EFSF?

Private sector participation in Greece – the cornerstone of the July and October 2011 summits – was also put to gather dust this week. Firstly, the European Banking Authority clearly stated that efforts to-date to agree such ‘voluntary’ participation have come short of the required target of 90% of foreign bond holders. Secondly, in the 5^th review of Greece’s progress under the lending programmes, the IMF team in Athens concluded that: “There are yet significant risks ahead for the [Greek] authorities’ program, including …the possible failure to agree with creditors on a PSI deal, leading to a non-voluntary outcome.” And furthermore, despite having engaged in planning PSI operations since June 2011, after six months of haggling and planning by the EU, “… the specific details of the operation remain to be finalized …” The sums involved are hardly insignificant. October 26 summit – up to 1/4 of the entire EFSF once banks recapitalization measures are included. Absent full implementation of PSI, Greece will be insolvent vis-à-vis IMF, triggering a mother of all defaults.

Last, but not least, the hopes of the ECB riding into the battle with direct quantitative easing were cindered by Frankfurt. Following the summit, ECB decision makers were quick to state that direct assistance to the member states and expanded bonds purchases were not consistent with the ECB statutes and strategy. Of course, no open market operations – no matter how large – could have been sufficient to deal with the crisis. To-date, ECB balancesheet of loans to sovereigns (via direct purchases of Government bonds) and euro area banks has swollen dangerously close to €1 trillion. And, yet, this had virtually no real long-term effect on the crisis dynamics.

Adding insult to the already grave injuries, the Summit precipitated two new crises in Europe – a political one and an economic one. The former is manifested in the legal problems surrounding formulation, passing and enforcement of the new Fiscal Pact. But these are legal and political problems so let us focus on the economic ones.

Even for the deficit hawk like myself, the Fiscal Pact is equivalent to an economic suicide. The Pact formula of 3%-0.5%-60% is a combination of the already failed Stability and Growth Pact targets enriched with the lethally obscure and totally unattainable 0.5% structural deficit limit.

Between 1990 and 2008 – in other words, before the crisis hit – Ireland was able to satisfy the 0.5% structural deficit target only once in very 10 years, same as Belgium, Germany and the Netherlands. Austria, France, Greece, Italy, Portugal and Spain never once satisfied this criterion. Two best performers in the euro area – Malta and Finland have met the target in 6 out of the 19 pre-crisis years. In terms of 0.5% structural deficit rule, all member states, except Germany will require further austerity measures.

For Ireland, a longer-term expected slowdown in growth over the next 10 years compared to previous two decades will mean that it will be even harder to stick to the target for the structural deficit, as we see reduction in the potential growth rates going forward.

Ireland fared much better as far as the 3% standard deficit goes, satisfying the criteria in all but 1 year. The same does not hold for other euro area states. France has failed to meet the target in more than 5 out of 10 years, as did Spain; Italy in more than 7 in each 10 years; Portugal and Germany more than 4; Greece – never once. And looking forward, under rather rosy IMF September 2011 projections for 2012-2013, Belgium, Cyprus, France, Greece, Ireland, Slovenia and Spain will require even more austerity than already planned to comply with 3% deficit rule.

For Ireland, complying with the 3% rule will require the deepest additional adjustments in the euro area, while complying with the 0.5% structural deficit rule will need second largest adjustment. In fact, this week, Sen. Sean Barrett, a TCD economist proposed a bill that aims to bring about a more open and transparent approach to the public finances and stresses the overall significance of the structural deficits rules for Ireland.

Messrs Kenny and Noonan have signed off on the deal that will be the costliest to Ireland of all other states, disastrous to our economy in its current condition and, given the legal issues surrounding its enforceability for countries not in debt to the Troika, also pretty much useless for the EU at large.

The second point of weakness in the Irish Government position with respect to the new Pact relates to the implicit Government support for the Financial Services Transactions Tax (FSTT). Empirical evidence firmly shows that Tobin-styled taxes in financial services, when effective in reducing the speed and volume of transactions, have to be prohibitively high, impacting more adversely secondary financial services centres, like Dublin IFSC and benefiting offshore locations and jurisdictions that fall outside the new tax net. In summary, Tobin tax can lead to less transparency, more tax evasion and lower economic growth across the EU. James Tobin himself argued against the blanket introduction of his ideas in later years.

By agreeing to the new Pact without as much as voicing a threat of the veto over the FSTT, the Irish Government has signed a long term death warrant to Dublin's competitiveness in front-office international financial services - the highest value added segment of the sector and one of the best performing areas of Irish economy in recent years, including during this crisis.

On the net, as the direct result of the Summit failures, the probability of the Euro zone exits for Greece, Portugal, Ireland and Belgium has risen. At the same time, the sustainability of public finances in Italy, Spain and France is now in doubt as Fiscal Pact is likely to result in a reduction in the potential growth rates for Span and France and no increase in future growth for Italy. Likewise, the probability of Irish fiscal adjustment path must be questioned, especially since the Pact will depress our longer term growth rates, that are already, barring the Pact introduction, less than spectacular.

It is thus, that the Government deficit of leadership has finally contributed to a bitter failure at the EU policy level. Contagion has spread from all matters economics and financial to the heart of politics in Europe.

Box-out:

Breaking up the doom-and-gloom newsflow that dominates our everyday reality, last month’s high level Irish delegation trade visit to Russia, headed by Tanaiste Eamon Gillmore, yielded some encouraging progress on the longer-term bilateral trade and investment policies development front. Since 1976, Irish and Russian authorities have been in somewhat infrequent and irregular dialogues on these issues under the umbrella of the Joint Economic Council. Last month, for the first time ever both sides agreed to set up sector-specific working groups with regular reporting and strict annual targets for deliverables. Given that Irish exports to Russia are set to grow 40% plus this year, having 52% in 2010, while Irish trade surplus with Russia is about to expand by 150% in the last 2 years, this is a truly welcomed development. In 2010, Irish trade surplus with Russia was €465 million ahead of that with China, €352 million ahead of trade balance with India and €119 million greater than the trade surplus with Brazil.