31/12/2013: Debt and Growth: Consumption Crowding-Out Channel

Since the overhyped and outright hysterical 'controversy' over the Reinhart & Rogoff debt thesis blew up across the media earlier this year (I covered much of the controversy on the blog and in my columns, for example, here http://trueeconomics.blogspot.ie/2013/07/272013-village-june-2013-real-effects.html), it became - to put it mildly - unfashionable to reference the adverse effects of debt on growth and economy. Too bad, some economists seem to have missed that point.

A new study from the Korea Institute for International Economic Policy, titled "Nonlinear Effects of Government Debt on Private Consumption in OECD Countries" (see citation below) looked at "nonlinear effects of government debt on private consumption in 16 OECD countries. The estimated consumption function shows smooth regime switching depending on the debt-to-GDP ratio, and the threshold level of regime switching is found to be the ratio of 83.7 percent. The results reveal that a higher level of government debt crowds out private consumption to a greater extent, and that the degree of the crowding out effect has deteriorated since the global financial crisis."

Wait, there are thresholds here… 83.7% debt/GDP ratio - very close to the  S. Cecchetti, M. Mohanty and F. Zampolli thresholds (see http://trueeconomics.blogspot.ie/2011/09/26092011-irelands-debt-overhang.html). And there is the 'causal link' between debt and growth via crowding out of private consumption.

18/12/2011: Ballyhea & Charleville Protest Against the Bailouts

This weekend I was honored to be a guest of a group of real patriots of our country - a group of extraordinary people who over 40 weeks, one Sunday after another, take their families and friends into the streets of Ballyhea and Charleville to protest against the injustice of the banks bondholders bailouts.

It is a remarkable group of people - coming from all walks of life, united not by an ideology or by a vested interest, but by the knowledge that what is being done to our country behind the veil of the banking crisis is simply wrong. It is wrong on a multitude of levels - ranging from ethics to politics to economics to social justice. The people behind this protest are also united by their concerns for the future of Ireland, for the rising wave of emigration, for the simple fact that our country capacity to recover from this crisis is being destroyed for the sake of rescuing a handful of institutional bondholders.

I felt truly honored - and there can be no other word to describe it - to have been asked to speak to these courageous people last night, to share a delightful pint and a long conversation with them, and to march alongside them today.

Here are a couple of pictures from the march.

The group run a website listing all bonds coming due for repayment, called bondwatchireland.blogspot.com and a Facebook page for their events (link here). These are, in my view, a must to follow for anyone concerned with what has been happening in Ireland over the last 3 years.

07/11/2011: Sunday Times, Nov 06, 2011

This an unedited version of my article for Sunday Times, Nov 06, 2011 edition.

In a recent research paper titled “The real effects of debt” Bank for International Settlements researchers, S. Cecchetti, M. Mohanty and F. Zampolli provide analysis of the long-term effects of debt on future growth. The authors use a sample of 18 OECD countries, not including Ireland, for the period of 1980-2010 and conclude that “for government debt, the threshold [beyond which public debt becomes damaging to the economy] is in the range of 80 to 100% of GDP”. The implication is that “countries with high debt must act quickly and decisively to address their fiscal problems.” Furthermore, “when corporate debt goes beyond 90% of GDP, [the] results suggest that it becomes a drag on growth. And for household debt, … a threshold [is] around 85% of GDP.”

Thus, combined private non-financial and public debt in excess of ca 255% of GDP exerts a long-term drag on future growth even in the benign environment of the Age of Great Moderation, the period from the mid-1990s through 2007, when low inflation and cost of capital have spurred above-average global growth.

The period under consideration in the study, was also the period when Baby Boom generation was at its prime productive age, when rapid expansion of ICT drove productivity in manufacturing and services, and innovations in logistics revolutionized retailing (the so-called Wal-Mart effects).

And yet, despite all the positive push forces lifting the growth rates the negative pull force of building debt overhang was still visible. Euro area economies have posted average growth rates of 2.0% per annum in 1991-2007, well below less indebted group of smaller advanced economies that posted average annual growth of over 4.2%.

From the Irish perspective, these impacts of debt overhang on long-term growth present a clear warning. Ireland’s robust growth in the 1990s and through 2007 represent not a long-term norm, but a delayed catching up with the rest of the advanced economies. In other words, even disregarding the negative effects of the severe debt overhang we experience today, Ireland’s average growth rates in the foreseeable future will be close to the average growth for smaller open economies in the euro area. That rate, according to the IMF latest forecasts, is unlikely to be significantly above 2.0%.

But Ireland’s debt overhang, when it comes to debt that matters – i.e. debt analyzed by Cecchetti, Mohanty and Zampolli – is beyond severe. It is outright extreme. Across the 18 advanced economies, average real economic debts weighted by the economies’ size stood at 307% of GDP at the end of 2010 and are expected to rise to ca 310-312% of GDP or GNP. Ireland’s real economy debt to GDP ratio is likely to reach above 415% of GDP and, more importantly, 490% of GNP. (Chart below)

According to the Bank for International Settlements econometric model, the above overhang can be expected to reduce Irish GDP growth by ca 0.7 percentage points over the long run, implying that our long term potential growth rate rests somewhere closer to 1.3-1.4% per annum on average.

At these rates of growth, our Government debt repayments, even if the entire pool of Irish bonds were financed at the lowest currently available rates – the EFSF 3.3% – Ireland nation debt financing will be consuming the entire surplus generated by economic growth.

This issue frames the entire discourse about the ‘green shoots’ allegedly emerging on Ireland’s economy landscape.

In October, according to the NCB Purchasing Index Irish manufacturing sector moved back into growth territory. The headline index, however, came in at an anaemic 50.1 (index above 50 mark signaling growth). Crucially, jobs prospects continued to deteriorate with sub-index for employment standing at 47.1. New exports orders – the leading indicator of our exports-led ‘recovery’ still underwater at 49.8. Profit margins for Irish manufacturing firms continued to contract for the 32^nd consecutive month.

Even our much celebrated trade data is starting to flash warning signs. In August – the latest period for which trade statistics are available – seasonally-adjusted trade surplus was a hefty €3,699 million. This figure represents a year-on-year decrease of 1.3%. Given this trend, in annual terms, for eight months through August 2011, Irish trade surplus is running at 0.5% below 2010 result.

Per latest IMF projections, in 2012-2016, Irish current account surpluses are expected to average 1.38% of GDP per annum. Despite unprecedented collapse in imports, fuelling trade growth does require new debt financing and imports of inputs. Small open economies’ average forecast for the euro area is 1.94% over the same period. In other words, less indebted countries of the euro area are expected to generate greater current external surpluses than more indebted Ireland. Get the point? Debt overhang can hold back even exports-led recoveries.

The debt overhang is now also exposing the underlying weaknesses in the Exchequer fiscal adjustments. Lack of consumer demand, investment, and the resultant implosion of domestic economy are now driving the state finances deeper into the red despite massive capital spending cuts and sizeable tax increases over the last three years. The latest tax receipts show that in 10 months through October 2011, income tax receipts are behind the budgetary target by 1.2%, VAT -4.5%, corporation tax -4.2%. Adjusting for the hit-and-run pensions levy, year on year tax Exchequer deficit is down just €155 million. Fuelled by stubbornly high unemployment and lack of any real reforms in public finances, voted current exchequer expenditure is up from €33,662 million in 10 months to October 2010 to €34,450 million for the same period this year.

All indications so far are that the second half 2011 growth will once again post a nominal GNP contraction and quite possibly the same for nominal GDP.

Courtesy of overburdened households and companies, Irish economy is now stuck in a quick sand of a balance sheet recession, which risks becoming a full-blown decades-long stagnation. Even our greatest hope – improving competitiveness – is being threatened by debt. Again, referring to the latest data, despite the past gains, Ireland remains the least competitive 'old' euro area economy. Ireland has competitiveness gap of 34.7% compared to Germany and 14.7% compared to euro area as measured by differences between our harmonized competitiveness indicators. This gap will be virtually impossible to close, as the gains in competitiveness to-date have been driven primarily by jobs destruction and earnings declines. Cutting even deeper into earnings by raising taxes and/or reducing employment costs will either risk destabilizing even more our sick banking sector or will require cuts in taxes to compensate for disposable income losses.

To summarize, there is no hope of growing out of the debt crisis we face when the expected growth this economy can achieve in the next decade or so is roughly ten times smaller than the debt repayments we have to finance for the combined public and private non-financial debt. Once we rule out sovereign debt restructuring, the only solution to our crisis will require reducing the private sector debt overhang.

Box-out:

This week, European Financial Stabilization Fund postponed placement of €3 billion new bonds that were earmarked to provide new funding for Ireland under the Troika agreement. The funds are critical to our repayment of the €4.39 billion in Government bonds maturing November 11. While no one expects the Government to fall short on bonds redemption, the delay in raising EFSF funds is worrisome from the broader Euro area perspective. The hopes of leveraging the EFSF from its current €440 billion lending capacity to €1 trillion or more have hit a number of snags in recent days with all BRIC countries, the G20, the UK and Japan all suggesting that they will be unwilling to invest in EFSF leveraging on the basis of the terms implied by the current arrangements. The suspension of the latest issue, coming on foot of the original plans for 3.3% coupon pricing of the new and much smaller debt further extends concerns about the EFSF ability to leverage up. The EFSF leveraging is designed to provide cover for sovereign bonds of Italy and Spain, as well as for some limited capital supports to the euro area banking sector. If the EFSF cannot issue unlevered bonds at 3.3%, the implied commercial rates for levered EFSF issuance can be somewhere North of 5.25%. Costs and even the shallowest of the margins will push the effective lending rate to the member states to above 5.5%. Yet, at these rates, Italy’s sovereign financial imbalances cannot be sustained, regardless of whether the country deficit is 5% or 2%. Ditto for Portugal, and Greece, and Ireland. In other words, there’s not a snowball’s chance in hell the latest EU proposal for leveraging EFSF will work, given this week’s fiasco.

Economics 27/8/10: Manifesto I (?)

I will continue posting on this and will aggregate all ideas in my Long Term blog, with a banner link on my main page as well. All suggestions welcomed & will be published, some will make it to the list as well (as always - with proper attribution). So engage with me on this one!


Given the current market and economic conditions and the dire lack of credible economic policies (from any political party) aimed at moving Irish economy out of the combination of:

• deeply rooted crisis in public finances;
• structural collapse of the banking sector;
• stratospherically high and increasingly long-term unemployment levels;
• lack of significant gains in competitiveness (not limited to the area of wages competitiveness, but including basic utilities costs, and costs of living and doing business relating to state-controlled sectors);
• malfunctioning markets for provision of domestic services - dominated and restricted by the excessive market power of the incumbent state-owned and state-regulated oligopolies;
• a clear predominance of policy measures that are designed to saddle ordinary families and individuals (consumers and taxpayers) with the full cost of stabilizing vested interests and elites (manifesting themselves in rising tax burden, falling provision of public services, lack of reforms in banking and public sectors); and
• continued devastation of private entrepreneurship and businesses, contracting investment and lack of confidence in the future of the economy and broader social progress

it is now time to ask:
Is Ireland's electorate ready for an alternative political and popular movement that would put the interests of consumers and taxpayers at the top of governance and policy agenda?

Irish democracy cannot be surrendered to the vested interests, no matter how broadly-based, and elites (no matter how meritocratic or mobile they might be).

The current crisis has clearly shown that the corporatist state - where a group of vested interests colludes with the Government and state structures to set economic and social parameters for development priorities - is morally, politically and economically bankrupt.

The only two ways forward from this status quo are

• a generations-long and exceptionally deep crisis of stagnation and declining standards of living, or
  
• a path of structural reforms aimed at realigning the current political system to serve the interests of consumers and taxpayers - aka - the ordinary citizens and residents of this land.
  

Such a reform can only be achieved by creation of a radically different alternative to the existent structures. A new popular movement can champion the rights of consumers and taxpayers to counterbalance existent system that promotes the interests of the vested pressure groups and elites.

It is therefore, clear to me that at this point in time Ireland is on the cusp of either opting for change or electing to undertake decade (if not decades) long descent into the nightmare of economic stagnation.

In my view, the agenda of such a movement should include the following reforms:

1) Banking reforms:

• Banks should be recapitalized following Swedish model (imposing haircuts/equity swaps on bond holders; accepting correct amounts of writedowns; equity taking by the State in the name of taxpayers; equity to be held in a Trust for individual taxpayers until disbursal; at disbursal - equity sales proceeds to be rebated, net of cost to the taxpayers)
  
• Nama to be reversed
• Anglo Irish Bank and INBS to be shut down and their liabilities and assets to be wound up within 5 years
  
• All banks boards and senior management teams replaced within 3 months
• All banks middle management teams reassessed and rebuilt within 12 months
  
• FDIC insurance scheme to be set up for the future needs of the sector
  
• No future bailouts constitutional amendment to be put to a referendum to prevent a possibility of any future calls on taxpayers wealth from any private sector firm
  

2) Fiscal reforms:

• Flat tax to be enacted on all incomes (preliminary estimates suggest 15-17% tax rate) with no discretionary deductions, but a generous upfront deduction of 1/2 of the median wage to be made available to all earners, plus 1/5 median wage deduction per child.
  
• Provision of strong (current level -10%), but life-time capped welfare provisions. Life-time cap will allow any able bodied adult in the country to have access to a cumulative maximum of 7 years of welfare provisions over their life time. Provision of welfare supports to those unable to work due to health or family circumstances (e.g caring for the disabled relative etc) to continue without life-time limits.
  
• Strong support for the disabled and the elderly must continue
• Wages for politicians and all senior servants earnings are to be tied to the National Disposable Income (NDI) on per capita basis (pcNDI): Taoiseach=3.5 times pcNDI; Ministers=3 times pcNDI; senior civil servants=max 2.7 times pcNDI; TDs/Senators=2.5 times pcNDI and so on. If the country earns more in disposable income, then those running it should get a reward, otherwise, they will automatically bear the same burden as the rest of economy. No bonuses to be allowed and all pensions to be converted to Defined Contribution plans.
  
• Benchmark Government spending to 35% of GDP, with emergency spending not to exceed 37% of GDP in any given year, and a balanced budget over every 3 year period. This allows for small emergency spending boosts in recessions, but prevents spending sprees in elections etc
  
• All quangoes, except those with immediate independent oversight authority (e.g FR and Competition Authority) are to be abolished and their functions transferred to respective departments. Responsibility for governance and management must rest with the executive branch of the state - i.e. Government.
• There should be no taxation without representation - self-employed individuals who are fully tax compliant should have access to same unemployment benefits as anyone else.
• Tax system should be fully reformed to simplify existent taxation and ensure full compliance. This will include, in addition to the flat income tax - abolition of all indirect charges and taxes, other than direct user fees which will be fully ring-fenced to provide revenue necessary to maintain specific service (e.g. bin charges, water rates etc). VRT will be abolished. Any excise taxes will be set at a level required solely to support provision of services directly associated with the underlying consumption charged. For example, petrol levy will apply only to the amount required to support environmental programme related to CO2 abatement and improvement of the environment. It will not be allocated into the general budget. There will be a fully transparent tax on land values (LVT), but not a property tax. The revenue from LVT will be split 50:50 between central & local authorities and local authorities will be allowed a discretion to vary their rate of LVT within reasonable parameters. For example, if LVT is levied at 1% pa, then local authority can be allowed to charge between 0.25% and 0.5% as it deems suitable, while the central government will collect 0.5%. CGT and CAT will be abolished for all investments held for 5 years or longer to encourage longer term savings and investment.
  

3) Governance reforms:

• Core change to the Government model will be transparency and accountability based on automatic systems of disclosure and control that are not subject to tampering by individual ministers/politicians or civil servants
  
• Transparency: all state data/decisions/discussions not subject to secrecy of the state considerations will be published on the web and made accessible free of charge to all residents of the state. Commercially sensitive data will be published with exclusion of sensitive information and identifiers, until the time when it can be published in full. All data requested under FOI will be released free of charge to the requestee and will be automatically published also on the public web portal to remove any need for future FOI requests
• Accountability: performance and productivity metrics will be designed for all branches of public sector and wages and earnings in the public sector will be tied into these.
  
• Any attempts by public employees or office holders to undermine the principles of transparency and accountability in dealing with the public will be punished on the basis of publicly available procedures. All disciplinary actions against aforementioned employees or office holders will be made publicly available.
• Local authorities will be reformed, reducing the overall number of local authorities to 7, covering: West & North West, South, Greater Cork, Greater Dublin, Greater Limerick, Greater Galway and Border & Midlands.
• Seanad will be reformed (subject to referendum) to give it real powers of the upper chamber comparable to the US Senate. It will be elected directly by the people of Ireland, with equal representation of 5 senators from each of the 7 geographic region outlined above.
• Dail will be reformed - there will be no expenses, no additional pay for work in special committees (every TD will be required, subject to seniority to carry such work as a part of their duties). The number of TDs will be reduced to roughly 2/3rd of the current. TDs will be entitled to a defined contribution pension top up to their existent private pensions with the state matching 1:1 every euro they put into their pension.
• Members of the cabinet will have no drivers, state cars and there will be no Government jet. Members of the cabinet will qualify for a car allowance equivalent to €10,000 per annum. All members of the Oireachtas and Government traveling on official business will be reimbursed only to the full cost of the ticket for economy flight on any flight under 5 hours of length and business class for flights of longer duration. No employee of the State will be entitled to any travel reimbursement in excess of an economy class ticket.
  
• No member of the Oireachtas or employee of the state will be exempt from any of the standard tax codes or laws of this land. There can be no privilege for the servants of the public that the public itself cannot claim.
• All state purchasing will be carried on-line, made public and transparent.
  
• State will purchase services, such as health care, care for the elderly, disabled etc for those who cannot afford them, but the State will not own service providers. Instead, public companies will be mutualized or privatized and forced to compete directly for the custom of the people. Transition to such an arrangement will require significant reforms, but also support for current employees in training them in running a private/mutual/non-profit etc enterprises. This support will be provided.
• Higher education will be fees-based, with fees set by universities and overseen by the Department for Education. The State will set up (with participation of charities and other private agencies) a number of funds that will administer financial aid to students based on need (with an objective of creating an equal opportunity for all qualified students to undertake studies) as well as merit (with an objective of rewarding real achievement).

In the name of sanity, I should pause for now. I will continue posting on this and will aggregate all ideas in my Long Term blog, with a banner link on my main page as well.

All suggestions welcomed & will be published, some will make it to the list as well (as always - with proper attribution). So engage with me on this one!