Economics 9/10/10: Facing the Budget

This is an unedited version of my column in Business & Finance magazine for October 2010.

James Carville famously remarked that: "I used to think if there was reincarnation, I want to come back as a president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody."

Three years into financial, fiscal and growth crises, Ireland’s continued lack of progress in resolving our long term fiscal deficits has finally caught up with our policymakers. Since mid August, the bond markets have been breathing the fear of fundamentals.

Make no mistake, all the talk about ‘ridiculously high’ bond yields on Irish sovereign debt, foreign analysts errors and conspiracy theories according to which a number of home grown academics have colluded with international media to play down Irish success story are nothing more than saber rattling. Damaging to our internal process of shaping the correct policies and disastrous to our external reputation, these claims have no foundation in the reality.

The facts that inform, at least in part, market assessment of our sovereign bond risks, are simple. After three years of struggling with deficits, Ireland is once again facing an Exchequer shortfall in excess of 11% of our GDP this year. Even ex-banks recapitalization measures, we are the worst performing country in the Eurozone in terms of fiscal balances two years in a row. With banks support measures counted in, we will post the worst peace-time fiscal deficit in the history of Europe.

More than that, looking forward, we are facing a daunting task of brining our deficits down to 5.3-5.9 percent of GDP by 2015. Repeated promises by our Finance officials and politicians to cut deficit to 2.9% by 2014 are now firmly relegated to the realm of fiction.

Combining Department of Finance, IMF and my own forecasts (which fall closer to those of IMF), the expected deficit path for Irish Exchequer through 2011-2015 is shown in the table below.


In difference with our official forecasts, IMF predicts Ireland’s 2014 deficit to reach 5.3% of our GDP based on May 2010 estimates for economic growth and absent accounting for the latest banks recapitalization costs. Adjusting this path to reflect stickier unemployment and lower growth (both across GDP and GNP) as consistent with IMF revisions of global economic growth forecasts since May 2010 yields the expected exchequer deficit of 5.99% of GDP for 2014.

Equally important is a steeper debt curve that is factored in the above projections courtesy of higher cost of financing, cumulated banks and NAMA losses and lower growth. By my estimates, total state liabilities, inclusive of Nama and banks recapitalization measures, will reach 127% by 2013. The risk to these numbers is to the upside.

These estimates have some serious implications to the pricing of Irish debt in the markets.

In August IMF published research (WP/10/184) titled "Fiscal Deficits, Public Debt, and Sovereign Bond Yields" which provides analysis "of the impact of fiscal deficits and public debt on long-term interest rates during 1980–2008, taking into account a wide range of country-specific factors” for 31 economies.

The paper finds that “higher deficits and public debt lead to a significant increase in long-term interest rates, with the precise magnitude dependent on initial fiscal, institutional and other structural conditions, as well as spillovers from global financial markets. Taking into account these factors suggests that large fiscal deficits and public debts are likely to put substantial upward pressures on sovereign bond yields in many advanced economies over the medium term. …An increase in the fiscal deficit of 1 percent of GDP was seen to raise real yields by about 30–34 basis points."

By the above numbers, Irish bonds currently should be yielding over 7.5% in real terms, not 6.5% we've seen so far. This puts into perspective the statements about 'ridiculously high' yields being observed today.

If we add to this relationship the effect of change in our public debt position plus a risk premium over Germany (+180bps), the expected historically-justified real yield on our 10 year bonds will rise to around 9.3%.

Looking at a historic range of values, our ex-banks deficits warrant the yields in the range of 8-20%. Alternatively, for our bond yields to be justified at 6.5% we need to cut our deficit back to around 5.2% mark and hold our debt to GDP ratio steady.

The IMF findings are hardly alone. Another August 2010 study, this time from German CESIfo, titled "Long-run Determinants of Sovereign Yields" produces similar results, while using distinct econometric methodology and data from that deployed in the IMF paper. "For the period 1973-2008 [the study] consider the following countries: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, Sweden, Spain, UK, Canada, Japan, and U.S."

Current Account deficits, Debt to GDP ratios, and fiscal deficits all have predictable effect on the long-term interest rates and thus bond yields. Crucially, the Current Account channel of risk transmission to bond yields is based on the view that “the deterioration of current account balances may signal a widening gap between savings and investment, pushing long-term interest rates upwards."

Ireland shows relatively weak sensitivity in interest rates to debt, moderate to current account balances but severely strong (3^rd strongest, in fact) to deficits. By combined measures of three responses, we are now firmly in the PIIGS club, with our bond yields based on fundamentals justified at the levels well above Portugal.

And the matter doesn’t rest at the macroeconomic fundamentals. The latest bout of bond yields pressure, culminating in a number of large scale interventions in the market by the ECB is based on significant concerns about the quality of the collateral backing our covered bonds – theoretically the safest of all bond instruments. The bonds downgrade by the Moody’s – an action which in itself represents an extremely rare event in the advanced economies – also puts direct pressure on the likes of the Irish Central Bank and our banks’ repos with the ECB. Illustrative here is the case of the Anglo repos and other derivatives – some €14 billion of which have already gone into Nama and €11.5bn of which rests with the Central Bank under an Anglo MLRA repo agreement secured against the non-Nama loans.

Which, of course, brings us to the logical question of what has to be done to correct our current position.

The forthcoming Budget 2011 is the last line of defence the Government can attempt to hold. Failing to deliver significant (well in excess of €3 billion for 2011) reduction in the deficit, while providing a crystal-clear picture of all deficit measures and targets through 2013-2014 will likely see our long term bond yields rising to the levels above 7%, where Ireland’s application to the European Stabilization Fund (aka IMF/ECB rescue) will be inevitable.

Overall, the Government must cut current ex-banks deficit by around 5.5% of GDP before 2015. Using my projection for GDP growth, this amounts to over €10 billion in cuts.

Yes – cuts. My projections for deficits above are based on rather optimistic assumptions concerning Exchequer revenues (rising €8.2 billion between 2010 and 2015 or 23.8% on 2010 figure). Majority of these increases will happen due to tax burden increases, as capital spending and other automatic stabilizers will be weaker in years ahead due to contraction of capital investment. This implies that the Exchequer will have no room for further significant tax increases in years ahead. In addition, my projections factor in the need for a token reduction in cumulated debt, which spikes dramatically around 2014.

Of course, the above estimates do not account for the adverse effects of higher taxes and lower Government spending on our growth and unemployment. Virtually all of the tax increases to-date (both direct and indirect) fell on the shoulders of households. At this point in time, I see no room for further increases in the tax burden. Data from private savings and deposits shows clearly that Irish households are suffering a precipitous decrease in terms of their net financial buffers, resulting in an adverse knock-on effect on future spending and investment.

While no serious analysis of the labour force and growth sensitivity to tax rates and public spending in Ireland is available, both theory and practice elsewhere suggest that these will be non-trivial. Here, not only the level of cuts, but also their sources matter. So far, three quarters of the adjustment in public spending to-date has been carried on the shoulders of capital spending. Yet, capital expenditure is perhaps the only part of Government spending that is not subject to large economic losses to imports. Furthermore, unlike current spending, capital spending has a growth dimensions that is spread over time.

All in, Minister Lenihan needs to refocus our spending cuts away from capital programmes – where the cuts have already been dramatic, leaving very little new room for manoeuvre – and firmly on the side of current expenditure. Per chart below, the latest Exchequer figures strongly show that this has not been the case so far in the crisis. Furthermore, cuts to current expenditure are severely hampered by the Croke Park deal. In effect, by leaving out of the balancing equation current spending on wages and earnings in the public sector, the Croke Park deal is one single largest obstacle on Ireland’s path to solvency.

[see updated chart here]

Looking across the current spending landscape, it is completely inevitable that cuts will have to focus on reducing the numbers employed and the levels of pay in the public sector. Under current conditions in the labour markets, the Exchequer simply cannot avoid dramatically slashing back its wages bills. Thus, the 2011-2014 framework should aim to reduce public sector employment by at least 70-90,000, yielding savings of some €4.5-5.5 billion once statutory redundancy costs are netted out. Another must will involve reforming welfare system, once again reducing the overall costs. Savings here can amount to 12% of the current expenditure target of €10.6bn – much smaller reduction than that in the wages bill, but a very significant number when it comes to vitally important benefits for the most vulnerable members of our society.

Next in line are health and education. The Government can enact an ambitious reform of our health services, shedding completely the responsibility for managing services provision and aiming to act solely as a payer for these services for those who cannot afford private insurance. Such a reform can see savings of ca €2-2.5 billion netted out of the system on both current and capital sides. Education reforms – especially introduction of third level fees – can provide another €1 billion.

The Government should not only slash current spending, but also develop and implement strategic long-term reforms of management in the public sector. Currently Ireland lags behind the average levels of international best practice in deploying advanced management (including ICT) systems in public sector. Reforming the managerial processes in public sector, per international evidence, can yield longer-term savings of ca 5% of the total net current spending of the state, or €2 billion.

Overall, comes December, Minister Lenihan needs to present a convincing and extremely ambitious programme for reforming public spending in Ireland. At this point in time, international bond markets, as well as domestic economy will need to see a serious change in the path to fiscal solvency chosen to-date before our bond yields, as well as our businesses and households propensity to invest in Ireland improve.

Economics 7/10/10: Irish Government Spending habit

Our leadership - from the Minister for Finance to the heads of the Central Bank and various quangoes, to the affiliated leading business figures are keen on pointing the finger for Ireland's troubles at the banks. While the banks are certainly responsible for much of the problems we face, there are other troubles, of an equally pressing nature, that besiege our economy courtesy of the direct decisions taken by the Government.

Exchequer problems ex-banks are a good starting point for taking a closer look at our grave condition.

Irish Exchequer is expected (by the DofF) to bring in some €32 billion in Tax Revenues this year. The Government is expected to spend some €19 billion or 59.4% of the total tax take on its Wages and Pensions bill.

Imagine a household that is paying almost 60 percent of wages earned by those of its members working to purchase household services. Alternatively, imagine a household with a single earner where a person working earns, say €50,000pa and has a spouse who is engaged in full time household work. The implicit cost of such household work (labour alone) to this family, using our Government's metrics, would be €30,000 net of tax.

What would any household do in these circumstances? Of course - send the spouse into workforce and hire substitute services (childcare, cleaning, cooking etc)... What does the Irish state do? It signs a multi-annual agreement with the unions that ensures that the taxpayers will see no reprieve on wages and pensions bills they pay for Public Sector.

Now, let's put things into perspective. 2003 Exchequer Tax Revenues were at the same (nominal) level as the expected revenues this year - €32 billion. Exchequer Pay and Pensions bill was €13 billion or 40.6% of the total tax take.

So between 2003 and today, Irish Exchequer has managed to increase its exposure to public sector pay and pensions costs by a massive 46.2%. In the mean time, due to increased private sector competition (despite such competition being retarded by our regulatory regimes) and continuously improving demographics (younger population and a rising share of population with access to superior foreign public services, such as health - aka the immigrants), the overall public sector responsibilities in terms of services provision have actually declined.

Back to household analogy here - we've got a houseworker in the family who is now armed with newer technology, reducing time and effort input into work, as the cost of such houseworker to the family is rising by almost 50%.

Recap the top-line figures: pay and pensions bills of our sovereign are up 46%. Ex-exports, our domestic economy income is down 34.4% (see here). A country where 1.4 million private sector workers are forced to living beyond our means to pay the wages and pensions for some 470,000 public sector employees?

Mad stuff, but then again, Irish Public Sector is more like a WAG in its expectations of pay and performance, than a Cinderella.

Economics 2/7/10: Exchequer's sick(ly) arithmetic

Exchequer statement is out today. As usual, for the sake of the markets and the media - right before the closing of the working day. It's either a pint with friends, a dinner with the family, or dealing with Brian Lenihan's problems. Forgive me, the first two came ahead of the third one.

Mind you, not because Mr Lenihan's problems are getting any lighter. They are not. Second month running, tax receipts are under-performing the target. Sixth month in a row, the only saving grace to the entire shambolic spectacle of 'deficit corrections' is the dubious (in virtue) savaging of capital investment spending.

Let's take a look at the details: there was €80 million shortfall in June tax take. All tax heads receipts came roughly in line with the DofF monthly plans, except for income taxes (off €84 million behind expectations).

To hell with 'expectations', though, look at the reality
Tax receipts dipped below down-sloping long term trend line. Which is seasonally consistent. The deviation from the trend line was small, compared to previous 2 years. These are the good news. Total spending is below the flat trend line and roughly seasonally consistent. Given the scale of capital budget savaging deployed this year, this is not the good news. You see, it appears that the Government has back-loaded capital spending while front-loading capital receipts. If that is true, expect serious explosion (hat tip to PMD) of deficit in Autumn. If not,m and the cuts to capital budgets are running at the real rate observed so far, expect mass-layoffs by late Autumn. Either way - things are not really as good as they appear on the surface (more on this 'capital' effect later).

and back to the receipts: H1 2010 so far, income tax receipts are down €227 million cumulatively. Other tax heads are running €76 million above plan. Vat is actually improving, backed by falling value of the Euro and serious cuts in prices by retailers. There is a tendency to attribute this to 'improved retail sales', but in reality most of this 'improvement' is simply due to better weather and smaller savings margins to be had in Newry. Not exactly a graceful cheering point for Ireland Inc... but let's indulge:
€1 billion cut was applied to the expenditure side. Or so they say... Deficit on current account side is now €8.045 billion, up on 2009 €7.212 billion. Vote capital expenditure is down from €1.844 to €2.870 billion. But, wait, in 2009 (well, after Eurostat caught the Government red-handed mis-classifying things) there was €6.023 billion drain on Exchequer 'capital' side from Nama and the banks. This time around, the Exchequer posted only €500 million worth of banks measures on its balance sheet. Something fishy is going on? You bet. Anglo money are not in the Exchequer figures. At least not in six months to June. So things are looking brilliantly on the upside.
Hmm... but what about Anglo? and AIB? BofI? All the banks cash that flowed since January? Well, for now, this remains off-balance sheet. And, there's missing (we actually spent it last year forward) NPRF contribution. Were these two things to be counted, as they were in 2009, the true extent of cuts, the Government has passed through would be revealed. And, fortunately, we can do this much. Take a look at what our cumulative balance looks like to-date, compared with 2008 and 2009.

First - absent adjustments for the banks:
And now, with banks stuff added in:
Notice how all the improvement in deficit to-date gets eaten up by the banks? Well, this is simply so because when we are talking about the improvement on 2009, we are really comparing apples and oranges. Ex-banks in both years, there is virtually no improvement. Cum-banks both years - there is no improvement. But Minister's statement today compares cum-banks 2009 against ex-banks 2010...

Net voted expenditure by departments is running €141 million below expectations for June. Cumulatively, H1 2010 is below expected Budgetary outlook by some €500 million - 2.3% savings on the Budget 2010. Even more impressively, it is now 6.2% behind 2009, 'saving' us €1.4 billion. Not exactly the amount that gets us out of the budgetary hole we've dug for ourselves, but...

I'd love to stop at this point for a pause to enjoy the warm rays of achievement for Ireland Inc. But I can't - it's all due to cuts in capital spending - running some €609 million below Budget 2010 plan for the first xis months of the year. €400 million plus of this comes out of DofTransport budget. All in, current cuts to capital budget represent whooping 36% reduction on 2009 levels. Surely, this will cost many jobs in a couple of months ahead.

And on the other side of this equation - current spending is actually running ahead of Budget 2010 forecasts (actually made in March 2010, so no - DofF has not improved its forecasting powers, it simply is missing targets closer to its own estimation date). And this is true for the second month in the row. Overall, we are now in excess of forecasts by 0.5% and only 1.9% behind comparable figures for H1 2009.

Last few charts:

Now, keep reminding yourselves - the last chart above does not include banks funding in 2010 to-date... Your final tax bill - will. Get the picture?

Economics 05/06/2010: Exchequer returns May 2010

May tax revenues are behind Budget plan, as talk about recovery is intensifying.

Recall, April was the month of allegedly improved (aka above the plan) tax revenues. May came in, bringing about a double whammy:

1. cyclical components were trending tax revenue down. As normal and forecasted by the DofF;
2. non-cyclical trend was also down, which was not predicted by DofF.
   

Oops. Tax revenue came up to €3.11bn in May or €141mln behind the target. This brought the annual (to-date) position on revenue side to some €148mln below target. Annualized rate of revenue decline is down to 10.4% (massive, still) from 10.8%. Budget assumes that tax revenue for 2010 will be 6% behind 2009 - €31.05bn instead of €33.04bn collected for 2009. I don’t want to venture a forecast here, but we are clearly in the uncharted waters of volatile bottom bouncing.

Here are my charts, per usual:
Chart above highlights seasonal cyclicality: Tax revenue up in May – just as it done in 2008 and 2009, but the swing is shallower than in previous 2 years. Total revenue uptick in May is better than in 2008 (when there was actual slight decline in the series), but the same as in 2009. Total expenditure is down, just as it did in May 2008 and 2009, although decline in 2008 was stronger. So we are somewhere in-between in terms of dynamics – neither 2008 with its calmer Exchequer conditions due to lags on revenue side, and the extremely disastrous 2009.

To-date, 2010 is shaping out to be on a slightly better local trend than the linear trend line for 2008-present, when it comes to tax receipts, although the local trend is still downward. Ditto for the upward trend in expenditure. Notice that we undershot expenditure trend by about as much as in 2008 and there is a significant improvement on 2009.

In short, there is no dramatic change between previous years and today. The crisis is still in full bloom, folks.

Some annual comparisons due:
You can clearly see how in comparative terms, monthly receipts so far been coming in at below 2009 levels except in March. Was that a boost due to scrappage scheme and the combined effect of 2010 license plates luring in the silly vanity buyers (we still do have folks who think a lower range car with 2010 plates beats a higher range one with 2007 ones – the Celtic Hamsters, as I would call them: stripes and all, but clearly short of Tigers. Also, notice that May 2009 uplift in receipts brought the monthly figure closer to May 2008 than current uplift shifted us toward May 2009.

Here is a crude comparative to the ‘target line’ – drawn based on the basis of -6% deviation in receipts. Now, these are monthly receipts, so it is not exactly coincident with the ‘real’ DofF target line (which, frankly, I can’t be bothered to trace as it is irrelevant, as long as the annual target is set at 6%). If you assume that there will be a pick up in revenue (outside the seasonality factors) in the second half of the year, hold your hopes for the annual figure to come on-target. However, my ‘target’ line is telling:
We are clearly underperforming the ‘target’ so far, although we are moving close to it. Another interesting feature is the comparative between the ‘target line’ and 2008 revenue, clearly showing that we are in for another shocker of a deficit even if we hit the target. The reason is simple – our current expenditure is not really declining significantly relative to 2008. Which means that unless revenue surprise in H2 2010 will be a massive one, the deficit is going nowhere compared to the 7-9% objective set out by our counterparts in the PIIGS.

Chart above shows another set of comparatives. This time on the expenditure side and deficit. On the expenditure side, we are running much closer to 2008 figure this year than in 2009. But we are still above the 2008 level. On deficit side, we are better off than in 2009 since March, but still worse than in 2008, although the gap is closing in May relative to January-March. One wonders what will happens once the latest Live Register changes hit the unemployment rolls and their income taxes stop flowing in, over months ahead. Remember, there are lags here as some of the redundancy payments are taxable.

Now, look at cumulative receipts to date:It is clear just how resilient our underperformance, relative to 2009 and 2008 is over the 5 months of 2010. Take a look next at total receipts, with the aforementioned ‘target line’ in:
Again, underperformance is evident. What is dramatic, however, is that after rounds upon rounds of various tax increases, charges, duties etc rises, we are still nowhere near seeing an uplift in tax revenues. A Laffer curve? Perhaps. Alternatively – collapse of the tax base? May be both. It is, nonetheless clear that following the Unions-suggested path of ‘tax em, don’t cut spending’ is not an option.

Total expenditure comparatives. There has been much said – domestically and internationally – about dramatic cuts in public spending. Really, folks?
Tell me if I am not seeing something, but the yellow line is not showing any really dramatic cuts – not the ones you’d expect for a country with 14% deficits.

Suppose we decided to cut half of our deficit out of expenditure side alone (presuming the other half comes out of increased revenue – despite this being unrealistic, entertain such a possibility). Let’s call this scenario ‘½ target line’. Alternatively, suppose the entire adjustment to 3% deficit was to be carried out of expenditure side – call this scenario ‘full target line’. The following will be consistent with an expenditure target, relative to 2009:
So we are doing no too poorly in terms of ‘half-target’ line, implying that the Government is aiming to either dramatically raise taxes (and hope that it will result in a significant revenue uptake), or they are hoping to discover some sort of precious metals deposits somewhere in the bogs, perhaps at the end of a rainbow. Otherwise, we are not on track to any fiscal recovery, just to a moderate decrease in the deficit.

To Government’s credit, however, let us note that spending is down 8.9% yoy over the first 5 months. Then, of course, to their discredit – most of this decline came out of cuts to capital spending. Note also, reductions in spending are running on 2009 figures. That means that yoy we are currently saving some €1.7 billion (over 5 months) – a sizable chunk. Capital side of spending accounts for €890mln of that. Sounds like pretty fair? Well, not really – capital spending last year was held back until later in the year. Which means that in real terms, capital spending in the first 5 months of 2010 is a whooping 36% down on the same period in 2009 and is running at roughly 20% below 2009 annualized rate of spend. And the source of these capital savings? Oh – DofTransport and DofEnvironment – the two account for some 70% of the cumulative 5-months shortfall.

So the strategy might be: cut spending on roads and transport, charge people more for poor quality commute (‘carbon’ tax and fuel excises) and replenish the coffers… In other words, don’t dare call it a tax on income, but the twin contraction in investments in improving transport and expansion of taxes on commute are in the end exactly that. Unless, of course, you are in the Dail or Seanad – in which case, it’s Alice in Wonderland life for you, courtesy of commuting subsidies.

Current spending is only 5% below last year’s, generating savings of €850mln – bang-on with expectations. This masks two sub-trends:

• There has been 10.5% drop in overall current spending outside the Dof Social Welfare/Protection; and
• DofSocial Protection is running up 13.1% on current expenditure. Wait, as I’ve said before, until the latest additions to Live Register kick in and before a significant wave of long-term unemployed start getting into much more extensive social welfare benefits.
  

Final comparatives, therefore:
Yes, the deficit is improving on cumulative basis and on 2009. But we are far off the deficit figures for 2008 and our dynamics are pointing to no convergence toward 2008. Now, recall that in order to return back to 2008 deficits we need to also take into account that since 2008, Irish economy has contracted significantly. In other words, the task of restoring 2008 deficit levels (not spectacular either) will take even more cuts out of us today than we are so far willing to deliver.

Economics 12/05/2010: How not to do austerity...

How not to do austerity? Well, Ireland is a good example.

For all the tough talk about reforms and changes to spending habits of the public sector, the new employment in civil service document released two weeks ago, drawn up by the Department of Finance envisions that staffing levels will fall from 37,376 estimated for the end of 2010 to 36,594 at the end of 2012. That’s a whooping (or in terms of SIPTU/ICTU savage) drop of 782 workers, or less than 2.1%. The resultant savings, assuming jobs cut will be at the media level of pay for the civil service, will total a massive €39.41 million per annum. Translated into our public sector’s spending habits, that’s about 16 hours and 20 minutes of our deficit financing for the first 4 months of this year. Not counting the banks costs.

The Government has told the nation before that the new public service pay and reform deal negotiated with unions at Croke Park last month will "substantially" reduce the number of State employees over the coming years. Hmm... guess 2.1% is philosophically ‘substantial’, even if not economically substantive.

But wait, these are gross savings, pathetic as they might be. To get to the net figure, we must factor in early retirement incentives doled out to civil servants by Brian Cowen in Supplementary Budget 2009 and golden handshakes for voluntarily leaving staff.

So take a rule of thumb - the cost of laying off civil service workers ranges around 15-20% of their total annual salary per year of service – once the value of pensions and redundancy payments are factored in. This is very, very much conservative, given the one-off payments and other perks accruing to retiring public sector workers and given that their tax liabilities collapse upon the retirement, especially over the first year. Take 15% on the lower end and assume that average tenure of the workers leaving the service is around 15 years (lower-end assumption as those taking early retirement would more likely to be more senior than that).

What do you have? The cost – and not all of this obviously will hit the taxpayers at one single shot, but most will – will be around €133,400 per worker reduced. And that’s at the lower end.

Savings of €50,294 per annum, at a cost of €133,400 means that given our Government’s innate inability to manage its own workforce, the first time we, the taxpayers, will see positive net savings on the deal (assuming opportunity cost of funds at 5% and automatic stabilizers on the salary payments to public sector workers at 30% - income tax, levies, etc - none of which are going to apply under voluntary retirement) September 2015!

I am not kidding you – September 2015! By which time, of course, the Unions would have forced the Government to get a new Benchmarking going…

Folks, we are now truly turning the corner!

Economics 12/05/2010: How to do fiscal austerity... 2

Ireland, Spain and Portugal currently represent a major threat to the credibility of the euro, according to a number of observers, ranging from the FT to RBS. Not because of their public debts, but because of their deficits. Spanish and Portuguese deficits are expected to hit 11.4% and 9.2% respectively this year. Irish - anywhere between 11% and 18%, depending on how much of the banking liabilities will be covered by the Government. These levels are more than double Italy's deficits and almost double those of the Eurozone as a whole.

Moody’s are now talking about downgrading Portugal and Greece to junk status.

If you look at the countries that are really getting it right - Ireland is not at the races. So far we have seen largely cosmetic reductions in the deficit. As of April 2010 results, the deficit is down 4.86% year on year and up 86% still on the same period of 2008. Worse than that - most of this undramatic cut between 2009 and 2010 was achieved by reducing capital spending. Which means the cuts are not structural and we are rapidly running out of room for any future improvements.

I wrote yesterday about Bulgaria (with 1/4 the size of Irish deficit levels) slashing its public spending by 20% and hitting hard pensions and wages in the public sector (here). I forgot to mention Latvia - assisted by the IMF loan back in 2009 (USD10 billion) - cut public sector jobs by 20% and the remaining public servants took a minimum of 25% pay cut.

Replicating these cuts in Ireland, however, would only be a beginning of the process of restoring public purse to health - we need to shave off 39.5% of our ongoing spending (as of April 2010) figures to bring our finances into balance. The cuts will have to add up to 36% in order to get us down to the Growth & Stability Pact level of acceptable deficit.

At this stage, with Croke Park deal done, and with economy unable to pay much more in added taxes, and the banks still begging for money, the Government has simply run out of any options.

Economics 11/05/2010: Exchequer figures - no real relief in sight

You have to feel for some of our desperate cheerleading squad of ‘analysts’ who toil for some of our banks and stock brokers. These folks are clutching at the straws trying to find something to cheer about. Case in point – latest data from the Irish Exchequer, which was heralded as showing ‘stabilisation’ and even ‘improvement’ in ‘funding conditions’ and ‘headline deficit’.

Putting aside the fact that most of these analysts have no real idea what these terms really mean (and in some cases, neither do I, for they mean preciously nothing in the real world of economics), the fault in their logic is an apparent one:

They say: ‘Irish exchequer receipts are finally coming closer to the Budget 2010 projections. Therefore, things are improving or stabilising.’

I say: ‘Statements like this are pure bollocks, folks. Just because DofF has finally caught up (somewhat) in its forecasts with reality, does not mean reality is getting any rosier.’

Here is the evidence that I am correct. Forget the Exchequer forecasts, and look at the actual data.
Chart above shows that:

• Irish Exchequer tax revenue in April came in below the downward linear trend established since January 2008, which means that we are still returning tax receipts at below 2008-present average rates. Long term, things are still sliding down.
• Irish Exchequer total receipts fared better than tax revenue, but that’s because the Exchequer has managed to squeeze more out of the likes of the semistates. Don’t be fooled – the semistates do not create their own money. This is just a hidden tax on us all.
• Total expenditure, despite all the fanfare from the ‘analysts’ is heading up, and is now above the trend line again. Which (the trend line) is upward sloping. This means that long term trend is still rising for our public spending, and that we are on a seasonal upper push in public spending.
• Thus, our Exchequer deficit has gone up in April, and it did so at a rate virtually identical to April 2009. Long term deficit is still upward moving and we are now above the long term trend once again.

Translated into cardiology, the patient now has an accelerating erratic pulse reaching beyond the norm, and continuously falling blood pressure. Just as Good Doctors Brian & Brian are talking about discharging...

To see if things are indeed improving (or stabilizing) as our ‘analysts’ suggest, let’s put back to back receipts and expenditures for the last three years in one chart:
Clearly, our total Exchequer receipts (and recall, these are boosted by abnormally higher non-tax revenue) are now below those for April 2008 and April 2009. Indeed, only once so far in 2010 have receipts rose to above corresponding monthly levels for 2008 and 2009 – back in March, when the Exchequer booked some of the backed receipts on VAT, VRT and Excise.
Chart above shows that the Exchequer did indeed achieve some reduction in spending in April 2010. But,

1. Good ¾ of these savings came from reduced capital investment cuts
2. Cumulative savings for the first 4 months of 2010 are so far €1.346 billion, implying an annualized rate of savings of €4.035 billion. Over the same time, cumulative losses in revenue were €990 million, implying an annualized loss in revenue of €2.969 billion.
3. So we are looking at (omitting timing consideration) net savings on 2009 of €1.1 billion. This would be a reduction of just 4.3% out of an annual deficit for 2009, or related to GDP – a reduction of roughly 0.6% of GDP. In other words, all the ‘right decisions’ taken by this Government are currently looking like being able to reduce or 14.3% 2009 deficit to a massively ‘improved’ 13.7% deficit? And that’s assuming that the Anglo support this year will only impact the deficit by the same €1.5 billion as last year…
   

This miserably low level of achievement in our battle to restore Ireland to solvency is, of course, fully visible in the above chart, once one considers the Exchequer surplus performance.

Economics 11/05/2010: How to do fiscal austerity...

An interesting example for Ireland?

Two weeks ago, Eurostat confirmed that Bulgaria's deficit stood at 3.9% of GDP. A crisis was, therefore, unfolding in the Black Sea nation. The Bulgarian government decided to act and on the 5th of May it acted to drop public sector spending by 20% to reduce its budgetary deficit. The Government adopted an update to its 2010 budget in which spending on the part of State organisations, ministries and other public institutions is to be reduced by 20%. Flat cut across the board, with separate budgetary entities deciding on how the cuts should fall.

Clearly Bulgarians have not heard of the Croke Park 'deal' that, according to the Irish government, will help to stabilize Irish deficit (per my estimates, around 7% of GDP by the end of 2014, should all Croke Park-agreed provisions remain in place).

I will be blogging later today on the latest Exchequer results - which, recall, were received well by the banks' /stock brokerages' economists, cheering the fact that 'Exchequer revenue is now on target', without actually asking themselves the more important question: what is this target implying in terms of our solvency.

Economics 22/04/2010: Ireland's deficit tops Greece

Updated below

Breaking news: Eurostat just revised Irish General Government Deficit figures from 11.7% officially reported in Budget 2010 to a whooping 14.3%, raising our deficit above revised Greek figure. Here is the link to the note.

Excerpt: "Ireland had its budget deficit revised even more [than Greece] -- to 14.3 percent from the initially reported 11.7 percent. Irish Finance Minister Brian Lenihan said this was a result of a technical reclassification associated with government support provided to the banking sector. "It is important to note that the underlying 2009 general government deficit for Ireland is 11.8 percent of GDP, which is broadly similar to that projected in December's budget," he said. "There is no additional borrowing associated with this technical reclassification. This is a once-off impact, and will not affect the government's stated budgetary aim of reducing the deficit to below 3 percent of GDP by 2014," Lenihan said."

That would be putting a brave face on what now amounts to the most deficit-ridden country in the EU!

One question remains to be answered - given that all 2009 recapitalization funds for banking sector came from NPRF, what 'technical reclassification' yielded this massive upward revision?

Update: There has been a lot of talk in the blogosphere about the 'silver lining' to today's news. In particular, one argument is making rounds that goes as follows: "Since our deficit has increased for 2009 to 14.3%, then the reduction to 10.6% envisioned in the Budget 2010 will be even more impressive to the markets".

Here is why this argument is fallacious:

1. Today's revision of deficit for 2009 represents a reflection by Eurostat that cash injected into the Anglo Irish Bank by the state was borrowed via general spending fund in the open markets and as the result constitutes deficit financing. If so, where do you think this year's banks recapitalization will come from? Uncle Sam? or may be Angela Merkel? These recapitalizations are not, repeat not factored in the Government Budgetary projections per Budget 2010. The Eurostat rulling means that should the Government borrow the €10-12 billion to recapitalize the banks in the markets this year, this too will be reflected in our deficit. Now do the math - Government budget allows for €18.7 billion in General Government Deficit or 11.6% of GDP in 2010. If we add to this the lower bound of recapitalization estimates, our deficit rises to over €28 billion or a whooping 17.4% of GDP. Even if the Government wrestles out of the NPRF more cash to plug the banks balancesheet black hole, and assuming that our borrowing for banks purposes goes up by just half of the announced requirement, our Gen Gov Deficit will reach 14.7% of GDP. At which point we can all shout 'Eat our shorts, Greece!' once again.
2. Today's revision clearly shows that the Government has been caught red-handed in attempting to avoid labeling our true General Government liabilities as such. This is about as reputation-destroying as Greece's use of financial derivatives in the past.
   
3. An argument of a 'silver lining' assumes that as a one-off increase, this deficit revision does not matter going forward. This, in effect, is equivalent to saying that no cyclical deficit matters, no matter how big it is. Of course, such an argument is absolutely devoid of any anchoring in finance or economics. Cyclical deficits add up to total deficits. Total deficits - cyclical or not - add up to the total debt. This is exactly how Greece got itself into the bin!
   

Economics 29/03/2010: PS productivity deal will cost us all

Per latest reports on the talks with the Unions, it now appears that the Government will yield on the Budget 2010 pay cuts and accept a premise that our vast structural deficit can be corrected through a long-term change in work practices in the public sector.

This position represents a drastic reversal of the attempted correction of the structural deficit and has the following long-run implications for Ireland:

1. Since productivity gains do not address the issue of reducing actual spend in the public sector, the entire burden of correcting the structural deficit can be expected to fall on the shoulders of the taxpayers;
2. If the deal commits the Government to no future cuts in public spending in Budgets 2011-2013, the deal will mean that the entire €13-14 billion in Budget adjustments needed before 2014 will have to be carried by the Irish taxpayers. This means taxes will have to rise by a massive €13,000 per annum per current tax payer - a move that would trigger a meltdown in the economy;
   
3. Since higher earning taxpayers are already paying more than half of the income tax bill, the new taxes will have to disproportionately impact lower middle classes, thus in effect inflicting pain on the very workers whom the unions are allegedly aiming to protect;
4. Since the structural deficit will remain unaddressed, Ireland will not reach 3% deficit target by 2014, or for that matter by 2020, implying that we will be facing excruciatingly high cost of borrowing through the next 10 years or so, a cost, once again to be carried by our middle and lower-middle classes.

Using a simple prisoners' dilemma game, one can easily show that the Government currently has all the incentives to run the economy deeper into depression. Such a move will ensure that the poisoned chalice the current Government passes to the opposition will be even more toxic, thus giving Fianna Fail stronger chances of election victory in the next 5 years.

In other words, if the Government does indeed sign up to the unions'-conjured 'plan' for 'efficiency'-exit from the deficit, it will be implicitly acting to derail any hope of a fiscal and economic recovery, while optimising its own political objectives.



PS: For all those who are keen on accusing me of being anti-Fianna Fail: nothing I write is designed to attack any political party in general or its members in totality. There are plenty of very good people in FF, and some of my friends are members of the party. There some competent, well-meaning and experienced members of the Government. Sometimes I disagree with them on policies, sometimes on ideologies, sometimes we agree. I express these views in public and privately. I always prefer an open debate.

The collective actions of the current Government, in my view, deserve very severe criticism. And that criticism I tend to provide: not behind the back, but in the open, publicly accessible fora.

Economics 24/01/2010: A Mexican stand-off: Eurozone v Greeks

It is nice to note that the theme picked up by the post below has been followed upon by the continued media debate today:

According Der Spiegel today: the European Commission warned that the euro area’s chances of survival would depend on adjusting the internal imbalances. DG Ecfin apparently claims in a new paper that internal imbalances would weaken confidence in the euro and endanger the cohesion of the monetary union. Rising deficits and weakening competitiveness in several countries, notably Ireland, Spain and Greece are singled out by the Commissions as the main causes of the pressure on the euro. DG Ecfin, allegedly says the necessary adjustment in the deficit countries will require wage moderation to address rising unemployment in the above countries.

And another one from today: here.

So what is going on with Greece? Not much, it appears. Just like Ireland did before it, Greece decided to throw some smoke around its fiscal debacle with promises of reaching the 3% SGP limit by 2012 (Ireland is now saying it will be 2014, although ESRI’s presentation last Monday was clearly showing they expect deficit to be well above 3% level then).

And like Ireland, Greece has elected to cut some easy expenditure targets – capital investment and irregular payments and some social services. Ireland has gone slightly further by imposing a modest cut on wages and passing a gratuitous tax on pensions in the public sector. Of course, wage cuts were far from what was necessary, while the pensions tax was not even enough to cover the expected future increases in pensions liabilities that will arise due to, frankly Marcian in its surreality, practice of indexing future public sector pensions to wage rises in the sector.

And so, like Ireland, Greece has not been reckoning with the reality of its deficits. Unlike Ireland, however, it was not able so far to fool the markets, and it was unable to raise taxes. And unlike Ireland, Greece was a serial offender on the front of deficits (see charts) in recent years, during the boom. Note, this, of course, does not reflect the fact that Greek’s deficit accounts for their banks supports measures (negligible), while ours does not (massive).
And this means, everyone is still wondering – what is going to happen with Greece?

Last week several significant statements were made on the subject. First, Handelsblatt reported that "the EU has put the thumb-screws to the Greeks", noting that "under massive European pressure the Greek government has agreed to have its state finances cleaned up faster than initially planned". Greece has now pledged to reduce its budget deficit from around 12.7% in 2009 to under 3% of GDP by the end of 2012.

Handelsblatt information de facto denied by senior EU figures. In an interview with Il Sole 24 Ore, ECB Executive Board Member Juergen Stark said that the EU would not help bail out Greece, arguing: "Greece is in dire straits: not only has the deficit reached very high levels, but the country has also witnessed a serious loss of competitiveness [haven’t Ireland?]. Such problems are not due to the global crisis, since they are substantially homemade. …Rules... are unequivocal: being part of the Monetary Union doesn't guarantee any right to claim for financial support by other member states."

Of course, if pressure was applied on Greece [per Handelblatt], there must have been some sort of a threat. What can such a threat be?

Could the EU officials told Greek Government ‘Shape up or you are out of the Eurozone’? Nope – no such possibility even in theory.

Could they have told the Greeks ‘If you don’t resolve the problems with you deficit optics, we can’t give you a bailout’? Oh, yes, that could have happened. In fact, the threat of ‘no EU goodies, unless…’ threat is just what EU has used before on other countries –Switzerland and Norway (access to EU markets), and Ireland and Denmark (access to ‘influence’ within the EU).

So let us take it as a possibility, no mat6ter how remote, that the EU folks told the Greeks to get working on some sort of a face-saving formula to allow for their rescue by the EU/ECB.

Last Friday Wall Street Journal reported that the EU Commission spokeswoman outright denied such a rescue plan being worked on, saying she wasn't aware of any financial bailout packages being arranged. But then, in an interview to Die Welt Chief Economist of Deutsche Bank Thomas Mayer (a man whose statements are not to be taken lightly) said: "The situation [in Greece] is more serious than it has ever been since the introduction of the euro. The trouble in Greece plays a key role for future development... If the Greece situation is handled badly, the Euro-zone could break down, or suffer major inflation. Neither the European Central Bank nor the Commission nor any other EU body can force Greece to implement necessary reforms in exchange for help."

What does he mean ‘no body in the EU can force Greece’? He means here not the political infeasibility of the EU actually slapping on the conditions on Greece to implement austerity measures in exchange for funding. That can be done. What cannot be achieved is the enforcement of such conditions.

The problem is really simple and, thus, grave.
The EU can give Greece a loan – via ECB, say, for 10 years at 2-3% per annum, in the amount of 30% of its debt. That would be fine. It will not solve Greece’s problem, but it will alleviate pressures on deficit side, as country interest bill will fall substantially, allowing it some room to reduce structural side of deficit more gradually. But the EU will have to impose severe restrictions on Greek fiscal policy in order to discourage other potential would-be-defaulters today and in the future. They would have to require, as a condition of the loan, a constraint on Greek deficits going forward so severe that other PIGIES (note the renaming of the club – Austria is out, Estonia is in) don’t dare roll their massive deficits into debt into perpetuity in hope of a similar rescue.

That won’t work – the Greeks will take the money and will do nothing to adhere to the conditions, for there is no claw back in such a rescue.

Alternatively, the EU might commit ECB to finance existent Greek debt on an annual basis. This will allow some policing mechanism, in theory. If Greeks default on their deficit obligations, they get no interest repayment by ECB in that year. Sounds fine in theory but what happens if the Greeks for political reasons default on their side of the bargain?

If ECB enforces the agreement and stop repayment of interest, we are back to square one, where Greece is once again insolvent and its insolvency threatens the Euro existence. Who’s holding the trump card here? Why, of course – the Greeks. And, should the ECB play chicken with Greeks on that front, the cost of financing Greek bonds will rise stratospherically, and that will, of course, hit the ECB as the payee of their interest bill.

Thus, in effect, we are now in a Mexican standoff. The Greeks are dancing around the issue and promising to do something about it. The EU is brandishing threats and tough diplomacy. And the problem is still there.

Martin Wolf of Financial Times: "the crisis in the eurozone's periphery is not an accident: it is inherent in the system. …When the eurozone was created, a huge literature emerged on whether it was an optimal currency union. We know now it was not. We are about to find out whether this matters."

Indeed, we are about to find out… hold on to your socks, folks.

Economics 20/10/2009: Ahead of DofF

A quick announcement:
RDS Concert Hall 8pm Wednesday Oct 21st

HOW NAMA WILL LOSE €12bn: There's a Sounder Alternative
by Banking Expert Peter Mathews, MBA, FCA, AITI.

Peter is the only senior banker with experience in managing large distressed loans portfolio. His work, in collaboration with myself and Brian Lucey is featuring in the current issue of Business&Finance magazine. This should be very informative and worth attending. See Peter's excellent website in the issue of Nama costs: http://www.bankermathews.com.

We will also hold a Q&A session after the speech, with yours truly also on the panel.

Free for students.



A quick note:

Apparently the latest Government projections for 2009 tax intake are €31bn. Pre-budget estimate in April 2009 was €34bn, while January 2009 addendum to the Finance Bill was €37bn (here).

My forecasts earlier this year gave this figure (here) back in August, May (here) and April (here). In fact, since December 2008 I have been giving forecasts for revenue figures that were ahead of the official numbers produced by a sizable department responsible for doing these forecasts within DofF. Table below lists their projections before the April Budget:
Latest Government admission - €31bn... welcome to TrueEconomics, folks...

Economics 03/10/2009: Exchequer receipts - bad news redux

Another month, another set of Exchequer returns and another prediction of mine confirmed: Exchequer revenue is not stabilizing. A second wave of downgrades for Income Tax and VAT, as well as the adverse timing effects on Corpo Tax are now appearing.

This time around, the prediction was not only made on this blog (here), but was also elaborated in my Business & Finance magazine column. A combination of poor forecasting (overestimating the extent of seasonality on tax revenue in August, while underestimating the impact of seasonality on other months revenue) and of a naïve belief that things can’t get much worse from April 2009 Supplementary Budget position are now at play.

In other words, it now appears that summer months’ targets were seasonally adjusted in a simplistic linear fashion. August out-performance by actual returns looks like a DofF failure to see that in a recession more people will be taking forced ‘time-off’ in summer months and that this can boost, temporarily, spending. The DofF also dramatically underestimated the extent of forward payment of corporate taxes, which automatically means that they overestimated corporate revenue expected in the future months.

During the boom, underestimated revenue projections by DofF were routine. Nay, they were annual regularity, so much so that the Government came to depend on these ‘windfall revenues’ as a sweetener to various Social Partnership deals – a little annual bonus for cronies. This time, looking to September, the DofF folks grossly underestimated the extent of the recession impact on income and thus the direction of the income tax. Having stabilized and even improved (very slightly) through July on the back of new levies, Income Tax has since taken a dive again. The implicit assumption that ‘things always improve in September might hold at the times of a boom, when July and August mark mass exodus of consumers from Ireland, while September marks return of the school year and back-to-work spending rises. But it will not hold in a recession, where economic activity remains slow in September or even falls (due to falling tourism and recreational spending).
For some inexplicable reasons, DofF set targets for income tax to rise through September at a constant rate of roughly €1bn per month from May on. Given timing of self-employed filings and seasonalities in their incomes (with many taking unpaid ‘holidays’ during the summer), plus given the fact that the numbers of self-employed are rising due to redundancies and high unemployment, such an assumption of relatively static growth in Income Tax revenues is a bit amateurish.

The same factors have a knock on effect on VAT revenues. As income falls, consumption drops. As people get more leisure time, they tend to shop for cheaper goods and might take two trips up North instead of one. All point to the significant possibility that VAT receipts will be losing ground in summer months. Furthermore, the DofF forecasters also missed the effect of unemployment and falling incomes on parent’s willingness to spend vast fortunes of kids ‘back-to-school’ shopping. More importantly, what DofF clearly had no idea about is the psychology of ‘bundled shoppers’ – parents going to buy kids school-related items. If in Celtic Tiger days such a shopping outing was bound to end in a department store where parents can indulge in some compulsive shopping of their own, this year back-to-school shopping took them more likely to Aldi and Lidl, with only compulsive co-purchases taking place relating to the luxury items of, say, a box of chocolate biscuits. Not exactly an item where 21.5% tax rip off means much.
To be fair to DofF folks, they don’t really have much data to go to get an accurate model working. But to assume that July-September 2009 tax receipts will be directly proportionate (at a virtually constant rate) to those in 2008 is, at very best, naïve. Yet, per chart below, this was simply 'assumed'…
Now, September numbers confirmed more than just a shoddy quality of forecasting by the DofF (with an accumulated error for just 5 months-ahead forecast now standing at 3.91% we really do have a shoddy quality forecast here). Instead they show that all tax heads (apart from artificially inflated by timing changes) tax heads are tanking through 2009 relative to the already crisis-ridden 2008. Chart below and table illustrate:
As far as state solvency goes, there is surprising one off change in our borrowings, which have apparently fallen back by some €5.2bn in September. I have no explanation for this, other than potential maturity of some earlier issued bonds or an error in reporting of the figures. Meanwhile the deficit trend continues to diverge from last years in the direction of further widening in fiscal deficit this year. Chart below illustrates.
Income and expenditure gap is also still widening as the chart above shows. But there is something else that can be glimpsed from the data. Remember that in May 2009 this Government started a campaign to assure the markets and domestic taxpayers that their policies are working, that the worst is almost over and that the economy is in the state of having ‘bottomed out’. Chart below shows that even in the Government’s own back yard such statements were completely unjustified. Suppose that May did mark a month of arrested downward slide in this economy. One would expect at the very least that Government finances will not continue deteriorating at a greater rate than before April Budget. The path of fiscal deficit that is traced out by the black arrows in the chart below corresponds to exactly such an assumption.
It is clear that we are not, currently, anywhere near the state of ‘improvement’ in the economy (as far as the Exchequer figures are concerned), or even the ‘bottoming out’ stage. We are still in a relative free-fall stage.

And this clarity is magnified by the expenditure side of the Exchequer balance sheet. Per Ulster Bank research note, the chart below shows the break down of the excessive spending by two main categories:Minister Lenihan is more than willing to cut into Government's only official stimulus to the economy - capital spending. This is a right way forward as much of our capital 'investment' was, in reality, simply masked-up wasteful current expenditure on soft targets like 'training & education', 'social cohesion' etc. But the chart above shows that current spending cuts to date have been extremely shallow. This is not a policy consistent with the claims of rigorous addressing of the deficit - cyclical or structural.
Table above clearly indicates the following facts about our Exchequer's spending side:

1. Capital spending is down significantly, at -13.1% yoy, but not really enough still - cutting capital spending back by 50% would do a better job;
2. Current spending is still rising +0.7% yoy in September (and no, increased social welfare and unemployment payments are not the only story here);
3. Waste on current spending side is still abundant - table shows those articles of reductions where cuts in spending for each department are the deepest. Predominantly, these cuts are on the capital side and not on the current expenditure side;
4. Increased spending on social welfare is now clearly indicating that early job cuts in 2007 are now translating into people signing off unemployment benefits and onto the dole - a move that is likely to lead to a very long-term dependency on social welfare.
   

The verdict from all of this is a simple one - this Government is not doing enough to correct for structural and cyclical fall off in revenue. Tax increases and levies passed in October 2008 and April 2009 are not working. While cuts promised since July 2008 are not forthcoming. We are still on a path to state insolvency.