16/6/2013: NPRF, Stimulus & Futility of Policy: Sunday Times June 9, 2013

This is an unedited version of my Sunday Times article from June 9, 2013.



With the coalition mulling over the idea of investment 'stimulus', there are only two questions everyone in the Leinster House should be asking: Where is the money coming from? and Is there value for money in these investments?

Since the beginning of this crisis, the State piggy bank, aka the National Pensions Reserve Fund (NPRF) has been as rich of a target for Government raids as the taxpayers pockets. Back in 2007, NPRF assets were valued at EUR21,153 million with almost 94% of these, or EUR19,817 million, held in liquid financial instruments, such as cash, listed equities and bonds. Q1 2013 data shows that the fund discretionary portfolio (portfolio of assets excluding government-mandated 'investments' in AIB and Bank of Ireland) has declined to EUR6,449 million with only EUR4,243 million of this held in relatively liquid assets that can be meaningfully used to fund any stimulus.

The reason for the NPRF’s disastrous demise has nothing to do with the fund management or strategy - both of which were relatively good, compared to some of Ireland's 'leading' private sector asset managers. The cause of the precipitous 79% drop in liquid assets held by the NPRF was the banking sector collapse and the Government decision alongside the Troika to waste some EUR20,700 million of NPRF funds to 'invest' in two pillar banks equity stakes, with EUR16,000 million of this sunk into the black hole of AIB. As of Q1 2013, the NPRF 'investments' in the banks were valued at EUR8,800 million. This, accounting for dividends paid and disposals made to-date, implies a loss of some 47% of the original investment outlay.

The sheer absurdity of the use of the NPRF to fund every possible twist and turn of the State financial crisis is magnified by the latest Government plans. The exchequer returns through May 2013 released this week show clearly that as in previous years, the heaviest burden of spending cuts by the public sector is once again falling onto the capital expenditure side. January-May current voted spending is running 1.6% ahead of the target, with capital spending outstripping targeted cuts by 12.6%. Now, the same state that has been for years slashing voted capital expenditures is angling to raise a capital investment stimulus by raiding the remaining liquid NPRF funds.

The key issue with NPRF asset holdings is that even theoretically liquid funds will have to be leveraged in order to raise cash for any meaningfully sizeable Government investment. Leveraging NPRF funds via Public-Private partnership-type schemes can yield, realistically speaking, around EUR8-10 billion of total funding for the proposed seven years-long investment envelope, or just about 8% of the cumulated gross domestic capital formation taken at the 2011-2012 running levels.

Use of NPRF funds to finance economic stimulus while the state continues to borrow cash for day-to-day management of unsustainable deficits is of a dubious virtue to begin with. The costs of leveraging the NPRF funds will add further pain to the economics of stimulating investment in the environment of already high levels of government and private sector indebtedness. Worse than that, leveraging NPRF will either increase the Government debt and deficits or put a hefty new cost onto the taxpayers and users of services funded via the stimulus. In effect, the very attractiveness to the Government of the leveraged finance via NPRF is that such funding for capital programmes will most likely be off the official balancesheet of the State. This, however, means that it will also become a direct cost to consumers and, possibly, also to the taxpayers.

Let me explain the last point in greater detail. In 2012, Irish Government spent 3.7% of the country GDP or EUR6,133 million on paying interest on its debts implying an average effective interest rate of 3.19%. With the markets in a relative calm, our latest issue of Government bonds on March 20 this year saw NTMA raising EUR5 billion in 10-year debt at 3.9% annual coupon. This is the benchmark rate for any long-term lending in the country.

Even assuming the markets conditions will not change in the wake of a significant leveraging of funds from the NPRF, current cost of funds to the State is well in excess of recent returns earned by the NPRF on its liquid assets portfolio. In Q1 2013, NPRF delivered annualised rate for return of 2.8% on its discretionary portfolio and over 2000-2011 period, compounded returns earned by the NPRF run at 3.23% per annum.

Now, consider the second question posited above. Much of the public investment in infrastructure and general economic activities, as detailed in September 2011 Strategic Investment Fund (SIF) initiative issued by the current Government requires heavy involvement of the Private Sector co-funding. Quoting NPRF annual report for 2011, under  the SIF, "investment on a commercial basis from the NPRF will be channeled towards productive investment into sectors of strategic importance to the Irish economy (including infrastructure, water, venture capital and provision of long-term capital to the SME sector) and matching commercial investment from private investors would be sought." In other words, we are already leveraging the state finances for previous rounds of stimuli.

Private co-investment requires two things to succeed: sovereign assurances and preferential treatment to reduce overall levels of risk, plus annual return well in excess of sovereign debt returns. In other words, in any PPP and joint co-investment scheme, the State must assure premium return to the co-investing private sector agents.

If the State investments were to be financed at a sovereign cost of funding absent any negative effects on Government bond yields from increased borrowings, the underlying returns on public investments through the 'stimulus' scheme, based on a 50:50 split with private funding, would have to be yielding well in excess of 7-8% per annum. These returns will have to come either from the users of services backed by the PPP investments or from the taxpayers via minimum return guarantees.

Do the math: we can borrow at 3.9% in the markets or we can borrow at 7-8% via PPPs. The only difference is that under the latter arrangement, Minister Noonan can pretend that we didn’t borrow at all, as most of the money to repay the PPP investments will simply come out of the economy directly, instead of via the Exchequer.

That is the hope that is driving the Government to use NPRF instead of its own funds to fund capital spending. This hope, however, is based on rather thin analysis of the economic realities of the PPPs.

It is worth noting that between 1999 and the end of 2011, the total volume of PPP-based investments in Ireland, both committed and allocated, was just over EUR6.4 billion - or a fraction of the hoped-for amount of funds currently under the discussion for the next stage stimulus on foot of NPRF assets. This excludes EUR2.25 billion stimulus announced in July 2012 by the Government, which is not producing much of a desired effect of a stimulus on the economy so far.

Setting aside the issues of financial returns feasibility, it is highly doubtful that this level of investment can be economically efficiently deployed in the economy. And this is on foot of rather poor PPPs performance documented for pre-crisis period, as was highlighted in a number of studies on the subject. Several reports found that the final PPP deals involving capital funding for schools, water infrastrcture and transport programmes returned final costs well above the costs of direct procurement. Severe cost transfers to the state from the PPP projects have been found in the cases of major roads contracts in Ireland, including Clonee-Kells project and Limerick Tunnel project.

An in-depth research note on the problems inherent in PPP funded capital investments in Ireland published by the NERI Institute in January 2013 concluded that "it is striking that after thirteen years of procurement under PPP, there has been no official in-depth analysis of the experience to date. Yet PPP is now a major part of the current governments plan to stimulate the economy. The absence of any publicly available body of evidence in support of this plan represents a major shortcoming in terms of the formation of economic policy."

In contrast to the pre-crisis periods, current business, investment and economic environment in Ireland is characterised by high levels of debt overhang in the private sector, involuntary entrepreneurship, falling rates of growth in global demand for indigenous exports out of Ireland, stagnant or declining real assets valuations and a number of other factors significantly increasing the risk of any new investment. In other words, any new stimulus will have to come at the time when investment opportunities are thinner on the ground and risks associated with such investments are higher.

All of the risks associated with PPP-funded projects, thus, are only exacerbated in the current economic environment.

Instead of first attempting to fix the problems with the core financing schemes, the Government is setting out to drive more forcefully into the troubled waters of privately co-funded schemes. Previously announced stimuli, ranging from capital investment supports to stamp duty and R&D tax incentives, to the 2011-2012 announcements of similar PPP-based leveraged capital investment programmes have been insufficient to stimulate the domestic economy out of its structural collapse. This time around, the Government is attempting to up the ante by increasing the amounts of funds it aims to pump into the economy. The hope, obviously, is that doing more of the same on an increasing scale will yield a different outcome.

More likely, the outcome will be a further debasing of the consumers’ disposable incomes via higher taxation and higher cost of services, in exchange for wiping out completely the NPRF – our only remaining cushion against any potential future risks. Doubling-up when losing repeatedly in the economic policy roulette is not a good idea.  Doubling-up using granny’s pension cheques might be outright reckless.

Box-out:

Back in April this year, the IMF stole the headlines in Ireland after pointing that combined unemployment and underemployment rate in Ireland stood at a staggering 23%. However, the only really surprising thing about the IMF statement was that this data was already reported by the CSO before. In fact, CSO reports quarterly broader unemployment statistics since Q1 1998. Last week, CSO database showed that in Q1 2013, the broadest measure of unemployment – the measure that includes unemployed, discouraged workers and underemployed workers – has hit 25%, rising from 23.7% in Q1 2011 when the current Government took office. However, the above measure is still incomplete, as it excludes those workers who are drawing unemployment supports but are classified as participants in state training programmes, e.g. JobBridge. Adding these workers to the broader measure referenced by the IMF, Irish broad unemployment rate in Q1 2013 stood at a massive 29% - a historical high for the metric and up 2.7 percentage points on Q1 2011.

21/7/2012: Sunday Times July 1, 2012 - Not a 'stimulus' again...

An unedited version of my Sunday Times article from July 1.

One of the points of contention in modern economics is the role of fiscal spending shocks on economic growth. Various empirical estimates suggest Irish fiscal multiplier at 0.3-0.4, implying that for every euro of additional Government spending we should get a €1.30-€1.40 in GDP uplift. However, these are based on models that do not take into the account our current conditions. Despite this fact, Irish policymakers continue talking about the need for Government to stimulate the economy, while various think tanks continue to argue that Ireland should abandon fiscal stabilization or more aggressively tax private incomes to deliver a boost to our spending.

International research on this matter is more advanced, although it too leaves much room for a debate.

June 2012 IMF working paper titled “What Determines Government Spending Multipliers?” by Giancarlo Corsetti, Andre Meier and Gernot Muller (June 2012) studied the effects of government spending on the economy under the variety of macroeconomic conditions.

What IMF researchers did find is that the initial conditions for stimulus do matter in determining its effectiveness – an issue generally ignored in the domestic debates about the topic.

Under a pegged exchange rate regime, similar to Ireland’s but still allowing for some exchange rate and interest rates adjustments, trade balance is likely to worsen in response to a fiscal stimulus, while output can be expected to rise. Domestic investment and consumption will decline in response to the positive stimulus shock. These factors are likely to be even more pronounced in the case of Ireland’s currency ‘peg’ that permits no adjustment in real exchange rate except via domestic inflation.

The role of weak public finances in determining the effectiveness of fiscal spending stimulus is also revealing. The study defines fiscally constrained conditions as the gross government debt exceeding 100 percent of GDP and/or government deficit in excess of 6 percent of GDP. Both of these are present in the case of Ireland. On average, the study shows that consumption response to fiscal stimulus is negative-to-zero following the stimulus, but becomes positive in the medium term. Impact on output and investment is negative. The core reasons for the adverse effects of fiscal expenditure on economic performance are losses from stimulus through increased imports of goods and services by the State, internal re-inflation of the economy through inputs prices, plus the expectation from the private sector consumers and producers of higher future taxes required to cover public spending increases.

In the case when financial crisis is present, increase in Government spending results in a positive and strong output expansion, rise in consumption and, with some delay, rise in investment. However, net exports still fall sharply and the stimulus leads to the inflationary loss of external competitiveness in the economy.

The problem with the above results is that the IMF study still does not consider what happens to a fiscal stimulus in a country like Ireland, combining a strict currency peg, exclusive reliance on trade surplus for growth generation and characterized by historically high levels of fiscal imbalances and financial system collapse. In other words, even the IMF research as imprecise as it is, is far from conclusive.

These are non-trivial problems in the case of Ireland. Official estimates for fiscal policy multiplier in this country range between 0.38 (European Commission) and 0.4 (Department of Finance).  These are based on relatively simplistic models and are, therefore, likely to be challenged by the reality of our current conditions. A more recent study from the Deutsche Bank cites Irish fiscal multiplier of 0.3 without specifying the methodology used in deriving it. Either way, no credible estimate known to me puts the fiscal multiplier above 0.4 for Ireland.

In short, Government stimulus is not exactly an effective means for raising output, even at the times when the economy can take such stimulus without demolishing the Exchequer balancesheet. And lacking precision in estimating the fiscal multiplier, the entire argument in favor of fiscal stimulus is an item of faith, not of scientific analysis.

In my opinion, Ireland does not need a Government expenditure boost. Instead we need a policy shift toward stimulating domestic and international investment, plus the public expenditure rebalancing away from current spending toward some additional capital investment.

Quarterly National Accounts clearly show that the problem with the Irish economy is not the fall off in private or public consumption, but a dramatic collapse in private investment. While private consumption expenditure in Ireland has declined 13.6% relative to the economy’s peak in 2007, net expenditure by Government is down 12.0% (including a decline in public investment). However, overall private investment in the economy is down 67%. 2011 full year capital investment was, unadjusted for inflation, at the level last seen in 1997, while consumption is down ‘only’ to 2005-2006 levels and Government spending is running at around 2006 levels. With nominal GDP falling €33.5 billion between 2007 and 2011, our investment declined €32.6 billion over the same period, personal consumption dropped €12.8 billion, while net Government expenditure on goods and services is down a mere €3.4 billion. Between 2007 and 2011, total voted current expenditure by the Government rose 12%, while total net voted capital expenditure fell 44%.

Adding a Government investment stimulus of €2 billion would have an impact of raising net capital expenditure by the Exchequer in 2012-2014 to the levels 22.4% below those in 2007 and will lift our GDP by under 1.8% according to the EU measure of fiscal multiplier. However, factoring in deterioration in the current account as estimated by the IMF, the net effect might be closer to zero. Based on IMF model re-parameterized to our current conditions, the net result can be as low as 0.1% increase in GDP.

Again, the problem here is the effect of capital spending on our imports. As a highly open economy, Ireland imports most of what it consumes. This includes Government and private capital investment goods – machinery, materials and know-how relating to construction, assembly, installation and operation of modern transport systems, energy and ICT, etc. Some of these imports will continue well beyond the period of actual investment. In other words, using fiscal stimulus to finance public capital investment risks providing some short-term supports for lower skilled Irish labour and few professionals with the lion’s share of expenditure going to the multinational companies supplying capital goods and services into Ireland from abroad.

The fiscal cost of such a stimulus, however, would be exceptionally high. Between 2008 and 2011, Irish Government has managed to cut €4.3 billion off the annual capital spending bill while increasing current spending by €662 million. This resulted in total voted spending reduction of only €3.6 billion. A stimulus of €2 billion on capital investment side will throw the state back to 2009 levels of expenditure, erasing two years worth of consolidation, unless it is financed out of cutting current spending and transferring funds to capital programmes. The extra capital spending will lead to further retrenchment in private consumption and investment, as households and businesses will anticipate relatively rapid uplift in tax burdens to recover the momentum to the fiscal consolidation. This, coupled with already committed €8.6 billion in further fiscal adjustments in the next three years, will further reduce growth effects of the stimulus and shorten its positive effects duration.

Overall, the right course of policies to pursue today requires restructuring of the debt burden carried by the real economy, starting with household debts and stimulating, simultaneously domestic and foreign investment into small and medium enterprises and start-ups. Instead of focusing on the less labor-intensive MNCs’ investments, we need to put in place tax and institutional incentives to increase inflow of equity capital, not new debt, to Irish businesses. Such incentives must target two areas of investment: investment into activities associated with new jobs creation by the SMEs, plus investment into strategic repositioning and restructuring of Irish SMEs to put them onto exporting path.

Lastly, if we really do want to have a stimulus debate, the discussion should not be focusing on creating a net increase in the public expenditure, but on the potential for reallocating some of the funds from the current expenditure side of the Exchequer balancesheet to capital investment.

  

Box-out:

The latest Index of Failed States published this week ranks Ireland the 8^th best state in the world. Our overall score in the league table was helped by extremely high performance in some specific indicators. Surprisingly, according to the Index authors, we are having a jolly good time throughout the crisis. Allegedly, Ireland’s problem in terms of emigration is relatively comparable to that found in New Zealand and Germany. Our economy, heavily dominated by MNCs exports in pharma, medical devices and ICT sectors ranks higher in terms of the balance of economic development than majority of the advanced economies that have more diversified and domestically anchored sources of growth. Our ‘balanced development’ model, having led us into the current crisis, is allegedly more sustainable, according to the Index, than that of Canada – a country that escaped the Great Recession. In terms of poverty and economic decline we are better off than France, Japan and New Zealand, which had a much less severe recession than Ireland over the last 5 years. In quality of public services, we are better than Belgium and the UK, and are ranked as highly as Canada. And our elites are less factionalized than those in the vast majority of the states of the Euro area. In short, according to the Foreign Policy, index publisher, Ireland is a veritable safe haven within a tumultuous euro zone, comparable to New Zealand, Luxembourg, Norway and Switzerland. We rank well ahead of Canada, Australia, the UK and the US, as well as all other states that currently receive tens of thousands of Irish emigrants.

7/6/2012: Sunday Times May 13, 2012

This is an unedited version of my Sunday Times article from May 13, 2012.

With Greek and French elections results out last week, the European leadership is rapidly shifting gears into neutral when it comes to austerity. Within two weeks surrounding the French elections, the Commission has issued a set of statements pushing forward its ‘growth budget’, and issued new proposals for enhancing European investment bank.

This, of course, is a classic rhetoric of damage limitation, contrasted by the reality of the currency union that is in the final stage of the crisis contagion. Having spread from economic to financial and subsequently to fiscal domains of the euro area, the cancer of Europe’s debt overhang has now metastasised to its political leadership. And the financial pressures are back on. Since the late March, credit default swaps spreads have widened for all but two core euro area states (excluding Greece), with an average rate of increase of 10.6%, implying that the markets-priced cumulative probability of the euro zone country default within the next 5 years is now, on average, close to 24%.

Next stop is a period of extended navel-gazing, with summits and ministerial dinners, contrasted by the European electorate moving further away from the centre of power gravity.

By autumn we will be either in a selective euro unwinding (Greece exiting) or in a desperate policies u-turn into mutualisation of the national and banking debts, supported by a return to high pre-2011 deficits and an acceleration of the debt spiral.

The former is going to be extremely disruptive in the short run. Portugal will be watching the Greeks closely, while Spain and Italy will be sliding into unrest. If properly managed, Greek and, later Portuguese exits will allow euro area to cut losses. With a stronger ESM balancesheet, euro area will buy more time to deal with the markets panic, but it will still require serious structural adjustments to shore up the failing currency union. Mutualisation of debt will remain inevitable, but deficits run up can be avoided in exchange for slower reduction in deficits.

The latter option of starting with mutualising debt, while allowing for new deficit financing of growth stimuli will be a road to either a collapse of the common currency within a decade or a Japan-style stagnation. The central problem is that the current political dynamics are forcing the euro area onto the path of growth stimulation amidst a severe debt overhang. The lack of real catalysts for economic recovery means that a temporary stimulus will have to be replaced by sustained debt accumulation. In other words, the political cure to the crisis a-la Hollande, not the austerity, will spell the end of the euro zone.

There are two sides to this proposition.

Firstly, the villain of the European austerity is a bogey. In 2011-2012, euro area fiscal deficits will average 3.7% of GDP per annum, identical to those recorded in 2010-2014 and deeper than in any five-year period from 1990 through 2009, including the period covering the recession of the early 1990s. The ‘savage austerity’, as planned, is expected to result in historically high five-year average deficits. At over 3.2% of GDP, 2012 forecast deficit for the common currency zone will be 6^th largest since 1990.

Instead of shrinking, euro area governments over-spending will remain relatively static under the current ‘austerity’ path. Per IMF, general government revenues will account for 45.6% of GDP in 2011-2012, well ahead of all five-year period averages since 1990 except for 1995-1999 when the comparable figure was 46% of GDP. The same comparative dynamics apply to the government expenditure as a share of GDP.

In other words, euro area voters are currently revolting against the austerity that, with exception of Greece and Ireland, is hardly visible anywhere.

Secondly, the talk about Europe’s growth stimulus is nothing more than a return to the policies that have led us into this crisis in the first place. In 1990-1994, euro area public debt to GDP ratio averaged 59%. By 2005-2009, the average has steadily risen to 71%. In 2010-2014, the forecast average will stand at 89%, identical to the ratio in 2011-2012. Euro area is now firmly stuck in the policy corner that required accumulation of debt in order to sustain economic activity. Since the mid-1990s, the EU has produced one growth policy platform after another that relied predominantly on subsidies and public investment.

By the mid-2000s, the EU has exhausted creative powers of conceiving new subsidies, just as the ECB was flooding the banking system with cheap liquidity. At the peak of the subsequent sovereign debt crisis, in March 2010, Brussels came up with Europe 2020 document – yet another ‘sustainable growth’ scheme through featuring more subsidies and public investment.

At the member states’ level, private debt-fuelled construction and banking bubbles were superimposed onto public infrastructure investments schemes and elaborate R&D and smart economy bureaucracies as the core drivers for jobs creation. State spending and re-distribution were the creative force driving economic improvements in a number of countries. Amidst all of this, euro area overall growth remained severely constrained. For the entire period between 1992 and 2007, euro area real economic growth averaged less than 2.1% per annum, while government deficits averaged over 2.5%. The only three years when public deficit financing was not the main driver of growth were the peaks of two bubbles: 2000, and 2006-2007.

In brief, Europe had not had a model for sustainable growth since 1992 and it is not about to discover one in the next few months either.

Which brings us to the core problem facing the European leadership – the problem of debt overhang.

As a research paper by Carmen M. Reinhart, Vincent R. Reinhart and Kenneth S. Rogoff published last week clearly shows, “major public debt overhang episodes in the advanced economies since the early 1800s [were] characterized by public debt to GDP levels exceeding 90% for at least five years.” The study found “that public debt overhang episodes are associated with growth over one percent lower than during other periods.” Across all 26 episodes studied, “the average duration …is about 23 years.”

Now, according to the IMF data, the euro area will reach the 90% debt to GDP bound in 2012 and will remain there through 2015. Statistically, the euro area will be running debt levels in excess of 90% through 2017. Between 2010 and 2017, IMF forecasts that seven core euro area states will be facing debt to GDP ratios at or above 90%. Of the four largest euro area economies, Germany is the only one that will remain outside the debt overhang bound. Increasing deficits into such a severe debt scenario would risk extending the crisis.

After two years of half-measures and half-austerity, the euro as a currency system is now less sustainable. The survival of the euro (even after Greek, Portuguese and, possibly other exits) will depend on structural reforms, including change in the ECB mandate, political federalisation and fiscal harmonisation beyond the current Fiscal Compact treaty.

The real problem Europe is facing in the wake of the last week’s elections in Greece and France is that traditional European elites are no longer capable of governing with the tools to which they became accustomed over decades of deficits and debt accumulation, while the European populations are no longer willing to be governed by the detached and conservative elites. Not quite a classical revolutionary situation, yet, but getting dangerously close to one.

CHARTS: 

Box-out:

This was supposed to be a boom year for car sales as the threat of getting an unlucky ‘13’ stuck on your shiny new purchase for some years was supposed to spell a resurgence in motor trade fortunes. Alas, the latest stats from the CSO suggest that this hoped-for prediction is unlikely to materialise. In the first four months of 2012, new registrations of all vehicles have fallen 8.5% year on year and 60% on 2007. New private cars registrations have suffered an even deeper annual fall, down 10.2% year on year although since the peak they are down ‘only’ 56%. The news of the motor trade suffering is hardly surprising. Unemployment stuck above 14%, fear of forthcoming tax increases in the Budget 2013, plus the dawning reality that sooner or later interest rates (and with them mortgages costs) will climb sky-high are among the reasons Irish consumers continue to stay away from purchasing large ticket items. Cyclical consumption considerations are also coming into play. Over the last 4 years, Irish households barely replaced their stocks of white goods. Given the life span of necessary household appliances, the households are likely to prioritize replacing ageing dishwasher or a fridge over buying a new vehicle. Families compression with children returning back to parental homes to live and grandparents taking over expensive crèche duties are also likely to depress demand for cars. Lastly, there is a pesky consideration of the on-going deleveraging. Irish households have paid down some €36 billion worth of personal debts and mortgages in recent years. Still, Irish households remain the second most indebted in the Euro area. New cars registrations fall off in 2012 shows that in the end, sanity prevails over vanity and superstition, at the detriment to the car sales industry.