Source: CMA.
Monday, November 1, 2010
Economics 2/11/10: Spot the odd ones out
As of yesterday's close, implied probability of default based on CDS spreads and spreads themselves are:
Source: CMA.
Source: CMA.
Sunday, October 31, 2010
Economics 31/10/10: Mortgages, relief and stimulus
David McWilliams' idea of deferring mortgage repayments for 2 years is continuing to generate some discussions in the 'new' media. Here are my thoughts on the topic.
David's idea starts from the right premise that households are currently suffering from mortgage/debt repayment burden that is non-sustainable in the current economic conditions and acts to depress consumption and household investment. But in my view, it is not going to yield any significant impact on the economy.
As expected incomes fall due to:
Collapse of consumption and household investment we are witnessing today is the direct outcome of the above forces and it will continue to worsen as long as households' disposable after tax incomes continue to decline and remain at risk of further pressure. In addition, non-discretionary segment of consumption (energy, education, transportation and health) show no signs of price deflation, implying that discretionary disposable after tax income - the stuff we get to spend in the shops or invest - is even more distressed.
The problem here is not that we face a temporary shock to our income. The problem is of debt overhang - basically, the insolvent nature of our households' balancesheets.
Thus, any solution to this problem will require a permanent debt writedown. It cannot be resolved by temporarily suspending mortgages repayments for several reasons:
We have - on aggregate - households facing:
While on per-capita basis the overall household debt liabilities amount to ca 310% of our national income, in real terms what matters is the incidence of the debt on productive households. We currently have ca 41.3% of population in employment (or 1,859,000). Of these, 552,900 are in the age group of 25-34 years of age, 469,600 are in 35-44 years of age and 393,900 are in the age group 45-54 years of age. Assume that the demographic pyramid does not change (for better or worse) in the next 10 years. Total employment pool of those that can be expected to carry the debt burden is actually closer to 1.42 million or 31.5% of the total population of the country.
This raises public and household debt leverage ratio on population that can be expected to repay it to a whooping x10 times household income. This, folks, is a bankruptcy territory for roughly speaking 1/3 of our entire population or for nearly 100% of our productive population.
A 2 year holiday from mortgages repayment will simply not solve this problem. Only significant debt write-off of household debts or full restructuring of our sovereign debt and deficit (to eliminate the need for future tax increases and reverse recent tax increases) or a combination of both will be able to correct for this severe debt overhang.
David's idea starts from the right premise that households are currently suffering from mortgage/debt repayment burden that is non-sustainable in the current economic conditions and acts to depress consumption and household investment. But in my view, it is not going to yield any significant impact on the economy.
As expected incomes fall due to:
- continued recession in the economy (courtesy of the insolvency crisis we face across the entire economy);
- elevated risk of unemployment (ditto);
- rising tax burden on households (courtesy of the Government's perverse logic which puts the needs of financial services and Exchequer ahead of those of the real economy - households and firms);
- heightened risk of further tax increases in the future (ditto);
- behavioral implications of the severe and deepening negative equity (being further reinforced by the FR and Government denial of the problem and asymmetric treatment of development debts and household debt); and
- continued increases in the cost of mortgages finance and credit (courtesy of the Government approach to dealing with the banking crisis)
Collapse of consumption and household investment we are witnessing today is the direct outcome of the above forces and it will continue to worsen as long as households' disposable after tax incomes continue to decline and remain at risk of further pressure. In addition, non-discretionary segment of consumption (energy, education, transportation and health) show no signs of price deflation, implying that discretionary disposable after tax income - the stuff we get to spend in the shops or invest - is even more distressed.
The problem here is not that we face a temporary shock to our income. The problem is of debt overhang - basically, the insolvent nature of our households' balancesheets.
Thus, any solution to this problem will require a permanent debt writedown. It cannot be resolved by temporarily suspending mortgages repayments for several reasons:
- Temporary suspension of mortgages repayments will not draw down the overall debt burden, as banks will reload increases in mortgage finance costs into the future to offset for losses incurred during the holiday even if there is no roll up of interest during the holiday. In other words - suspending mortgage repayment for 2 years will likely lead to banks pushing even higher cost of mortgages interest into years 3 and on for all households concerned;
- Any rational household will anticipate (1) above to take place and will ramp up precautionary savings to compensate for expected cost increases in their mortgages, withdrawing even more cash from today's consumption. A mortgage holiday in these conditions will lead to zombie banks turning into zombie households;
- Any rational household will, also in anticipation of (1) withhold any purchases of property until the full realisation of true future mortgage finance costs takes place post holiday;
- If any suspension of mortgages finance involves rolling up of the interest for 2 years, the burden of future mortgage liabilities will increase dramatically, which, once again will be anticipated by the rational households. As a result, households will take 2 years worth of 'free' rent and then default at the point of interest roll up kicking in. We can expect a wall of mortgages defaults in 2013;
- In order for the repayment holiday to have any real effect, the long term growth rate in personal disposable income will have to exceed: increase in the cost of mortgage finance post-holiday + inflation - tax increases expected. This, using current growth estimates etc suggests that in order for a 2 year holiday on repayment of mortgages to have any positive effect, our aggregate expected growth rate in personal income should be in excess of 50% in years 2013-2018. This is clearly not anywhere near being realistic.
We have - on aggregate - households facing:
- current long and short term debt burden of ca 145% of GNP, and
- expected (2014) sovereign debt burden of ~140% of GDP or ca 165% of GNP (under rather optimistic assumptions on GDP/GNP gap) - at least 80% of this will have to be repaid out of the pockets of our households.
While on per-capita basis the overall household debt liabilities amount to ca 310% of our national income, in real terms what matters is the incidence of the debt on productive households. We currently have ca 41.3% of population in employment (or 1,859,000). Of these, 552,900 are in the age group of 25-34 years of age, 469,600 are in 35-44 years of age and 393,900 are in the age group 45-54 years of age. Assume that the demographic pyramid does not change (for better or worse) in the next 10 years. Total employment pool of those that can be expected to carry the debt burden is actually closer to 1.42 million or 31.5% of the total population of the country.
This raises public and household debt leverage ratio on population that can be expected to repay it to a whooping x10 times household income. This, folks, is a bankruptcy territory for roughly speaking 1/3 of our entire population or for nearly 100% of our productive population.
A 2 year holiday from mortgages repayment will simply not solve this problem. Only significant debt write-off of household debts or full restructuring of our sovereign debt and deficit (to eliminate the need for future tax increases and reverse recent tax increases) or a combination of both will be able to correct for this severe debt overhang.
Economics 31/10/10: €15bn in cuts will not be enough
This is an unedited version of my article in yesterday's Irish Examiner.
The last three days have seen dramatic volatility and extreme upward pressures on Irish, as well as Greek and Portuguese Government bonds. Briefly, early on Thursday morning, Irish 10 year bonds have set a new all-time record with yields reaching North of 7.07%. Much of these changes have been driven by the budgetary news from all three countries.
First, Greece and Portugal have shown the signs of increasing uncertainty about projected tax revenues and ability to deliver on ambitious austerity programmes.
Then, Ireland came into the line of fire.
Back in December 2009, the Government outlined a plan for piecemeal cuts in deficits over 2011-2014 that added up to a gross value of €6.5 billion (with at least €3 billion in tax measures). This was supposed to get us from having to borrow €18.8 billion in 2010 to a deficit of ca €9 billion in 2014. All courtesy of robust economic growth of more than 4% per annum penned into the Department of Finance rosy assumptions for 2011-2014.
This week, the Minister for Finance had to come down from the lofty heights of the “now you see the deficit, now your don’t” estimates by his Department. Courtesy of continuously expanding unemployment, declining tax revenues, plus ever-growing interest bills on Government debts, the headline gross savings target for 2011-2014 has been increased to €15 billion.
Dramatic as it might be, this figure is still far from being realistic – the fact that did not escape the bond vigilantes and some analysts. More than that, it represents the very conservative ethos of the Department of Finance and the Government that got us into a situation where three years into the crisis Ireland is still light years away from actually doing anything serious about correcting its fiscal position.
Let me explain.
First of all, take the actual announced plans for cuts in public spending. Over two months ago I have argued in the media that to get us onto the track toward reaching the goal of 3% to GDP deficit ratio, we need ca €7 billion in cuts in 2011, followed by €5 billion in 2012. The grand total of gross deficit reductions from now through 2014 adjusting for the effects of these cuts on our GDP and unemployment, plus steeper cost of financing Government debt, excluding new demand for funding from the banks is not the €15 billion, but €19-20 billion. In other words, once fiscal stabilizers (automatic clawbacks on Government spending) are added in, to achieve 3% target requires more than 33% deeper cuts than Minister Lenihan announced this Wednesday.
The markets know this. Just as they know that given the Government record to date there is very little chance that even €15 billion in cuts will be delivered. This mistrust in Government’s capacity to actually administer its own prescription is manifested most explicitly by the Croke Park agreement that effectively put one third of the current public expenditure out of reach of Mr Lenihan’s axe. It is further highlighted by the fact that this Government has failed to
substantially reduce public spending bills from 2008 through today. Back in 2008, net government spending stood at €55.7 billion. This year, we are likely to post a reduction of just €2.4 billion on 2008, all of which is accounted for by cuts in capital investment programmes.
Third, the markets also understand long-term implications of deficits. Even if the Irish Government manages to bring 2014 deficit close to 3% target, our Sovereign debt will grow by over €5 billion in that year. At this pace, Irish Exchequer is likely to be on the hook for a debt to GDP ratio of 125% by the end of 2014 reaching over 140% if expected additional banks liabilities materialise in 2011-2014. And all of this after we account for Mr Lenihan’s €15 billion cuts planned for 2011-2014.
Fourth, Government budgetary arithmetic falls further apart when one considers economics of the proposed deficit reduction measures. So far, the Government has planned for €3 billion increase in taxes on top of tax revenues gains due to rosy economy growth expectations between now and 2014. €15 billion target announcement raises this most likely 2-fold.
I have severe doubts that this economy has capacity left for tax revenue increases. Signs are, households are struggling with personal debts and their disposable after-tax incomes are barely sufficient to cover day-to-day spending. Credit card debts and utilities arrears are rising, savings are falling – all of which points to growing stress. Weakening sterling is pushing more retail sales out into the North just in time for Christmas shopping season. Cash economy – judging by
anecdotal evidence and corporate tax revenue in light of booming exports sectors – is expanding. The tax base is shrinking due to unemployment, underemployment and falling earnings.
Again, any rational investor will look at this as the evidence that the Government has run out of capacity to tax itself out of the fiscal corner.
But wait, this is only half of the story. The other half relates to the banking side of consumer affairs. In 2011 we can expect significant increases in mortgages costs as Irish banks once more go rummaging through the proverbial couch in search for a new injection of pennies. Bank of Ireland’s bond placing this week, with a yield of 5.4%, suggests a bleak future for lending markets. Any increases in mortgages costs will hike Government expenditure (by raising the cost of interest subsidies), hammer revenues (by reducing household consumption) and trigger new demands from banks for capital (to cover defaulting mortgages).
None of which, of course, appears to be attracting much attention from the Upper Merrion Street. At least judging by the budgetary projections released so far. At the same time, these numbers are impacting our long term growth potential and increasing the probability that Ireland, in the end, will have to restructure its public debt.
This week, similarly brutal arithmetic concerning Greek fiscal situation has prompted Professor Nouriel Roubini to make a dire prediction of the inevitable default by Greece on its Sovereign debt. Given Minister Lenihan’s recent statements and his boss’ staunch unwillingness to scrap the Croke Park agreement, it is hard to see how the forthcoming budgetary framework for 2011-2014 can get us out a similar predicament.
The last three days have seen dramatic volatility and extreme upward pressures on Irish, as well as Greek and Portuguese Government bonds. Briefly, early on Thursday morning, Irish 10 year bonds have set a new all-time record with yields reaching North of 7.07%. Much of these changes have been driven by the budgetary news from all three countries.
First, Greece and Portugal have shown the signs of increasing uncertainty about projected tax revenues and ability to deliver on ambitious austerity programmes.
Then, Ireland came into the line of fire.
Back in December 2009, the Government outlined a plan for piecemeal cuts in deficits over 2011-2014 that added up to a gross value of €6.5 billion (with at least €3 billion in tax measures). This was supposed to get us from having to borrow €18.8 billion in 2010 to a deficit of ca €9 billion in 2014. All courtesy of robust economic growth of more than 4% per annum penned into the Department of Finance rosy assumptions for 2011-2014.
This week, the Minister for Finance had to come down from the lofty heights of the “now you see the deficit, now your don’t” estimates by his Department. Courtesy of continuously expanding unemployment, declining tax revenues, plus ever-growing interest bills on Government debts, the headline gross savings target for 2011-2014 has been increased to €15 billion.
Dramatic as it might be, this figure is still far from being realistic – the fact that did not escape the bond vigilantes and some analysts. More than that, it represents the very conservative ethos of the Department of Finance and the Government that got us into a situation where three years into the crisis Ireland is still light years away from actually doing anything serious about correcting its fiscal position.
Let me explain.
First of all, take the actual announced plans for cuts in public spending. Over two months ago I have argued in the media that to get us onto the track toward reaching the goal of 3% to GDP deficit ratio, we need ca €7 billion in cuts in 2011, followed by €5 billion in 2012. The grand total of gross deficit reductions from now through 2014 adjusting for the effects of these cuts on our GDP and unemployment, plus steeper cost of financing Government debt, excluding new demand for funding from the banks is not the €15 billion, but €19-20 billion. In other words, once fiscal stabilizers (automatic clawbacks on Government spending) are added in, to achieve 3% target requires more than 33% deeper cuts than Minister Lenihan announced this Wednesday.
The markets know this. Just as they know that given the Government record to date there is very little chance that even €15 billion in cuts will be delivered. This mistrust in Government’s capacity to actually administer its own prescription is manifested most explicitly by the Croke Park agreement that effectively put one third of the current public expenditure out of reach of Mr Lenihan’s axe. It is further highlighted by the fact that this Government has failed to
substantially reduce public spending bills from 2008 through today. Back in 2008, net government spending stood at €55.7 billion. This year, we are likely to post a reduction of just €2.4 billion on 2008, all of which is accounted for by cuts in capital investment programmes.
Third, the markets also understand long-term implications of deficits. Even if the Irish Government manages to bring 2014 deficit close to 3% target, our Sovereign debt will grow by over €5 billion in that year. At this pace, Irish Exchequer is likely to be on the hook for a debt to GDP ratio of 125% by the end of 2014 reaching over 140% if expected additional banks liabilities materialise in 2011-2014. And all of this after we account for Mr Lenihan’s €15 billion cuts planned for 2011-2014.
Fourth, Government budgetary arithmetic falls further apart when one considers economics of the proposed deficit reduction measures. So far, the Government has planned for €3 billion increase in taxes on top of tax revenues gains due to rosy economy growth expectations between now and 2014. €15 billion target announcement raises this most likely 2-fold.
I have severe doubts that this economy has capacity left for tax revenue increases. Signs are, households are struggling with personal debts and their disposable after-tax incomes are barely sufficient to cover day-to-day spending. Credit card debts and utilities arrears are rising, savings are falling – all of which points to growing stress. Weakening sterling is pushing more retail sales out into the North just in time for Christmas shopping season. Cash economy – judging by
anecdotal evidence and corporate tax revenue in light of booming exports sectors – is expanding. The tax base is shrinking due to unemployment, underemployment and falling earnings.
Again, any rational investor will look at this as the evidence that the Government has run out of capacity to tax itself out of the fiscal corner.
But wait, this is only half of the story. The other half relates to the banking side of consumer affairs. In 2011 we can expect significant increases in mortgages costs as Irish banks once more go rummaging through the proverbial couch in search for a new injection of pennies. Bank of Ireland’s bond placing this week, with a yield of 5.4%, suggests a bleak future for lending markets. Any increases in mortgages costs will hike Government expenditure (by raising the cost of interest subsidies), hammer revenues (by reducing household consumption) and trigger new demands from banks for capital (to cover defaulting mortgages).
None of which, of course, appears to be attracting much attention from the Upper Merrion Street. At least judging by the budgetary projections released so far. At the same time, these numbers are impacting our long term growth potential and increasing the probability that Ireland, in the end, will have to restructure its public debt.
This week, similarly brutal arithmetic concerning Greek fiscal situation has prompted Professor Nouriel Roubini to make a dire prediction of the inevitable default by Greece on its Sovereign debt. Given Minister Lenihan’s recent statements and his boss’ staunch unwillingness to scrap the Croke Park agreement, it is hard to see how the forthcoming budgetary framework for 2011-2014 can get us out a similar predicament.
Saturday, October 30, 2010
Economics 30/10/10: Euro area growth forecast
Updating leading indicator data for Euro area growth from Eurocoin:
Having posted bang on forecast for September (forecast was 0.34 and this is what the final number came in at), I missed October turning point. The latest uplift suggests growth of 0.9% in Q3, but I am not convinced for a number of reasons:
Having posted bang on forecast for September (forecast was 0.34 and this is what the final number came in at), I missed October turning point. The latest uplift suggests growth of 0.9% in Q3, but I am not convinced for a number of reasons:- Growth in the lead indicator is driven strongly by the EU Comm survey of business expectations which has been trending strongly up since Feb 2010. In the mean time, PMIs-based expectations metric is showing a renewed expectation for a slowdown.
- Consumer confidence surveys are flat.
- Exports (to August) are down
Friday, October 29, 2010
Economics 29/10/10: Retail sales
After two weeks of absolutely excessive work loads, including a week of marathon teaching (gotta love that feeling of total exhaustion after 5 days worth of 6 hours straight lecturing on top of regular work), the blog is back.
The first order of the day - catching up with today's data. Retail sales... well, they are still tanking. Predictably, given weakening sterling (incentive to shop North), beginning of the festive season shopping (another incentive to head North for larger ticket items savings) and continued decline of overall economy.
Per CSO today, let's deal with the volumes and values of total sales first
Looks like bottom fishing just got slightly more fun on both value and volume. And it's too bad you can't short retail sales:
Relative to peak, total sales are...
...errr... sickening?
As I highlighted on many occasions before, our Government's desire to subsidize Japanese, Korean, French, German etc manufacturers of motor vehicles, coupled with the vanity plates year have meant that our total retails sales are rather overly optimistic when it comes to determining the real retail environment out there. So let's drop Motor Trades out of the data:
If Motor Trades are excluded, there was
Yeah, that does look like an AIB share price chart... and then the rates of change:
Painful? Yes. Brian & Brian will not be happy campers - VAT receipts must be depressed. Jobs are also clearly going to be under pressure as we exit festive season, implying that absent a dramatic reversal of the recent trends, retail sector will be in severe pain comes January.
Not that it was avoiding that pain in recent past:
We now have provisional estimates for Q3 2010, so let's update quarterly graphs - which confirm broadly the weakening trend:
The first order of the day - catching up with today's data. Retail sales... well, they are still tanking. Predictably, given weakening sterling (incentive to shop North), beginning of the festive season shopping (another incentive to head North for larger ticket items savings) and continued decline of overall economy.
Per CSO today, let's deal with the volumes and values of total sales first
- Retail Sales volume decrease by 0.3% in September 2010 compared with September 2009
- The volume of retail sales (i.e. excluding price effects) decreased by 0.3% yoy and declined 0.9% mom.
- The value of retail sales decreased by 2.6% yoy and there was a mom change of -1.2%.
Looks like bottom fishing just got slightly more fun on both value and volume. And it's too bad you can't short retail sales:
Relative to peak, total sales are...
...errr... sickening?As I highlighted on many occasions before, our Government's desire to subsidize Japanese, Korean, French, German etc manufacturers of motor vehicles, coupled with the vanity plates year have meant that our total retails sales are rather overly optimistic when it comes to determining the real retail environment out there. So let's drop Motor Trades out of the data:
If Motor Trades are excluded, there was
- an annual decrease of 4.1% in the value of retail sales and a monthly decrease of 0.9%
- volume of retail sales decreased by 2.5% in September 2010 yoy and fell 0.8% mom.
- thus, increases yoy in volumes were posted in: Motors (+13.2%), Non-Specialised Stores (+0.8%)
- of course, decreases were led by Other Retail (-12.4%) and Bars (-11.6%).
- mom declines in the volume "were evident in ten of the categories while only three categories showed monthly increases in September 2010". So broadly, monthly adjusted series were heading down.
Yeah, that does look like an AIB share price chart... and then the rates of change:
Painful? Yes. Brian & Brian will not be happy campers - VAT receipts must be depressed. Jobs are also clearly going to be under pressure as we exit festive season, implying that absent a dramatic reversal of the recent trends, retail sector will be in severe pain comes January.Not that it was avoiding that pain in recent past:
We now have provisional estimates for Q3 2010, so let's update quarterly graphs - which confirm broadly the weakening trend:
- volume of retail sales increased by 0.2% in the third quarter of 2010 compared with the same quarter in 2009, and
- there was no change in the volume of retail sales when comparing the third quarter of 2010 with the second quarter.
- If Motor Trades are excluded the volume of retail sales decreased by 2.3% year-on-year, while the quarterly decrease was -2.0%.
Thursday, October 14, 2010
Economics 14/10/10: Innovation Union from European Union
Just in case you thought our own Government's naive and overly optimistic 'knowledge economy' papers were original in their lack of understanding of business, take a look at the latest EU-wide policy idea.
According to the European Commission boffins, by 2020 we will be living not in a Fiscal Union (won't happen, cause Germans wouldn't want a de jure responsibility for PIIGS) or the Monetary Union (can't last much longer in its current shape due to contradictory forces of sovereign economic policies) or even a Bailout Union (the current reincarnation of the big idea)... instead we will be the happy citizens of an Innovation Union.
The details (if one call them such) of this well-meaning stuff are provided here.
Not to waste anybody's time with navigating the lofty dream space of European 'thinkers' on development policy, let's cut straight to the chase. Two things come to mind reading the document.
Spot what's missing in the grand vision? Here:
So this is why, in my view, the latest idea, despite being aspirational and well-intentioned risks becoming yet another Titanic of economic policy, to join such hits of the past as:
According to the European Commission boffins, by 2020 we will be living not in a Fiscal Union (won't happen, cause Germans wouldn't want a de jure responsibility for PIIGS) or the Monetary Union (can't last much longer in its current shape due to contradictory forces of sovereign economic policies) or even a Bailout Union (the current reincarnation of the big idea)... instead we will be the happy citizens of an Innovation Union.
The details (if one call them such) of this well-meaning stuff are provided here.
Not to waste anybody's time with navigating the lofty dream space of European 'thinkers' on development policy, let's cut straight to the chase. Two things come to mind reading the document.
- It is aspirational (good thing) of benefits of the Innovation-driven economy and is strong on traditional bits of bureaucratic competency, promising good targets on legal environment and strategic partnerships, but
- The big iceberg awaiting the Euro dreamliner (err... Titanic) is also right here - on the Welcome page: "Innovation as described in the Innovation Union plan broadly means change that speeds up and improves the way we conceive, develop, produce and access new products and services. Changes that create more jobs, improve people's lives and build greener and better societies."
Spot what's missing in the grand vision? Here:
- Sales
- Marketing
- Logistics
- Commercialization
- Consumer
- Finance (especially the issue of relationship between current fiscal imbalances and promised subsidies)
- Lower taxes to promote greater consumption, especially given we are facing rapidly aging and more risk averse European demographic, which is not exactly representative of early adopter consumer types needed for Innovation Union? Nope, not needed.
- Lower state charges to promote more investment, again especially in economies where savings will be increasingly consumed by pensioners instead of invested by the younger income earners? Why bother!
- Fewer Nanny State regulations to improve 'access', especially in the regulatory environment that has by now even managed to ban insurance companies from pricing the basic risks? Will have Innovation without that, thank you.
- More entrepreneurship to support deployment of products into the marketplace, again a major bottleneck in the aging and largely socially immobile society of EU? Uh, oh, what's 'entrepreneurship'?
- Improved early stage finance environments with fewer state subsidies inducing distortions in the market, especially crucial given the state of public finances in the non-Innovation EU? We can't have anything that involves 'fewer subsidies'!
So this is why, in my view, the latest idea, despite being aspirational and well-intentioned risks becoming yet another Titanic of economic policy, to join such hits of the past as:
- The Lisbon Agenda (which aimed for EU to overtake US in terms of economic growth, jobs creation etc by 2010);
- The Social Economy (which aimed for the EU to become a singular welfare state where the young labour away assets-less and savings-less to preserve the status quo of landed gentry and pensioned state employees);
- The Knowledge Economy (which aimed for the EU to become a heaven for all sorts of knowledge), and
- The Green Economy (which aimed to turn EU into one big nature preserve at a wave of a magic wand of subsidies).
Economics 14/10/10: Rip-off Ireland is roaring its ugly head
CPI for September is out... kinda out... it was sent out yesterday without an embargo, by mistake, and now it was re-released again.
So the headline figure is: +0.5% yoy gain in CPI and -1.0% yoy loss in HICP. Mixed bag, you'd say. By one measure (CPI) it looks like things are getting back to a (positive) normal, while by HICP reading we are still in the (crisis) normal.
But let's take a closer look at decomposition of price changes. Per CSO, the most notable changes in the year were:
The most significant monthly price changes were:
So good news then is that:
Clearly, we've turned another corner, folks, and it's the 'Ugly Boulevard' ahead of us, consumers.
So the headline figure is: +0.5% yoy gain in CPI and -1.0% yoy loss in HICP. Mixed bag, you'd say. By one measure (CPI) it looks like things are getting back to a (positive) normal, while by HICP reading we are still in the (crisis) normal.
But let's take a closer look at decomposition of price changes. Per CSO, the most notable changes in the year were:
- increases in Education (+9.5%),
- increases in Housing, Water, Electricity, Gas & Other Fuels (+8.5%) and Communications (+2.9%) [Note: monthly CPI ex mortgage interest decreased by 0.2% in the month and was down by 0.9% in the year], and
- decreases in Clothing & Footwear (-7.4%), Furnishings, Household Equipment & Routine Household Maintenance (-3.7%) and Alcoholic Beverages & Tobacco (-3.1%).
The most significant monthly price changes were:
- decreases in Transport (-1.6%) - driven by airfares drop (not by the state-controlled bus and train fares, mind you) and
- decreases in Miscellaneous Goods &Services (-0.4%) - primarily due to cuts in health insurance charges;
- increase in Clothing & Footwear (+4.5%).
So good news then is that:
- State services, such as Education (+9.5% ! in 12 months);
- Banks payback to consumers for propping them up (CPI is up +0.5% yoy and ex-mortgages CPI is down -0.9% over the same period. So far, we have had, courtesy of our banks rescue plans: in a year to September 2009 mortgages costs fell 48%, in a year to September 2010 they rose 25.1%. All despite the fact that Irish banks are no longer facing higher costs of funding - instead they are simply borrowing from ECB using our bonds, for which you, me and our kids will be liable);
- State-set charges on energy (+8% yoy);
- State set health costs (+0.5%);
- Largely state-set or influenced transport costs (+1.4%)
Clearly, we've turned another corner, folks, and it's the 'Ugly Boulevard' ahead of us, consumers.
Saturday, October 9, 2010
Economics 9/10/10: Path to reforms
This is an unedited version of my column in October 2010 Village magazine:
The events of the recent months have clearly shown that the current policies path leads to a continued status quo. This is the sole and unavoidable conclusion currently being reached by all independent analysts and commentators on either side of ideological divide. It is a non-partisan concern that informs the rising tide of discontent within the Fiana Fail and Green parties, recent changes within Fine Gael, positions of all other opposition parties, and indeed the entire electorate – as reflected in the opinion polls.
At this junction, there is no longer any need to enlist numerous factual manifestations of this reality – they are all around us, expressed by politicians and ordinary citizens. The tide of international opinion concerning the prospects for Ireland should the current policies persist has turned against us. The IMF (since April 2010), the EU Commission (since May 2010), markets makers and participants – all have put out challenging assessments of Irish Government official projections for the recovery. Irish banks – far from being repaired by Nama – just keep asking for more taxpayers bailouts with a frightening regularity of a drug addict returning to a methadone dispensary.
It is, therefore, time to challenge the existent policy consensus. It is the time to put forward proposals for reforms, to debate real alternatives and to provide those political parties and individual politicians willing to champion change with new ideas to energise the electorate.
Here is my own set of ideas – the offshoot of the ongoing ‘Manifesto Project’ I have decided to run on my blog.
To preclude any ‘kill the messenger’ objections, allow me to state that the following is just a set of policy reforms proposals that any party or politician are welcome to adopt in part or as a whole and put to the electorate.
Fine print aside, let me outline the backdrop to the policies – the backdrop of the specific crises we face as a nation. The Irish economy has been hit by a Perfect Storm that combines:
These crises have been exacerbated by the Government policies since 2008. These policies have saddled ordinary families and individuals (regardless of whether they work in public sector or private sector, employed or unemployed, young or old) with the full cost of stabilizing vested interests and elites. This manifested itself in rising tax burden, falling provision of public services, lack of reforms in banking and public sectors. The resulting devastation of private entrepreneurship and businesses, contracting investment and availability of operating capital, a catastrophic lack of confidence in economy are the corollaries. The accompanying spikes in unemployment and businesses failures, and a hike in precautionary savings are additional manifestations of these.
The current crisis has clearly shown that the corporatist state - where vested interests, including Political, Business, Social and Environmental collude with the state to set economic and social preferences and priorities - is morally, politically and economically bankrupt. I believe that Irish democracy cannot be surrendered to the vested interests, no matter how broadly-based or highly minded they might be.
There are only two ways forward from this status quo. The first is the path we are travelling – the path of a generations-long and painfully deep crisis of stagnation and declining standards of living. The second one is a path of structural reforms aimed at realigning the current political system to serve the interests of the ordinary citizens and residents of this land.
Such a reform is also a disruptive and a painful one. It can only be achieved by creation of an alternative to the existent policies and structures.
In my view, the agenda for reform should champion the rights of ordinary citizens – consumers and taxpayers – to counterbalance existent system that promotes the interests of the vested pressure groups and elites. It must, therefore, include changes to the state political and governance systems, to the principles governing provision of the public services, to the systems of our private markets and, lastly, to the rebuilding of our financial system. For the sake of brevity, I will focus on the first two objectives.
Changes to political and governance systems
The core changes to the political and governance systems must put transparency and accountability principles of governance to the front. This will require creation of automatic systems of disclosure and control that are not subject to tampering by individual office holders. It also requires ending Social Partnership, delegating all authority, and the responsibility, for developing, implementing and monitoring economic and social policies solely to the Legislative and Executive branches of the State.
In terms of transparency, default setting must be public disclosure and unrestricted free access to all data not subject to the secrecy of the state considerations. Sensitive data should be published with exclusion of sensitive information and identifiers, until the time when it can be published in full.
Accountability requires that performance and productivity metrics should be designed and refined through experience for all branches of public sector. All earnings in the public sector should be linked to individual productivity.
Local authorities must be reformed, reducing the overall number of local authorities to, say, 7, covering: West & North West, South, Greater Cork, Greater Dublin, Greater Limerick, Greater Galway and Border & Midlands.
Seanad should be given real powers of the upper chamber and be elected directly by the people of Ireland, with equal representation for each of the 7 geographic region outlined above. Dail should be reformed by reducing the number of TDs and to cover both local and national mandates. The former will preserve a number of seats allocated locally, while the latter will allocate some proportion of seats based on national polls.
Both chambers along with the Executive should accord no privilege to their members that will put them above the ordinary citizens of the state. This will require abolition of unvouched expenses, enforcement of the Benefit-in-Kind principle of taxation and removal of the un-provisioned pensions entitlements.
All state purchasing should be carried on-line, made public and transparent and subject to annual audits by independent external board.
State services reforms should include the separation of provider of services from the supplier of services. This means that the Irish state should aim to be a purchaser of services, e.g. health care and care for the disabled, for those who cannot afford them. But the State should not own service providers. Instead, public services can be supplied by mutual, private for-profit or non-profit providers. Transition to such an arrangement will require significant training and logistics support for current employees.
Higher education should be based on fees set by universities and overseen by the Department for Education. The State should set up (with participation of charities and other private agencies) a number of funds that will provide financial aid to students based on need (with an objective of creating an equal opportunity for all qualified students to undertake studies) as well as merit (with an objective of rewarding real achievement). A further system of state-guaranteed student loans should be set, subject to independent oversight and audit.
The state should focus significant resources on the need to improve and strengthen provision of universal early, primary and secondary education in order to achieve maximum equality of opportunity for the children independent of the social and/or economic status of their parents.
Changes to fiscal systems
There is a need to rebalance the burden of taxation in the economy to deliver on three core objectives. First, the taxation system should be fair, transparent and protected from abuse. Second, it should involve participation from all agents in the economy. Third, it should not attempt to pick winners and leave in its wake the losers.
With these objectives in mind, I would suggest adoption of a flat rate income tax system with single personal standard deduction plus a child allowance, potentially linked to the level of unemployment benefits. All discretionary tax breaks should be removed, including any tax incentives for farming and any other economic activity. Non-residency limits should be set to reflect the needs of Irish citizens working abroad and commuting home – e.g. a limit of maximum 124 days annually to cover all weekends plus standard vacation. A move to a single rate income and corporate tax can also be used to deliver full equalization in taxation between workers, entrepreneurs and businesses.
Existent Byzantine system of indirect taxes and levies is to be simplified with a view that all such charges should be based on user fee principle and be fully ring-fenced to finance provision of services covered and mitigation of adverse externalities (e.g. environmental degradation etc) generated by these services.
There is a need for having strong, but life-time capped, welfare provisions. This will provide a sufficient insurance cover for all able-bodied working age adults in the country to a cumulative maximum of 7 years over the life-time. Provision of welfare supports to those unable to work due to health or family circumstances (e.g caring for a disabled relative etc) should be exempt from life-time limits.
The basic social insurance pension reform should ensure that the elderly are covered by s sufficient safety net, but the working-age individuals are encouraged to privately invest in their pensions.
Wages for politicians and senior public servants are to be tied to the National Disposable Income in order to create a direct link to the overall levels of welfare in the society (including that of the unemployed and socially vulnerable). There should be no bonuses or discretionary pay and all public sector pensions should be converted to a Defined Contribution system with generous matching from the employer.
Government spending should be benchmarked to a specific range of GDP (for example – 35-38%). A balanced budget should be maintained over every 3-year period. This allows for small emergency spending boosts in recessions, but prevents spending sprees before the elections and other abuses of the public funds.
All quangoes, except those with immediate independent oversight authority (e.g FR and Competition Authority) are to be abolished and their functions transferred to the respective departments. Responsibility for governance and management must rest with the Government.
There is a need for a fully transparent tax on land values (LVT) in order to finance public infrastructure investments and provision of local services, including environmental protection and improvements. I would suggest that the revenue from LVT should be split 50:50 between central & local authorities. Local authorities should be allowed to vary their rate of LVT within reasonable parameters. For example, if LVT is levied at 1% pa, the local authority can be allowed to charge between 0.25% and 0.5% as it deems suitable, while the central government will collect 0.5%.
After three years of ever-deepening crises in political, economic, and banking spheres, Ireland now faces a stark choice between two alternatives. We can, as a nation, elect to either follow the status quo path that leads to a stagnation. Alternatively, we can choose to challenge the existent policy consensus to champion the rights of ordinary citizens – consumers and taxpayers.
The events of the recent months have clearly shown that the current policies path leads to a continued status quo. This is the sole and unavoidable conclusion currently being reached by all independent analysts and commentators on either side of ideological divide. It is a non-partisan concern that informs the rising tide of discontent within the Fiana Fail and Green parties, recent changes within Fine Gael, positions of all other opposition parties, and indeed the entire electorate – as reflected in the opinion polls.
At this junction, there is no longer any need to enlist numerous factual manifestations of this reality – they are all around us, expressed by politicians and ordinary citizens. The tide of international opinion concerning the prospects for Ireland should the current policies persist has turned against us. The IMF (since April 2010), the EU Commission (since May 2010), markets makers and participants – all have put out challenging assessments of Irish Government official projections for the recovery. Irish banks – far from being repaired by Nama – just keep asking for more taxpayers bailouts with a frightening regularity of a drug addict returning to a methadone dispensary.
It is, therefore, time to challenge the existent policy consensus. It is the time to put forward proposals for reforms, to debate real alternatives and to provide those political parties and individual politicians willing to champion change with new ideas to energise the electorate.
Here is my own set of ideas – the offshoot of the ongoing ‘Manifesto Project’ I have decided to run on my blog.
To preclude any ‘kill the messenger’ objections, allow me to state that the following is just a set of policy reforms proposals that any party or politician are welcome to adopt in part or as a whole and put to the electorate.
Fine print aside, let me outline the backdrop to the policies – the backdrop of the specific crises we face as a nation. The Irish economy has been hit by a Perfect Storm that combines:
- a deeply rooted crisis in public finances;
- a structural collapse of the banking sector;
- an unemployment crisis stemming from the collapse of employment and jobs creation;
- a competitiveness crisis that is not limited to wages and labour costs, but the cost of living and doing business;
- the crisis in the quality and efficiency of domestic services - dominated and restricted by the excessive market power of the incumbent state-owned and state-regulated oligopolies.
These crises have been exacerbated by the Government policies since 2008. These policies have saddled ordinary families and individuals (regardless of whether they work in public sector or private sector, employed or unemployed, young or old) with the full cost of stabilizing vested interests and elites. This manifested itself in rising tax burden, falling provision of public services, lack of reforms in banking and public sectors. The resulting devastation of private entrepreneurship and businesses, contracting investment and availability of operating capital, a catastrophic lack of confidence in economy are the corollaries. The accompanying spikes in unemployment and businesses failures, and a hike in precautionary savings are additional manifestations of these.
The current crisis has clearly shown that the corporatist state - where vested interests, including Political, Business, Social and Environmental collude with the state to set economic and social preferences and priorities - is morally, politically and economically bankrupt. I believe that Irish democracy cannot be surrendered to the vested interests, no matter how broadly-based or highly minded they might be.
There are only two ways forward from this status quo. The first is the path we are travelling – the path of a generations-long and painfully deep crisis of stagnation and declining standards of living. The second one is a path of structural reforms aimed at realigning the current political system to serve the interests of the ordinary citizens and residents of this land.
Such a reform is also a disruptive and a painful one. It can only be achieved by creation of an alternative to the existent policies and structures.
In my view, the agenda for reform should champion the rights of ordinary citizens – consumers and taxpayers – to counterbalance existent system that promotes the interests of the vested pressure groups and elites. It must, therefore, include changes to the state political and governance systems, to the principles governing provision of the public services, to the systems of our private markets and, lastly, to the rebuilding of our financial system. For the sake of brevity, I will focus on the first two objectives.
Changes to political and governance systems
The core changes to the political and governance systems must put transparency and accountability principles of governance to the front. This will require creation of automatic systems of disclosure and control that are not subject to tampering by individual office holders. It also requires ending Social Partnership, delegating all authority, and the responsibility, for developing, implementing and monitoring economic and social policies solely to the Legislative and Executive branches of the State.
In terms of transparency, default setting must be public disclosure and unrestricted free access to all data not subject to the secrecy of the state considerations. Sensitive data should be published with exclusion of sensitive information and identifiers, until the time when it can be published in full.
Accountability requires that performance and productivity metrics should be designed and refined through experience for all branches of public sector. All earnings in the public sector should be linked to individual productivity.
Local authorities must be reformed, reducing the overall number of local authorities to, say, 7, covering: West & North West, South, Greater Cork, Greater Dublin, Greater Limerick, Greater Galway and Border & Midlands.
Seanad should be given real powers of the upper chamber and be elected directly by the people of Ireland, with equal representation for each of the 7 geographic region outlined above. Dail should be reformed by reducing the number of TDs and to cover both local and national mandates. The former will preserve a number of seats allocated locally, while the latter will allocate some proportion of seats based on national polls.
Both chambers along with the Executive should accord no privilege to their members that will put them above the ordinary citizens of the state. This will require abolition of unvouched expenses, enforcement of the Benefit-in-Kind principle of taxation and removal of the un-provisioned pensions entitlements.
All state purchasing should be carried on-line, made public and transparent and subject to annual audits by independent external board.
State services reforms should include the separation of provider of services from the supplier of services. This means that the Irish state should aim to be a purchaser of services, e.g. health care and care for the disabled, for those who cannot afford them. But the State should not own service providers. Instead, public services can be supplied by mutual, private for-profit or non-profit providers. Transition to such an arrangement will require significant training and logistics support for current employees.
Higher education should be based on fees set by universities and overseen by the Department for Education. The State should set up (with participation of charities and other private agencies) a number of funds that will provide financial aid to students based on need (with an objective of creating an equal opportunity for all qualified students to undertake studies) as well as merit (with an objective of rewarding real achievement). A further system of state-guaranteed student loans should be set, subject to independent oversight and audit.
The state should focus significant resources on the need to improve and strengthen provision of universal early, primary and secondary education in order to achieve maximum equality of opportunity for the children independent of the social and/or economic status of their parents.
Changes to fiscal systems
There is a need to rebalance the burden of taxation in the economy to deliver on three core objectives. First, the taxation system should be fair, transparent and protected from abuse. Second, it should involve participation from all agents in the economy. Third, it should not attempt to pick winners and leave in its wake the losers.
With these objectives in mind, I would suggest adoption of a flat rate income tax system with single personal standard deduction plus a child allowance, potentially linked to the level of unemployment benefits. All discretionary tax breaks should be removed, including any tax incentives for farming and any other economic activity. Non-residency limits should be set to reflect the needs of Irish citizens working abroad and commuting home – e.g. a limit of maximum 124 days annually to cover all weekends plus standard vacation. A move to a single rate income and corporate tax can also be used to deliver full equalization in taxation between workers, entrepreneurs and businesses.
Existent Byzantine system of indirect taxes and levies is to be simplified with a view that all such charges should be based on user fee principle and be fully ring-fenced to finance provision of services covered and mitigation of adverse externalities (e.g. environmental degradation etc) generated by these services.
There is a need for having strong, but life-time capped, welfare provisions. This will provide a sufficient insurance cover for all able-bodied working age adults in the country to a cumulative maximum of 7 years over the life-time. Provision of welfare supports to those unable to work due to health or family circumstances (e.g caring for a disabled relative etc) should be exempt from life-time limits.
The basic social insurance pension reform should ensure that the elderly are covered by s sufficient safety net, but the working-age individuals are encouraged to privately invest in their pensions.
Wages for politicians and senior public servants are to be tied to the National Disposable Income in order to create a direct link to the overall levels of welfare in the society (including that of the unemployed and socially vulnerable). There should be no bonuses or discretionary pay and all public sector pensions should be converted to a Defined Contribution system with generous matching from the employer.
Government spending should be benchmarked to a specific range of GDP (for example – 35-38%). A balanced budget should be maintained over every 3-year period. This allows for small emergency spending boosts in recessions, but prevents spending sprees before the elections and other abuses of the public funds.
All quangoes, except those with immediate independent oversight authority (e.g FR and Competition Authority) are to be abolished and their functions transferred to the respective departments. Responsibility for governance and management must rest with the Government.
There is a need for a fully transparent tax on land values (LVT) in order to finance public infrastructure investments and provision of local services, including environmental protection and improvements. I would suggest that the revenue from LVT should be split 50:50 between central & local authorities. Local authorities should be allowed to vary their rate of LVT within reasonable parameters. For example, if LVT is levied at 1% pa, the local authority can be allowed to charge between 0.25% and 0.5% as it deems suitable, while the central government will collect 0.5%.
After three years of ever-deepening crises in political, economic, and banking spheres, Ireland now faces a stark choice between two alternatives. We can, as a nation, elect to either follow the status quo path that leads to a stagnation. Alternatively, we can choose to challenge the existent policy consensus to champion the rights of ordinary citizens – consumers and taxpayers.
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 (3rd 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.
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 (3rd 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.
Wednesday, October 6, 2010
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.
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 6/10/10: Mortgages arrears and paying FR staff
The latest, highly irritating, half-talk about the real issues comes courtesy of our FR. Per Matthew Elderfiled, Ireland's mortgage arrears figures stand at 36,000 borrowers or 4.3% of the borrowers. Now, the number clearly does not include:
- Those who have renegotiated their mortgage terms (acknowledged by Mr Elderfield), forced to do so by... err... inability to pay; and
- Those who are in the receipt of state aid to pay their mortgage interest, due to their... err... inability to cover their mortgage; and
- Those who are missing some of the payments, without triggering actual arrears (say paying 5 months out of every six, thus sliding in and out of arrears)
It's a hugely difficult subject," Mr Elderfield told the Dail Committee today. Really? What's all the highly paid FR staff for, then? To write speeches for the Regulator and arrange events calendar?
Another question for Mr Elderfield. Q1 2010 estimate by NIRSA showed that 32,321 mortgages were in arrears 90 days or over. Figures from the Central Bank show that 36,438 mortgages were in arrears for more than 90 days at the end of June 2010. What's the value of Mr Elederfiled's latest statement if it offers no new information?
And just when you get the idea that Mr Elderfield should have been answering more questions than he did, here's the last one: What is his office doing to prevent banks from savaging more vulnerable (to increases in the cost of mortgage finance) ARM mortgage holders?
Economics 6/10/10: Irish spreads in the need of a new catalyst
Updated below
A quick post on foot of last morning call (here) on ECB propping up Irish Government bonds
Yesterday, absent visible ECB interference in the markets, Ireland’s 10-year yield rose 6 bps relative to benchmark German bund. The gap now stands at above 408 bps, still below a record 454 bps posted on September 29.
The Portuguese-German spread rose by 1/3 of Irish-German spread - up 2 bps to 385 bps, while the Spanish-German spread stayed put at 180. Greece-Germany spread is at 777, but it is largely academic, as the country does not borrow from the open markets anymore.
The spreads are moving up on Moody’s latest threat to Ireland's sovereign ratings. Moody's downgraded Ireland to Aa2 in July. The agency now says that it will complete a new review of country position within three months. Accoridng to Moody's: “Ireland is on a trajectory toward lower debt affordability over the next three to five years.” Which of course means the probability of Ireland having to restructure its debts is rising, primarily on the back of deteriorating economic conditions.
S&P’s cut Ireland’s credit rating one step to AA- on August 24, while Fitch has a AA- rating.
So in the nutshell, the 'honeymoon' post-Lenihan's announcement last Thursday seems to be over - we are back into the markets-determined volatility and there's a desperate need for a catalyst to shift yields either way.
Update:
Oh, and of course, since hitting the 'Publish Post' button, this is just in: Fitch downgraded Irish credit rating to A+ from AA- and put it on a negative outlook. Causes: bigger-than-expected cost of cleaning up the country's banks and uncertainty over economic recovery.
Irish-German spreads moved up to 421.4 bps
A quick post on foot of last morning call (here) on ECB propping up Irish Government bonds
Yesterday, absent visible ECB interference in the markets, Ireland’s 10-year yield rose 6 bps relative to benchmark German bund. The gap now stands at above 408 bps, still below a record 454 bps posted on September 29.
The Portuguese-German spread rose by 1/3 of Irish-German spread - up 2 bps to 385 bps, while the Spanish-German spread stayed put at 180. Greece-Germany spread is at 777, but it is largely academic, as the country does not borrow from the open markets anymore.
The spreads are moving up on Moody’s latest threat to Ireland's sovereign ratings. Moody's downgraded Ireland to Aa2 in July. The agency now says that it will complete a new review of country position within three months. Accoridng to Moody's: “Ireland is on a trajectory toward lower debt affordability over the next three to five years.” Which of course means the probability of Ireland having to restructure its debts is rising, primarily on the back of deteriorating economic conditions.
S&P’s cut Ireland’s credit rating one step to AA- on August 24, while Fitch has a AA- rating.
So in the nutshell, the 'honeymoon' post-Lenihan's announcement last Thursday seems to be over - we are back into the markets-determined volatility and there's a desperate need for a catalyst to shift yields either way.
Update:
Oh, and of course, since hitting the 'Publish Post' button, this is just in: Fitch downgraded Irish credit rating to A+ from AA- and put it on a negative outlook. Causes: bigger-than-expected cost of cleaning up the country's banks and uncertainty over economic recovery.
Irish-German spreads moved up to 421.4 bps
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