08/12/2011: Budget 2012: Irish Examiner

This is an unedited version of my article for the Irish Examiner (December 8, 2011) covering Budget 2012.

As Peter Drucker once said  “Effective leadership is not about making speeches or being liked; leadership is defined by results not attributes.” By Drucker’s measure of leadership, Budget 2012 is a complete failure.

The Budget was launched with much pomp and circumstance. But in the end, the highly emotive language of ‘change’, ‘long-term thinking’ and ‘fundamental reforms’ served to cover up the return to the failed policies of the previous Government. No real change took place, and no real reforms were launched.

While much of the media attention is focused on the specific headline measures, especially those applying to the poor and the unemployed, very little analysis has been deployed to cover the budgetary dynamics – the very raison d’etre of the current austerity drive. Let’s take a closer look at what the Budget 2012 promises to deliver on the fiscal consolidation front and what it is likely to deliver in reality.

According to the Budget 2012 Ministerial Duet of Brendan Howlin and Michael Noonan, public expenditure reductions envisioned under the budget will amount to €1.4 billion in current spending and €755 million capital investment cut. These are gross savings, that will have second round effects of reduced associated tax revenues and thus their impact on deficit will be lower than envisaged.

Capital savings will come from mothballing a handful of white elephants carried over from the Bertie Ahearn’s era, but these will cost jobs and neglect in existent capital stock. Coupled with changes to CGT and CAT and Dirt, these measures will further depress investment in the economy that continues to experience collapse in this area. Yet, absent investment, there can be no jobs.

Perversely, the FG/Labor government thinks that the only capital investment worth supporting is that in property. The economy based on high value added services and knowledge and skills of its workforce is now fully incentivised for another property boom and fully disincentivised to invest in skills and entrepreneurship. The latter disincentives arising from the upper marginal income tax rate of 53% for all mortals and a special surcharge to 55% on self-employed. Never mind that self-employment is usually the first step toward enterpreneurship and business investment.

Short-termist reductions in one-parent family and jobseekers benefits are counterproductive to supporting large group of single parents in their transition to work. In the place where real reforms toward workforce activation should have been deployed, we now have a “all stick and no carrot” approach.

Health budget is one of the three mammoths of the fiscal ice age, with total spending this year projected to reach €12.83 billion this year, up 10.5% on 2010 levels. Instead of rationalising management systems at the HSE, the area where the bulk of waste resides, the Budget is achieving ‘savings’ by charging middle class insurance holders more for the very same services. A new tax, in effect, is now called ‘savings.

This Cardiffescue approach to accounting for sovereign funding and expenditure flows creates an illusion of something being done about the constantly rising current expenditure, while avoiding challenging operational and structural inefficiencies in public sector spending.

Budget 2012 is a mini-insight into a collapsed capability of a leadership system unable to cope with fiscal pressures and incapable of change.

Nothing else highlights this better than the host of new taxes that accompany the incessant drone of ‘jobs, jobs, jobs’ refrain from the Government.

Take the illogical hikes in VAT and fuel-related taxes. A 2% increase in the cost of shopping in Ireland, coupled with increase in the cost of petrol and diesel and a massive increase in tobacco taxes here will create tripple incentives for consumers to flee Irish retail sector in favour of Northern Ireland and to transact in the Black markets. None of these substitution effects are priced into Government budgetary projections, despite the fact that an error of omitting direct substitution effects of tax increases would have been a fatal one for an undergraduate student of economics.

The entire exercise looks like the repeat of Brian Cowen’s Grand Strategy of waiting until something turns up and rescues us. Thus, behold the rosy budgetary projections for 1.6% GDP growth in 2012, published just days after OECD confirmed its forecast for 1.0% growth and ESRI published its outlook with 0.9% growth projection.

These differences are material. Should the Budgetary assumptions on growth fail to materialize, the cuts and revenue measures envisioned by the Government will fall far short of what will be needed to keep the headline general government debt to GDP ratio at bay.

Karl Marx famously remarked that history repeats itself twice, first as tragedy, second as farce. Based on Irish Governments’ policies over the last 4 years, history ultimately blends into a farcical tragedy once leadership failures become a norm. Welcome to the farce of the long-term fundamental non-reforms of this new Government.

08/12/2011: ECB call - denying the obvious

Today's ECB call in charts:

First, timeline and international comps.

Next, comparatives to other advanced economies.

Do tell me if ECB is running the weakest, most liquidity-constrained system in the advanced world. Charts above don't show that...

So Doc Dragho has just hooked a fresh plasma pouch to the Zombiefied Euro Patient... and it's half-empty...

06/12/2011: Budget 2012 - quick guide

In days to come I will be writing about the Budget 2012 in the press, so this is a quick summary of my current view. The Budget is a combination of:

• Safety (35%) - the Croke Park remains intact and largest vested interest in the state remains unchecked
• Platitude (5%) - a belated, but welcome increase in mortgage interest relief for 2004-2008 buyers
• Homage to Bertie (10%) - all measures aimed at stimulating growth in the economy are property reliefs and tax incentives and
• Absurdity (50%) - explained below

Absurdity of this Budget arises from glaring logical inconsistencies of its measures and stated policy objectives:

1. The Irish Government is concerned with the stability of the banks deposits. It raises DIRT and CGT
2. The Irish Government is concerned with jobs destruction. It raises VAT, fuel taxes, capital taxes and does nothing to correct for egregious, entrepreneurship reducing USC surcharge on self-employed. It also makes it more risky for firms to hire workers
3. The Government is concerned with tax revenues lags. It introduces tax hikes that will drive more economic activity into the Black Markets - VAT, petrol tax, cigarettes tax etc
4. The Government is concerned with declining private consumption. It introduces VAT hike, cigarettes hike, and measures reducing disposable income
5. The Government is concerned with skills bottlenecks. it introduces higher cost of education
6. The Government is concerned with high demand for public health services. It raises cost of buying private insurance, thus cutting back incentives to hold that which at least partially offsets rising costs of higher demand for public services
7. The Government is concerned with underfunding of private sector pensions. It removes 50% credit for employer PRSI for contributions to occupational pension schemes

5/12/2011: Sunday Times, December 4, 2011

For those of you who missed it - here is an unedited version of my article for Sunday Times, December 4, 2011.


Comes Monday and Tuesday, the Government will announce yet another one of the series of its austerity budgets. Loaded with direct and indirect taxation measures and cuts to middle class benefits, Budget 2012 is unlikely to deliver the reforms required to restore Irish public finances to a sustainable path. Nor will Budget 2012 usher a new area of improved Irish economic competitiveness. Instead, the new Budget is simply going to be a continuation of the failed hit-and-run policies of the past, with no real structural reforms in sight.

Structural reforms, however, are a must, if Ireland were to achieve sustainable growth and stabilize, if not reverse, our massive insolvency problem. And these reforms must be launched through the budgetary process that puts forward an agenda for leadership.

Firstly, Budgetary arithmetic must be based on realistic economic growth assumptions, not the make-believe numbers plucked out of the thin air by the Department for Finance. Secondly, budgetary strategy should aim for hard targets for institutional and systemic improvements in Irish economic competitiveness, not the artificial targets for debt/deficit dynamics.

Let’s take a look at the macroeconomic parameters framing the Budget. The latest ESRI projections for growth – released this week – envision GDP growth of 0.9% and GNP decline of -0.3% in 2012. Exports growth is projected at 4.7% in 2012, consumption to fall 1.5% and investment by 2.3%. Domestic drivers of the economy are forecast to fall much less in 2012 than in 2011 due to unknown supportive forces. This is despite the fact that the ESRI projects deepening contraction in government expenditure from -3% in 2011 to -4% in 2012. ESRI numbers are virtually identical to those from the latest OECD forecasts, which show GDP growing by 1.0% in 2012, but exports of goods and services expanding by 3.3%. OECD is rather less pessimistic on domestic consumption, projecting 2012 decline of just 0.5%, but more pessimistic on investment, predicting gross fixed capital formation to shrink 2.7%.

In my view, both forecasts are erring on optimistic side. Looking at the trends in external demand, my expectation is for exports growing at 2.9-3.2% in 2012, and imports expanding at the same rate. The reason for this is that I expect significant slowdown in public sector purchasing across Europe, impacting adversely ICT, capital goods, and pharmaceutical and medical devices sectors. On consumption and investment side, declines of -1.5-1.75% and -4-4.5% are more likely. Households hit by twin forces of declining disposable incomes, rising VAT and better retail margins North of the border are likely to cut back even more on buying larger ticket items in the Republic. All in, my forecast in the more stressed scenario is for GDP to contract at ca 0.6% and GNP to fall by 1.7% in 2012. Even under most benign forecast assumptions, GDP is unlikely to grow by more that 0.3% next year, with GNP contracting by 0.5%.

Under the four-year plan Troika agreement, the projected average rate of growth for GDP between 2012 and 2015 was assumed to be 3.1% per annum. Under the latest pre-Budget Department of Finance projections, the same rate of growth is assumed to average 2.5% per annum. My forecasts suggest closer to 1.5% annual average growth rate – the same forecast I suggested for the period of 2010-2015 in these same pages back in May 2010.

Using my most benign scenario, 2015 general government deficit is likely to come in at just above 4.0%, assuming the Government sticks to its spending and taxation targets. Meanwhile, General Government Debt to GDP ratio will rise to closer to 120% of GDP in 2015 and including NAMA liabilities still expected to be outstanding at the time, to ca 130% of GDP.

In brief, even short-term forecast changes have a dramatic effect on sustainability of our fiscal path.

Yes, the Irish economy is deteriorating in all short-term growth indicators. The latest retail figures for October, released this week show that relative to pre-crisis peak, core retail sales are now down 16% in volume terms and 21% in value terms. In the first half 2011, nominal gross fixed capital formation in the Irish economy fell 15% on H1 2010 levels and is now down 38% on pre-crisis peak in H1 2007. And exports, though still growing, are slowing down relative to imports. Ireland’s trade balance expanded 5% in H1 2011 on H1 2010, less than one fifth of the rate of growth achieved a year before. More ominously, using data through August this year, Ireland’s exports growth was outpaced by that of Greece and Spain. Ireland’s exporting performance is not as much of a miracle as the EU Commissioners and our own Government paint it to be.

However, longer-term budgetary sustainability rests upon just one thing – a long-term future growth based on comparative advantages in skills, institutions and specialization, as well as entrepreneurship and accumulation of human and physical capital. Sadly, the years of economic policy of hit-and-run budgetary measures are taking their toll when it comes to our institutional competitiveness.

This year, Ireland sunk to a 25^th place in Economic Freedom of the World rankings, down from the average 5-7^th place rankings achieved in 1995-2007. In particular, Ireland ranks poorly in terms of the size of Government in overall economy, and the quality of our legal systems, property rights and regulatory environments. The index is widely used by multinational companies and institutional investors in determining which countries can be the best hosts for FDI and equity investments.

In World Bank Ease of Doing Business rankings, we score on par with African countries in getting access to electricity (90^th place in the world), registering property (81^st in the world), and enforcing contracts (62^nd in the world). We rank 27^th in dealing with construction permits and 21^st ease of trading across borders. Even in the area of entrepreneurship, Ireland is ranked 13^th in the world, down from 9^th last year. This ranking is still the highest in the euro area, but, according to the World Bank data, it takes on average 13 times longer in Ireland to register a functional business than in New Zealand. The cost of registering business here amounts to ca 0.4% of income per capita; in Denmark it is zero. In the majority of the categories surveyed in the World Bank rankings, Ireland shows no institutional quality improvements since 2008, despite the fact that many such improvements can reduce costs to the state.

I wrote on numerous occasions before that despite all the talk about fiscal austerity, Irish Exchequer voted current expenditure continues to rise year on year. Given that this segment of public spending, unlike capital expenditure, exerts a negative drag on future growth potential in the economy, it is clear that Government’s propensity to preserve current expenditure allocations is a strategy that bleeds our economy’s future to pay for short-term benefits and public sector wages and pensions.

Similarly, the new tax policy approach – enacted since the Budget 2009 – amounts to a wholesale destruction of any comparative advantage Ireland had before the crisis in terms of attracting, retaining and incentivising domestic investment in human capital. Continuously rising income taxes on middle class and higher earners, along with escalating cost of living, especially in the areas where the Irish State has control over prices, and a host of complicated charges and levies are now actively contributing to the erosion of our competitiveness. Improvements in labour costs competitiveness are now running into the brick wall of tax-induced deterioration in the households’ ability to pay for basic mortgages and costs of living in Ireland. Year on year, average hourly earnings are now up in Financial, Insurance and Real Estate services (+3.1%) primarily due to IFSC skills crunch, unchanged in Industry, and Information and Communications, and down just 2.6% in Professional, Scientific and Technical categories. In some areas, such as software engineering and development, and biotechnology and high-tech research and consulting, unfilled positions remain open or being filled by foreign workers as skills shortages continue.

By all indications to-date Budget 2012 will be another failed opportunity to start addressing the rapidly widening policy reforms gap. Institutional capital and physical investment neglect is likely to continue for another year, absent serious reforms. In the light of some five years of the Governments sitting on their hands when it comes to improving Ireland’s institutional environments for competitiveness, it is the Coalition set serious targets for 2012-2013 to achieve gains in Ireland’s international rankings in areas relating to entrepreneurship, economic freedom and quality of business regulation.

Box-out:

Amidst the calls for the ECB to become a lender of last resort for the imploding euro zone, it is worth taking some stock as to what ECB balance sheet currently looks like on the assets side. As of this week, ECB’s Securities Market Programme under which the Central Bank buys sovereign bonds in the primary and secondary markets holds some €200 billion worth of sovereign debt from across the euro area. Banks lending is running at €265 billion under the Main Refinancing Operations and €397 billion under the Long-Term Refinancing Operations facilities. Covered Bonds Purchasing Programmes 1 and 2 are now ramped up to €60 billion and climbing. All in, the ECB holds some €922 billion worth of assets – the level of lending into the euro area economy that, combined with EFSF and IMF lending to peripheral states takes emergency funding to the euro system well in excess of €1.5 trillion. Clearly, this level of intervention has not been enough to stop euro monetary system from crumbling. This puts into perspective the task at hand. Based on recently announced emergency IMF lending programmes aimed at euro area member states, IMF capacity to lend to the euro area periphery is capped at around €210 billion. The EFSF agreement, assuming the fund is able to raise cash in the current markets, is likely to see additional €400-450 billion in firepower made available to the governments. That means the last four months of robust haggling over the crisis resolutions measures between all euro zone partners has produced an uplift on the common currency block ‘firepower’ that is less than a half of what already has been deployed by the ECB and IMF. Somewhere, somehow, someone will have to default big time to make the latest numbers work as an effective crisis resolution tool.

5/12/2011: Two 'Austerity' charts

In previous two posts we covered Exchequer revenues and balance. Here is an interesting follow-up chart showing the dramatic swing in spending priorities of the Irish state:

And a neat chart summarizing the extent of our and indeed global 'austerity' (this one is courtesy of the OECD):

Pretty darn clear, no?

5/12/2011: Exchequer balance: November

In the previous post we looked at the Exchequer receipts. Now, let's take on Exchequer deficit.

Based on data through November 2011, Exchequer deficit stands at €21.37bn in 2011 against the same period 2010 deficit of €13.35bn. However, netting out banks recapitalizations and the sale of stake in BofI, Exchequer deficit on comparable basis was €11.72bn in 11 months of 2011 or €1.63bn below that in 2010.

Factoring in the pensions levy (temporary measure), savings to-date amount to €1.18bn on 2010 period.

Anti-climatic? You bet. Chart below breaks down the 'savings' achieved, with data reported for annualized rate of spend based on January-November 2011 receipts. Voted current expenditure for 2011 rose from €36.39bn in 2010 to €37.59bn in 2011 (data through November for both). Voted capital spending fell from €4.26bn in 2010 to €3.08bn in 2011 (again, data through November). So all of the above 'savings' come from tax increases and capital cuts. Again, when it comes to current spending (Government services), there is no austerity on the aggregate. In fact, there is ever-increasing profligacy. Once again, keep in mind, this does not mean there is no pain. It's just that the pain we have is really in the form of robbing Peter to pay Paul.

05/12/2011: Irish Exchequer Receipts: November 2011

Time to catch up with that data on Exchequer receipts for November - the critical month that makes or breaks Government budgets.

Income tax receipts: these are down to €12,709mln in 11 months of 2011, or -€272mln to target (-2.1%) but an impressive 22.5% above same period 2010 levels.

Sounds like tax policies of the past bearing fruit? Not really. Income tax rose €2,336 on 2010 in absolute terms, but at least €1,850mln of this is due to Health Levy reclassification as USC and aggregation into income tax receipts. Yes, folks, for all income tax increases in years past, the Exchequer netted less than €500mln in new revenues this year, or to be slightly more precise - an uplift not of claimed 22.5% (DofF maths), but of closer to just below 4.7%. The picture below looks good, but in reality, Income tax revenues are running below 2008 and 2009 levels, still, once Health Levy is factored in.

More ominously, the under-€500mln lead this year is based on the annual rate of Health Levy pay-in for 2010 spread evenly over all months. Of course, it probably was also peaking at around November, as usual seasonality in returns applied to it as well as to other income-related measures. Which means that it is quite possible that the annual rate of income tax increases will be even lower, once we see December figures than 4.7% figure suggests.

Let's recall that these figures come on top of shrinking workforce and rising unemployment and you get the picture - people at work are not getting anywhere, with their taxes rising dramatically in recent years, but Government revenue is not recovering either.

When it comes to VAT (second largest source of state revenues), the numbers are abysmal. November 2011 revenue is at €9,550mln or €464mln off target and 3.3% below 2010 figure (-€464mln). VAT receipts are 7.9% below those for the same period of 2009. Chart below shows what happens

Corporation tax receipts - the reflection of our booming exporting economy came in at €3,510mln or €236mln behind target and 4.3% or -€158mln down on 2010. Compared to 2009 these are now off 6.43% or -€241mln. Fourth straight year of decline.

Excise tax, the third largest category, is upo a whooping €15mln on target to €4,130mln, year on year the uplift is €39mln or 0.9%. And there was an even greater uplift in Stamps - up €442mln o  target to €1,297mln and up 51.6% year on year. Except, of course, that uplift is accounted for by the hit-and-run pension levy. Net of the pension levy, Stamps are actually down 1.75% yoy.

So total tax receipts are:

• Down €520mln on target (-1.6%) but officially up 7.9% (+€2,325mln) yoy
• Up just €18mln year on year once we net out Pension & Health Levies.
• Down on target in 3 out of top 4 tax headings and 
• Down on target in 5 out of 8 headings

Meanwhile, rosy forecasts continue to flow from the DofF which projects that 2012 total tax revenue will rise 4.13% (see here)... pass that funny gas mask, doc.

05/12/2011: Government Book of Estimates 2012 - latest comic from DofF

So the book of estimates is out pre-Budget 2012 and there are some notable numbers in it. Let's run from the top:

• Table 1 projects Current Receipts of  E38,081mln in 2012 or E1,344mln of 'natural increases' in tax receipts, presumably from roaring economic growth
• Table 1 also projects capital receipts falling by E660mln due to lesser tax on tax (aka banks measures 'returns')
• Table 1 projects increase in total revenue of E683mln to E39,905 - where this will come from, one might wonder. Table 2 shows that all of these increases will come from tax revenues growth - remember, estimates do not include any new measures to be passed in Budget 2012. In particular, DofF assumes that tax revenues will rise 4.13% yoy in 2012. Why? How? On back of 1.3% growth - the rosiest forecast we've had so far? How much do they plan to extract from value-added o get these figures? Suppose economy expands by 2.2 billion in 2012 (ca 1.3%), tax revenue is supposed to grow by E1.41 billion, so 'extraction rate' is over 64%. That is the full extent of our assumed upper marginal tax rate pre-Budget 2012 measures, folks. Either we are worse than France (the highest full economic tax rate) or the DofF estimates are a bit shambolic.

On the austerity side, there are some notable features of the 'estimates':

DofF assumes interest payments on Government debt of E7.488bn in 2012, up on €4.904bn in 2011. That means that we will be spending

• 71% more on payment on our debt, including that to our 'European Partners' than we will be spending on capital investment, or
• 21% of all our tax receipts will be going to finance interest on government debt
• Given projected yield from Income tax of E15.09bn in 2012 (do forget for the moment that this is basically a form of numerical lunacy, not a hard number, as there is absolutely no reason why income tax next year will be at these levels), our Government debt interest bill will account for 49.6% of our entire projected income tax revenue.

Remember, this all is sustainable, per our Green Jersey 'experts' and we haven't even reached the peak of our debt, yet...

And, yes, there's Austerity... after three years of 'cuts' we have:

• Current spending is expected to rise from E48.148 bn in 2011 to E51.233 bn in 2012, so that
• General Government Deficit will reach E16.2 billion or E600 million ABOVE 2011 level.

At last we have our truth - in the numbers of even overly optimistic Government own projections - there is no austerity, folks. There is re-arrangement of spending chairs on Titanic's deck. Painful for many, to be true, whose services and subsidies are being cut, but certainly not visible in terms of actual fiscal balance.

So how rosy are Government figures on those projections side? Government 'estimates ' assume that in 2012 Irish GDP will stand at E162 billion, which is a whooping 4.88% above 2011 levels. Right, someone has been drinking that lithium-laced water that the nation should get per our Buba Doc proposals aired last week - GDP growth in 2012 will be 4.88% nominal per DofF.

Bonkers! QED.

3/12/2011: Latest Euro Crisis Proposal: A Debt Fund to Solve Nothing

The latest technocratic deram of European sovereign finance engineers is out. Here's the extracts from Reuters report with my comments (full report link here):

"Wolfgang Schaeuble outlined his plans under which states would effectively siphon off a chunk of their debt to a special national fund and pay it off over about 20 years while committing to reforms to keep debt levels on target."

What's that, you say? To "boost confidence" of the proverbial markets, the Euro states "should put into a special fund that part of its debt which exceed 60 percent of its GDP, and should pay that off with tax revenues. Over a period of 20 years, the debt should be reduced to 60 percent".

So let me run through this in some order:

1. The debt will remain the debt - within the fund and outside.
2. The 'balanced budget' rules once adopted (and in Germanic fashion anything adopted = implemented) will assure no new debt accumulated.
3. Part of the debt above 60% of GDP will be extended in maturity (somehow, there will be 'no credit event' there?)
4. The part of the debt above 60% of GDP will be repayable out of tax revenues (the rest, presumably will be repayable out of  Schaeuble's pension fund?)
5. There will be no common liability - as "an earlier proposal this month from a panel of independent economic advisers to the German government which was rejected as unrealistic by Merkel, envisaged a European Redemption Pact. That proposal, for a fund of up to 2.3 trillion euros, was anathema to Merkel because it suggested pooling excess debt into a fund with common liability." Which means risks of each individual state debt will remain the same within and outside the fund. Just how this will impact sovereign yields begs some explaining.
6. Repayment of debt accumulated in the fund will have, presumably, some priority over other debts. Otherwise, what's the difference if this debt is in the fund or not. If so, what seniority implications will there be for two types of debts - within the fund and outside the fund? If none, there will be no material difference between the two and thus no change on current status quo. If Fund debt were to be more senior (having a first call on repayment by tax revenues) then the remaining debt quality will deteriorate. Implications - the Fund will make things worse, not better, for the sovereigns.

Overall, the whole idea of a Fund can only work if the following are simultaneously true:

1. There is a pooled liability for the Fund-held debts to assure improved ratings (already ruled out).
2. The combined (Fund-held and non-Fund) debts of all countries participating in the fund are jointly and separately sustainable (repayable) and the reason for the Fund creation is solely a short-term liquidity crunch. Note: only in this case future tax revenue will be sufficient to repay debts. But of course we already know that the Euro area problem is that the debts are NOT sustainable in Italy, Portugal, Greece and Ireland, and most likely also unsustainable in Belgium.
3. More indebted countries receive, during the period of repayment, sufficient fiscal transfers to prevent their economies from imploding and thus preventing their unsustainable debts triggering common liability clauses. This might be the case, but how will it go down with the electorates and Governments in surplus countries, over 30 years, one can only wonder.
4. The commitments to new budgetary rules of, say 2% maximum deficit, are fully implemented in real budgetary processes across all member states over the entire 30 years horizon. 

And that's a lot of "if"s, even more "no"s and not a single one "Yes!"...

2/12/2011: Euro crisis: wrong medicine for a misdiagnosed patient

There's been much talk about the fiscal union and ECB money printing as the two exercises that can resolve the euro area crises. The problem is that all the well-wishers who find solace in these ideas are missing the very iceberg that is about to sink the  Eurotanic.
 (image courtesy of the ZeroHedge.com):

Let's start from the top. Euro area's problem is a simple one:

• There is too much debt - public and private - as detailed here, and
• There is too little growth - including potential growth - as detailed here.

Oh, and in case you think that discipline is a cure to debt, here's the austerity-impacted expected Government debt changes in 2010-2013, courtesy of the OECD:

In other words, it's not the lack of monetary easing or fiscal discipline, stupid. It's the lack of dynamism in European economy.

Let me explain this in the context of Euro area policies proposals.

• The EU, including member states Governments, believes that causality of the crisis follows as: Loss of market confidence leads to increased funding cost of debt, which in turn causes debt to become unsustainable, which in turn leads to the need for austerity and thus reduces growth rates in the Euro area economies.
• My view is that low growth historically combined with high expectations in terms of social benefits have resulted over the decades in a build up of debt, which was not sustainable even absent the economic recession. Economic recession caused the tipping point in debt sustainability beyond which markets lost confidence in European fundamentals both within the crisis environment, but also, crucially, beyond cyclical recession. My data on structural deficits (linked above) proves the last point.

So while Europe believes that its core malaise is lack of confidence from the markets, I believe that Europe's real disease is lack of growth and resulting high debt levels. Confidence is but a symptom of the disease. 

You can police fiscal neighborhood as much as you want (and some policing is desperately needed), but you can't turn European economy from growth slum to growth engine by doing so. You can also let ECB buy all of the debt of the Euro area members, but short of the ECB then burning the Government bonds on a massively inflationary pyre, you can't do away with the debt overhang. Neither the Euro-bonds (opposed by Germany) nor warehousing these debts on the ECB balance sheet (opposed by Germany & the ECB) will do the trick. Only long-term growth can. And in that department, Europe has no track record to stand on.

Take Italy as an example. Charts below illustrate the country plight today and into 2016. I use two projections scenarios - the mid-range one is from the IMF WEO for September 2011, the adverse one is incorporating OECD forecasts of November 2011, plus the cost of funding Italian debt increasing by 100bps on the current average (quite benign assumption, given that it has increased, per latest auctions by ca 300bps plus).

As chart below shows, Italy is facing a gargantuan-sized funding problem in 2012-2016. Note that the time horizon chosen for the assessment of fiscal sustainability is significant here. You can take two assumptions - the implicit assumption behind the Euro area policy approach that the entire problem of 'lack of markets confidence' in the peripheral states can be resolved fully by 2013, allowing the peripheral countries access to funding markets at costs close to those before the crisis some time around 2013-2014. Or you can make the assumption I am more comfortable with that such access to funding markets for PIIGS is structurally restricted by their debt levels and growth fundamentals. In which case, that date of regaining reasonable access to the funding is pushed well past 2015-2016.

Government deficits form a significant part of the above debt problem in Italy (see below), but what is more important is that even with rosy austerity=success model deployed by the IMF, the rate of decline in Italian public debt envisioned in 2013-2016 is abysmally small (again, see chart below). This rate of decline is driven not by the lack of austerity (deficits are relatively benign), but by the lack of economic growth that deflates debt/GDP and deficit/GDP ratios and contributed to nominal reductions in both debt and deficits.

But the proverbial rabbit hole goes deeper, in the case of Italy. IMF projections - made before September 2011 - were based on rather robust euro area-wide growth of the first quarter of 2011. Since then two things have happened: 

1. There is a massive slowdown in growth in Italy and across the euro area (see here), and
2. Cost of funding Italian debt has risen dramatically (see the second chart below).

These two factors, imperfectly reflected in the forecasts yield my estimation for Italian fiscal sustainability parameters under the 'adverse' scenario.

The above shows why, in the case of Italy, none of the solutions to the crisis presented to-date will work. Alas, pretty much the same applies to all other peripheral countries, including Ireland.

Which means that the latest round of euro area policies activism from Merkozy is simply equivalent to administering wrong medicine in greater doses to the misdiagnosed patient. What can possibly go wrong here?

1/12/2011: Manufacturing PMI for Ireland - November

Manufacturing PMI for November has signalled renewed downward pressure in sectoral activity.

Having posted a surprise, EU-wide trend-breaking increase from 47.3 in September to 50.1 in October (a reading above 50 is consistent with expansion, albeit a reading between 50 and roughly speaking 52.5 is statistically insignificantly different from 50), the core Manufacturing PMI fell again into the contraction territory in November, posting 48.5.

More ominously, 3 mo average through November is now 48.6 and 3mo average through August is at 49.2, so last six months on average have posted a contraction in Manufacturing activity. Thus, Manufacturing PMIs are now firmly flashing recession warning signs. A year ago, 3mo average through November 2010 stood at 50.2. 12 mo MA is remaining above 50 at 51.8 due to solid gains achieved in January-April 2011.

Output reading is now also below 50 with November Output measure coming in at 48.3, down from 52.7 in October. 3mo average through November is barel above 50 at 50.3 and 3mo average through August is at 50.5. November 2011 reading is the lowest since January 2010.

Like the main indicator, New Orders sub-index has posted average below 50 readings in 6 months through November. The sub-index is now at 49.7, down from 51.4 in October. New exports orders sub-index remained just below 50 for the third month in a row at 49.9 in November, compared against 49.8 in October. And backlogs of existent orders continued to contract at 44.2 in November - 9th month of straight declines.

Output prices accelerated factory gates deflation at 48.2 in November compared to 49.2 in October - for the fourth consecutive month. Meanwhile input prices index signalled continued strong inflation at 55.2 in November, unchanged from October. This trend is present in the data since January 2010 uninterrupted. Thus profit margins in manufacturing continued to decline at accelerating pace (more on this in a separate blog post once we have PMIs for services as well).

Stocks of purchases declined rapidly at 41.3 in November - deeper contraction than 44.5 registered in October. Meanwhile rate of decline in stocks of finished goods (46.1 against 45.4 in October) has slowed down, suggesting build up of inventories and putting potential pressure on one of components of GDP and GNP down the line.

Employment also posted third consecutive month of declines - November reading is 48.3 against 47.1 in October. 3mo average through November is 47.3 - well below already contractionary 3mo average through August at 49.5. In 2010, 3mo average through November stood at a less sharply contracting 47.9.

Overall, pretty brutal data for Manufacturing.

1/12/2011: Sunday Times, 27 November 2011

Here is the unedited version of my article in the Sunday Times, November 27, 2011.

Since the collapse of the bubble, Irish perceptions of the residential and commercial property markets have swung from an unquestioning adoration to a passionate rejection.

As the result of the bubble, the overall share of property in average household investment portfolio is likely to decline over time from its Celtic Tiger highs of over 80% to a more reasonable 50-60%, consistent with longer term averages in other advanced economies. But housing will remain a significant part of the household investment for a number of good reasons.

While providing shelter, housing wealth also serves as a long-term savings vehicle and an asset for additional borrowing for shorter-term investments. Security of housing wealth in normal times acts as an asset cushion for family-owned start up businesses and a convenient tool for regular savings. Over the lifetime, as demand for housing grows with family size, we increase our savings, normally just as our life cycle earnings increase. We subsequently can draw down these savings throughout the retirement when income from work drops.

In short, in a normal economy, housing and household investment are naturally linked. In this light, the grave nature of our economic malaise should be apparent to all. Ireland is experiencing a continued and extremely deep balance sheet recession, with twin collapses in property prices and investment that underlie structural demise of our economy.

The latest Residential Property Price Index, released this week, shows that things are only getting worse on the former front. Overall, residential property price index fell to 71.2 in October from 72.8 in September. The latest monthly decline of 2.2% is the sharpest since March 2009 and the third fastest in the history of the index. Relative to peak prices are now down 45.4%. Take a look at two components of household investment portfolios: owner-occupied and buy-to-let properties. For the majority of the middle class families, the former is represented by a family home. The latter, on average, is represented by apartments. Nationwide, per CSO, prices of these assets are respectively down 43.7% and 57.9% relative to the peak.

The impact of these price movements is significant and, contrary to the assertions of the Government and official analysts, real and painful. House price declines imply real capital losses to households and these losses have to be offset, over time, with decreased consumption and falling investment elsewhere. Absent normal loss provisioning available to professional financial sector investors and businesses, households suffer catastrophic collapses on the assets side of their balance sheet, while liabilities (value of mortgages) remain intact. Decades-long underinvestment and low consumption spending await Ireland.

Dynamically, things are not looking any brighter today than a year ago. House prices have fallen 14.9% year on year in October, the worst annual drop since February 2010. Apartments prices are down 19.8% over the last 12 months – the worst annualized performance since April 2010.  Given the price dynamics over the last three years, as well as the current underlying personal income, interest rates and rental yields fundamentals, Irish property prices remain at the levels above the short-term and medium-term equilibrium. This means we can expect another double-digit correction in 2012 followed by shallower declines in 2013.

Not surprisingly, the collapse of the property markets in Ireland is mirrored by an even deeper crash in overall investment activity in the economy. The latest National Accounts data shows that in 2010, gross fixed capital formation in Ireland declined to €19 billion in constant prices. This year, data to-date suggests that capital formation will drop even further, to ca €17 billion or almost 58% below the peak levels. In historical terms, these levels of investment activity are comparable only with 1996-1997 average. If we assume that the excess investments in the property sector were starting to manifest themselves around 2002, to get Irish economy back to pre-boom investment path would require gross fixed capital investment of some €26.9 billion per annum or more than 60% above current levels.

Between 2000 and 2009, Irish economy absorbed some €319 billion in new fixed capital investments. Assuming combined rate of amortization and depreciation of 8% per annum, just to keep that stock of capital in working shape requires €25.5 billion of new investment. This mans that in 3 years since 2009, the Irish economy has lost some €15.5 billion worth of fixed capital to normal wear-and-tear. In short, we are no longer even replacing the capital stock we have, let alone add new productive capacity to this economy.

Looking into sectoral distribution of investment, all sectors of economic activity outside building and construction have seen their capital investment fall by between 18.4% in the case of Fuel and Power Products to 70.4% in the case of Agriculture, Forestry and Fishing sector. So the aforementioned aggregate collapse of investment is replicated across the entire economy.

The dramatic destruction of capital investment in the private sector is not being helped by the fact that Government capital expenditure is also contracting. In 2010, Voted Capital Expenditure by the Irish Government declined to €5.9 billion. This year, based on 10 months through October data, it is on track to fall even further to €4 billion – below the target of €4.35 billion and more than 53% below the peak. In fact, the entire adjustment in public expenditure to-date can be attributed to the capital spending cuts, as current expenditure actually rose over the years of crisis. Since 2008, current expenditure by the state is up 1.9% or €775 million this year, based on the data through October. Thus in 2008, Irish Government spent 17.4% of its total voted expenditure on capital investment. This year the figure is likely to be under 8.8%.

Forthcoming Budget 2012 changes are likely to make matters worse for capital investment. In addition to taking even more cash out of the pockets of those still in employment – thereby reducing further the pool of potential savings – the Government is likely to bring in the first measures of property taxation. This will reinforce households’ expectations that by 2013-2014 Ireland will have a residential property tax that will place disproportional burden on urban dwellers – the very segment of population that tends to invest more intensively over time in property improvements, making the urban stock of housing more economically productive than rural. A tax measure that would be least distorting in terms of incentives to increase productivity of the housing stock – a site-value tax – now appears to be abandoned by the Government, despite previous commitments to introduce it.

Furthermore, we can expect in the next two years abolition of capital tax reliefs, increases in capital tax rates and high likelihood of some sort of wealth taxes – direct levies on capital and/or savings for ordinary households. In the case of the euro area break up, Ireland will also see draconian capital controls.

In short, we are now set to experience an 8-10 years period of direct and accelerating destruction of our capital base. It doesn’t matter which school of economic thought one belongs to, there can be no recovery without capital investment returning back to growth.

Box-out:

In the recent paper titled “The Eurozone Crisis: How Banks and Sovereigns Came to Be Joined at the Hip”, published last month, two IMF researchers identify Europe’s Lehman’s moment in the global financial crisis as the day when the Irish Government nationalized the Anglo Irish Bank. In contrast to the current and previous Governments’ assertions, the IMF study argues that the Anglo was not a systemically important bank worthy of a rescue. As the paper puts it: “The problems [of collapsing financial sector valuations] entered a new phase – becoming a full-blown crisis – with the nationalisation of Anglo Irish in January 2009. The relevance of Anglo is, at first, not obvious, since it was a small bank in a relatively small country. However, …it is possible that the large fiscal costs as a share of Ireland’s GDP associated with this rescue raised serious concerns about fiscal sustainability. Suddenly, the ability of the sovereigns to support the financial sector came into question.” In other words, far from helping to avert or alleviate the crisis, Anglo nationalization caused the crisis to spread. “In retrospect, the nature of the crisis prior to Anglo Irish was simple, being mostly driven by problems in the financial sector… The winding down of Anglo Irish, for example, would have been preferable to its nationalization…” In effect, the previous Government made Anglo systemically important by rescuing it. If there ever was a better example of the medicine that kills the patient.