Showing posts sorted by relevance for query fiscal compact. Sort by date Show all posts
Showing posts sorted by relevance for query fiscal compact. Sort by date Show all posts

Friday, May 4, 2012

4/5/2012: Sunday Times - 29/4/2012: Fiscal Compact

My Sunday Times article from April 29, 2012 (unedited version).

When first published, the Fiscal Compact (formally known as the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union) was billed as a ground-breaking exercise in European legislative activism. The main innovation of the treaty was not its content (which largely regurgitates already existent fiscal constraints established under the Maastricht Treaty), but its compact size and designed-to-be-digestible language.

Few months down the road, and the Fiscal Compact has become a subject to numerous conflicting claims and interpretations, thanks to both side of the referendum debate in Ireland. Mythology that surrounds the Fiscal Compact is impressively wide and growing. The fog of politicised sloganeering and scaremongering on the ‘Yes’ side is well matched by the clouds of emotive and quasi-economic nonsense from the ‘No’ camp.

The main alleged problem with the Compact is that its core rules – the 60% debt/GDP limit for Government borrowings, the 1/20 adjustment rule for dealing with excess public debt, the 3% deficit ceiling and the 0.5% structural deficit break – amount to prohibiting of the Keynesian economic policies in the future. This argument is commonly advanced by the Fiscal Compact opponents and implies that in the future crises, Ireland will not be able to use stimulative Government spending to support its economy.

In practice, however, Fiscal Compact restricts, but not eliminates the room for deficit financing. In the current economic conditions, under full compliance with the deficit rules, Irish Government would have been able to run a deficit of at least 2.97% of GDP – much lower than 8.6% targeted under Budget 2012, but close to 3.2% deficit forecast for 2012 for the euro area.

Far from ‘killing Keynesianism’, the Fiscal Compact induces in the longer run fiscal policies that are consistent with Keynesian economics. Any state that wants to secure a ‘fiscal stimulus’ cushion for future crises should accumulate surplus resources during the times of economic expansions, not rely on the goodwill of the bond markets to supply debt financing to the Governments when their economies begin to tank.

The treaty does limit significantly the state capacity to accumulate debt in the future. In the long run, debt to GDP ratio should converge to the ratio of average deficits to the long-term growth potential. Based on IMF projections, our structural deficit for 2014-2017 will average over 2.7% of GDP, which implies Fiscal Pact-consistent government deficits around 1.6-1.7% of GDP. Assuming long-term nominal growth of 4-4.5% per annum, our ‘sustainable’ level of debt should be around 36-40% of GDP. Although no one expects (or requires) Ireland to draw down our public debt to these levels any time soon, over decades, this is the level we will be heading toward if we are to comply with the Fiscal Compact rules.

On the ‘Yes’ side, the biggest myth concerning the Fiscal Compact is that adopting the treaty will ensure that no more fiscal crises the likes of which we have experienced since 2008 will befall this state.

In reality, the collapse of exchequer finances in Ireland has been driven by a number of factors, completely outside the matters covered by the Fiscal Compact.

Firstly, significant proportion of our 2008-2011 deficits arises from the state response to the banking sector implosion and closely correlated property sector collapse. The latter was also a primary driver for the decline in tax revenues. The former was a policy choice. Thirdly, our deficits were driven not just by the fiscal performance itself, but also by the unsustainable nature of our government spending and taxation policies. For example, during the boom, Irish Governments consistently acted to increase automatic payments relating to unemployment and social welfare financed on the back of tax revenues windfall from property transactions. Property revenues collapse coincident with increases in unemployment has led to an explosion of unfunded state liabilities.

None of these shocks could have been offset or compensated for by the Fiscal Compact-mandated measures. In fact, during the 2000-2007 period, Irish Governments’ fiscal stance, on the surface, was well ahead of the Fiscal Compact requirements. Ireland satisfied EU Fiscal Compact bound on structural deficits in all years between 2000 and 2007, with exception of two. Of course, in all but one year over the same period, we also failed to satisfy the very same bound if we were to use the IMF-estimated structural deficits in place of those estimated by the EU, but that simply attests to the difficulty of pinning down the exact value of the potential GDP, required to estimate structural deficits. We also satisfied EU-mandated debt break in every year between 2000 and 2008. In fact, between 2000 and 2007 our debt to GDP ratio was below 40% - the benchmark consistent with long-term compliance with the Fiscal Compact. More than fulfilling the requirement for a 3% maximum Government deficit, Irish Exchequer run an average annual net surplus of 1.97% of GDP, accumulating 2000-2007 period surpluses of €11.3 billion and the NPRF reserves which peaked in Q3 2007 at €21.3 billion.

In short, the Fiscal Compact is not a panacea to our current crisis, nor is it a prevention tool capable of automatically correcting future imbalances, especially given the difficulty of forecasting future sources of risk.

Instead, Ireland needs a combination of institutional reforms to enhance our domestic capacity to identify points of rising risks and to deploy policies that can address these risks in advance. A flexible and highly responsive early warning system, such as a truly independent Fiscal Advisory Council, coupled with reformed Civil Service, aiming at achieving real excellence and accountability within the key Departments and regulatory offices can help. Furthermore, abandonment of the consensus-focused systems of governance, eliminating the expenditure-centric Social Partnership and the Dail whip system, and reformed legislative and executive systems to increase the robustness of the checks and balances on local and central authorities, are needed to develop capacity to respond to emerging future crises. Legal reforms, to address the imbalances of power of the vested groups, such as bondholders or state monopolists, vis-à-vis the taxpayers, are required to prevent future bailouts of private and semi-state enterprises at the expense of the Exchequer. Local authorities reforms are required to ensure that the madness of over-development and land speculation do not build up to a systemic crisis. Taxation reforms are needed to stabilize future revenues and develop an economically sustainable tax system.

The Fiscal Compact is a wrong policy for all of the above because it risks creating a confidence trap, which can replace or displace other reforms. It represents a wrong set of objectives, as it diverts state attention from considering the nature of underlying imbalances. It also re-directs much of the fiscal responsibility away from Irish authorities, potentially amplifying the reality gap between the real economy and the decision-makers. By endlessly blaming Europe for tying Government’s hands, the Compact will continue building up voters’ perception disenfranchisement, fueling stronger local political orientation toward parochialism and narrow interests representation, while alienating voters from European institutions.

In short, the Compact is not an end to the politics as usual. This, perhaps, explains why no independent analyst or politician is prepared to vote in favour of the new Treaty except under the threat of the Blackmail Clause contained not in the Fiscal Compact itself, but in the forthcoming ESM Treaty and which requires accession to the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union as a pre-condition for gaining access to the ESM funds. Not exactly a moment of glory for either Europe or Ireland.


By now, we have become accustomed to the endless repetition of the boisterous claims that the continued declines in Government bond yields since mid-2011 signal the return of the markets confidence in Ireland. Alas, based on the last two months worth of data, things are not exactly going swimmingly for this school of thought. Based on weekly data, Irish benchmark 9-year bond yields spreads over Germany have contracted sharply in year on year terms, falling on average 1.30 percentage points since March 1, 2012 and 1.26 percentage points in April. The former is the second best performance in the euro zone after Italy, and the latter marks the third best performance after Italy and Portugal. Alas, weekly changes have been much less impressive. Since March 1, our yields have actually risen, in weekly terms, with an average rate of increase of 0.02 percentage points. For the month of April, the same metric stands at 0.05 percentage points. The same performance pressure on Ireland is building up in the Credit Default Swaps markets, with our 5 year benchmark CDS spreads declining just 0.24 percentage points compared to Portugal’s 5.2 percentage points drop since a month ago. Overall, European CDS and sovereign bonds markets are now signalling the exhaustion of the positive momentum from the December 2011 and February 2012 LTROs. Ireland’s bonds and CDS are no exception to this rule, suggesting that the ‘special relationship’ that we allegedly enjoy with the markets might be now over.

Sunday, May 13, 2012

13/5/2012: Village Magazine May 2012: Fiscal Rules & actual outruns

This is an unedited version of my article for Village magazine, May 2012.

However one interprets the core constraints of the Fiscal Compact (officially known as the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union), several facts concerning Ireland’s position with respect to them are indisputable.

Firstly, the new treaty will restrict the scope for the future exchequer deficits. This has prompted the ‘No’ side of the referendum campaigns to claim that the Compact will outlaw Keynesian economics. This claim is a significant over-exaggeration of reality. Combined structural and general deficit targets to be imposed by the Compact would have implied a maximum deficit of 2.9-3.0 percent in 2012 as opposed to the IMF-projected general government net borrowing of 8.5 percent of GDP. With the value of the Fiscal Compact-implied deficit running at less than one half of our current structural deficit, the restriction to be imposed by the new rules would have been severe. However, in the longer term, fiscal compact conditions allow for accumulation of fiscal savings to finance potential liabilities arising from future recessions. This is exactly compatible with the spirit of the Keynesian economic policies prescriptions, even though it is at odds with the extreme and fetishized worldview of the modern Left that sees no rational stops to debt accumulation on the path of stimulating economies out of recessions and broader crises.

Secondly, the Fiscal Compact will impose a severe long-term debt ceiling, but that condition is not expected to be satisfied by Ireland any time before 2030 or even later.

One interesting caveat relating to the 60 percent of GDP bound is the exact language employed by the Treaty when discussing the adjustment from excess debt levels. The ‘Yes’ camp made some inroads into convincing the voters to support the Compact on the grounds that debt paydowns required by the debt bond will involve annually reducing the overall debt by 1/20th of the debt level in excess of 60% bound. However, the Treaty itself defines “the obligation for those Contracting Parties whose general government debt exceeds the 60 % reference value to reduce it at an average rate of one twentieth per year as a benchmark” (page T/SCG/en5). Thus, there is a significant gap between the Treaty interpretation and its reality.

Another debt-related aspect f the treaty that is little understood by the public and some analysts is the relationship between deficit break, structural deficits bound and the long-term debt levels that are consistent with the economy growth potential. Based on IMF projections, our structural deficit for 2014-2017 will average over 2.7% of GDP, which implies Fiscal Compact-consistent government deficits around 1.6-1.7% of GDP. Assuming long-term nominal growth of 4-4.5% per annum, our ‘sustainable’ level of debt should be around 38-40% of GDP. Tough, but we have been at public debt to GDP ratio of below 40 percent in every year from 2000 through 2007. It is also worth noting that we have satisfied the Fiscal Compact 60% debt bound every year between 1998 and 2008.

Similarly, the Troika programme for fiscal adjustment that Ireland is currently adhering to implies a de facto satisfaction of the Fiscal Compact deficit bound after 2015, and non-fulfilment of the structural deficit rule and the debt rule any time between now and 2017. In other words, no matter how we spin it, in the foreseeable future, we will remain a fiscally rouge state, client of the Troika and its successor – the ESM.

On the negative side, however, the aforementioned 1/20th rule would be a significant additional drag on Ireland’s economic performance into the future, compared to the current Troika programme. If taken literally, an average rate of reduction of the Government debt from 2013 through 2017, required by the Compact would see our state debt falling to 87.6% of GDP in 2017, instead of the currently projected 109.2%. In other words, based on IMF projections, we will require some €42 billion more in debt repayments under the Fiscal Compact over the period of 2013-2012 than under the Troika deal.

On the net, therefore, the Compact is a mixture of a few positive, some historically feasible, but doubtful in terms of the future, benchmarks, and a rather strict short-term growth-negative set of targets that may, if satisfied over time, convert into a long-term positive outcomes. Confused? That’s the point of the entire undertaking: instead of providing clarity on a reform path, the Compact provides nothing more than a set of ‘if, then’ scenarios.

Let me run though some hard numbers – all based on IMF latest forecasts. Even under the rather optimistic scenario, Ireland’s real GDP is expected to grow by an average of 2.27% in the period from 2012 through 2017. This is the highest forecast average rate of growth for the entire euro area excluding the Accession states (the EA12 states). And yet, this growth will not be enough to lift us out of the Sovereign debt trap. Averaging just 10.3% of GDP, our total investment in the economy will be the lowest of all EA12 states, while our gross national savings are expected to average just 13.2% of GDP, the second lowest in the EA12.

In short, even absent the Fiscal Compact, our real economy will be bled dry by the debt overhang – a combination of the protracted deleveraging and debt servicing costs. It is the combination of the government debt and the unsustainable levels of households’ and corporate indebtedness that is cutting deep into our growth potential, not the austerity-driven reduction in public spending. In this sense, Fiscal Compact-induced acceleration of debt repayments will exacerbate the negative effect of fiscal deleveraging, while delaying private debt deleveraging.

However, on the opposite side of the argument, the alternative to the current austerity and the argument taken up by the No camp in the Fiscal Compact campaigns, is that Ireland needs a fiscal stimulus to kick-start growth, which in turn will magically help the economy to reduce unsustainable debt levels accumulated by the Government.

There is absolutely no evidence to support the suggestion that increasing the national debt beyond the current levels or that increasing dramatically tax burden on the general population – the two measures that would allow us to slow down the rate of reductions in public expenditure planned under the Troika deal – can support any appreciable economic expansion. The reason for this is simple. According to the data, smaller advanced economies with the average Government expenditure burden in the economy of ca 31-35% of GDP have expected growth rates averaging 3.5% per annum. Countries that have Government spending accounting for 40% and more of GDP have projected rates of growth closer to 1.5% per annum. Ireland neatly falls between the two groups of states both in terms of the Government burden and the economic growth rate. So, if we want to have growth above that projected under the current forecasts, we need (a) to accept the argument that growth is not a matter of the stimulus, but of longer-term reforms, and (b) to recognize that for a small open economy, higher levels of Government capture of economy is associated with lower growth potential.

Despite our already deep austerity and even after the Compact becomes operational, Irish Exchequer will continue running excess spending throughout the adjustment period. Between 2012 and 2017, Irish government net borrowing is expected to average 4.7% of GDP per annum, the second highest in the EA12 group of countries. Between this year and 2017, our Government will spend some €47.4 billion more than it will collect in taxes, even if the current austerity course continues. Of these, €39 billion of expenditure will go to finance structural deficits, implying a direct cyclical stimulus of more than €8.4 billion. The Compact will not change this. In contrast, calling on the Government to deploy some sort of fiscal spending stimulus today is equivalent to asking a heart attack patient to run a marathon in the Olympics. Both, within the Compact and without it, the EU as well as the IMF will not accept Irish Government finances going into a deeper deficit financing that would be required to ‘stimulate’ the economy.

The structural problem we face is that under current system of funding the economy and the Exchequer, our exports-driven model of economic development simply cannot sustain even the austerity-consistent levels of Government spending. IMF projects that between 2012 and 2017 cumulative current account surpluses in Ireland will be €40 billion. This forecast implies that 2017 current account surplus for Ireland will be €10 billion – a level that is 56 times larger than our current account surplus in 2011. If we are to take a more moderate assumption of current account surpluses running around 2012-2013 projected levels through 2017, our Government deficits are likely to be closer to €53 billion. Our entire exporting engine will not be able to cover the overspend of this state. In short, there is really no alternative to the austerity, folks, no matter how much we wish for this not to be the case.

Instead, what we do have is the choice of austerity policies we can pursue. We can either continue to tax away incomes of the middle and upper-middle classes, or we cut deeper into public expenditure.

The former will mean accelerating loss of productivity due to skills and talent outflows from the country, reduced entrepreneurship and starving the younger companies of investment, rising pressure on wages in skills-intensive occupations, while destroying future capacity of the middle-aged families to support themselves through retirement. Hardly trivial for an economy reliant on high value-added exports generation, higher tax rates on upper margin of the income tax will act to select for emigration those who have portable and internationally marketable skills and work experience. Given that much of entrepreneurship is formed on the foot of self-employment, high taxation of individual incomes at the upper margin will further force outflow of entrepreneurial talent. In addition, to continue retaining high quality human capital here, the labour markets will have to start paying significant wages premia to key employees to compensate them for our tax regime. All of these things are already happening in the IFSC, ICT and legal and analytics services sectors.

The latter is the choice to continue reducing our imports-intensive domestic consumption, especially Government consumption, and cutting the spending power of the public sector employees, while enacting deep structural reforms to increase value-for-money outputs in the state sectors. This, in effect, means increasing the growth gap between externally trading sectors and purely domestic sectors, but increasing it on demand and skills supply sides, while hoping that corrected workplace incentives will lift up the investment side of domestic enterprises.

Both choices are painful and short-term recessionary, but only the latter one leads to future growth. Anyone with an ounce of understanding of economics would know that the sole path out of structural recession involves currency devaluation. And anyone with an ounce of understanding of economics would recognize that the effects of such devaluation would be to reduce imports, increase differential in earnings in favour of returns to human capital and drive a wider gap between domestic and exporting sectors. The former choice of policies is only consistent with giving vitamins to a cancer-ridden patient – sooner or later, the placebo effect of the ‘stimulus’ will fade, and the cancer of debt overhang will take over once again, with even greater vengeance.

Looking back over the Fiscal Compact, the balance of the measures enshrined in the new treaty is most likely not the right – from the economic point of view – prescription for Ireland today. It is probably not even a correct policy choice for the future. But the reasons for which the treaty is the wrong ‘medicine’ for Ireland have nothing to do with the austerity it will impose onto Ireland. Rather, the really regressive feature of the Treaty is that it will make it virtually impossible for our economy to deal with the issue of private debt overhang and to properly restructure our taxation system to create opportunities for future growth.


Update:  In the above, I reference the 1/20th rule and identify it as 'taken literally'. This can cause some confusion for the readers. To clarify the matter, here is the discussion of the rule as 'taken' literally' as opposed to 'taken as implied' under the Treaty. The article has been filed before the linked discussion took place. Additional material on this can be found on Professor Karl Whelan's blog here.

It is also worth pointing out that I have consistently (until April 26th blogpost) referenced the 1/20th rule as applying to debt portion in the excess over 60% bound. This referencing traces back to my comments on the issue to the Prime Time programme for which I commented on the issue back in late January 2012. However, subsequent reading of the document has shown very clearly that the primary language of the Treaty clearly references one rule in the preamble, while the conditional statement in the Treaty article itself references the other. On the balance, I agree with Karl Whelan, that the implied and valid wording should relate to 1/20th of the excess over 60% bound.

Really shoddy job done by those who wrote this Treaty.

Friday, May 4, 2012

4/5/2012: Fitch Bells: Ringing de Panic?

Yesterday, Fitch Ratings issued an interesting report, titled "The Future of the Eurozone: Alternative Scenarios". The report sounds alarm bells over what some markets participants have thought of as a 'past issue' - the risks of contagion from Greece to the Euro area periphery.

Fitch Ratings core view is that the eurozone will 'muddle through' the crisis, surviving in its current composition,  while taking 'gradual steps towards closer fiscal and economic integration'. 

The interesting bit comes in the discussion of possible alternatives and the associated probabilities of these alternatives. According to Fitch, there is rising (not falling, as we would expect were LTROs and Greek debt restructuring, plus the Fiscal Compact and the ESM working) risk of a protracted growth slowdown or political shock or some other shock triggering either a possible facilitated Greek exit from the Euro or a disorderly Greek exit from the common currency.

And, crucially, according to Fitch, this risk cannot be discounted. 

This bit is where Fitch's assessment is identical to mine and contradicts that of the majority of Irish 'green jersey' economists: the tail risk of a disorderly unwinding of the euro is non-zero and rising, while the disruption or cost associated with such a outcome is by far non-trivial. Prudent risk management policy would require us to start contingency planning and addressing the possible realisation of such a risk. Instead, we are preoccupied in navel gazing through the lens of the Fiscal Compact, and not even at our own 'navel', but at the European one.

Fitch view is that a full break-up and demise of the euro is probabilistically highly unlikely. This belief is based on Fitch foreseeing large financial, economic and political costs of a break-up. More interestingly, Fitch determines that a partial break-up of the euro zone - with one or more countries exiting the common currency -  would "risk severe systemic damage, although cannot be discounted". 

For those thinking we've done much to resolve the systemic euro crisis (by doing much we usually mean creation of EFSF and agreeing ESM, deploying LTROs and restructuring Greek debts, and putting in place the Fiscal Compact), Fitch has some nasty surprises. Basically, Fitch believes (and I agree with their assessment here), that "additional measures will be needed to resolve the crisis. These are likely to include some dilution of national fiscal sovereignty [beyond the current austerity programmes and Fiscal Compact], potentially some partial mutualisation of sovereign liabilities [basically - euro bonds of sorts] and resources [some transfers to peripheral states], as well as measures to enhance pan-eurozone financial supervision and intervention, combined with further institutional reforms to strengthen eurozone economic governance". Basically, you can read this as: little done, much much much more to do still...

It gets worse.

Of all the alternative scenarios presented, Fitch believes that the most likely scenario will involve a Greek exit, with Greece re-denominating its debt in a new currency and default on its bonds again. Per Fitch, the core danger will be to Cyprus, Ireland, Italy, Portugal and Spain based on:

  1. Greek exit creating an 'exit precedent' for the already distressed economies
  2. Greek default impacting adversely other peripheral countries banks (especially true for Cyprus)
  3. Greek default increasing the risk of capital flight from the countries
  4. Greek default triggering a run on peripheral bonds just around the time when the 2013 'return to markets' horizon is in the crosshair.
Just as I usually do in my presentations on the topic, Fitch distinguishes two potential paths to Greek 'exit' - a structured and unstructured or 
  • an "orderly variation with an effective eurozone policy response and minimal contagion" and 
  • a "disorderly variation", involving "material contagion to the periphery and a significant increase in contingent liabilities facing the core".
Ouch, I must say, for all the folks who lost their voice arguing that my views are 'unreasonable' and 'scaremongering'. Sorry to say it, risk management approach to dealing with reality requires taking a probabilistically-weighted expected costs scenarios of the downside into the account. Simply shouting "all is sustainable here, nothing to bother with" won't do.

Thursday, June 21, 2012

21/6/2012: Few thoughts on G20 report on Euro Area

Joint G20 assessment of the euro area (emphasis and comments are mine):

"Efforts on several fronts  are still needed to build a stronger monetary union. Specifically: 

  1. moving toward a pan-euro-area financial stability framework, which inter alia implies centralized powers in banking supervision and resolution, and common deposit insurance; [banking union, consistent with my view of what is required to shore banking sector, but absent a pan-European insolvency resolution regime, not sufficient condition for sustainable crisis resolution]
  2. stronger fiscal integration, including national fiscal rules, as envisaged by the Fiscal Compact, complemented by fiscal risk sharing to ensure that economic dislocation in one country does not develop into a costly fiscal and financial crisis for the entire region; [Naive, or rather politically correct, statement. The Fiscal Compact can be expected to have any real effect on fiscal performance in the medium-long term. Precisely the time scale over which it will be most likely non-enforceable.]
  3. structural reform to strengthen competitiveness and improve the  ability to adjust to shocks, including by a wage-setting mechanism that is more responsive to firm-level economic conditions, reducing labor market duality and in general barriers to hiring and firing, and lowering barriers to domestic and foreign competitions in product markets. [This is another weak policy orientation. Structural reforms are needed, beyond any argument, but these must start not from altering cost competitiveness but from creating institutional and operational platforms for entrepreneurship and investment. Europe lacks growth dynamics not because its labour costs are too high or there is a difficulty with hiring and laying off workers. These are important factors, but they are not primary ones. Europe lacks growth because the Governments take up 50% of the economy, because taxes are prohibitive to investment and jobs creation, consumption and saving, because the structure of European institutions favors incumbents over newcomers and thus retards fully social mobility and renewal.]

There is growing awareness among European policy makers to move along these lines and
active efforts are underway to build the necessary consensus."

Overall, G20 is still held hostage to:

  1. Consensus policies represented by the IMF-think - of micro-fixing sub-structures of specific politically correct markets for inputs (labour) instead of focusing on the larger scale imbalances that lead to unsustainable expansion of the state over private sector opportunities and returns.
  2. Politically correct 'non-interference' in specific solutions designed by the euro area - most visible in the acceptance of the Fiscal Compact framework as a 'sustainable' solution to the fiscal crisis.

I find it amazing that the G20 (or rather it is IMF who authored the document) is treating recent adjustments in the economic imbalances in the euro area as if it is something that is consistent with a functional adjustment.

"The global financial crisis has triggered a noticeable narrowing of external imbalances. As world trade collapsed, current account balances of deficit economies improved substantially—well in excess of what would have been expected given the fall in output based on standard trade elasticities (i.e., “residual” changes are large), despite a significant increase in interest costs on their external debt. Substantial demand compression following the collapse of credit, asset and housing booms and a decline in confidence in periphery economies, reinforced by fiscal consolidation, played an  important role in this wrenching adjustment. Many of the factors identified below as contributing to the imbalances—such as excessive optimism and easy financial conditions begetting consumption and construction booms—are out of the picture now. Hence, much of the adjustment observed so far is likely to be lasting."

Firstly, I agree that much of the adjustment outlined above is now engrained into consumer and investor behavior. Secondly, I disagree that the fiscal adjustments have been either significant or sustainable in the long run. Let us keep in mind that there is no decrease in government spending in 2011-2012. There is an increase. But what worries me most in the above is that the adjustments described would be consistent with the rates of growth into the future that are hardly sustainable given debt overhang. In other words, the environment of depressed consumer credit, consumer spending, high interest cost of capital, etc warrants growth expectation for euro area of 1-1.5 percent annually in real terms, if not lower. Working out debt of 90% to GDP (fiscal debt alone) and well in excess of 250% for the total debt at the above rates of growth, in my view, is simply not going to happen. Unless we are talking about double-digit inflation.

An interesting related chart: 

The above clearly shows how deep collapse of economy has driven 'improvements' in Irish external balance (purple area representing collapse in growth) and how our automatic fiscal policy destabilizers (income & transfers) have been a 'break' on the external balance improvements. (Note: I am not suggesting there is a positive value in driving income & transfers down, just observing the fact). As per my term of automatic fiscal destabilizers, here's the quote from the report:
"In some booming economies (e.g., Ireland and Spain), debt ratios declined, but given the extent to which ample fiscal revenues had been linked to unsustainable asset market developments, structural balances remained fundamentally weak. That weakness was unmasked by the crisis."

I'll blog on specific risk assessment report tomorrow, so stay tuned.

Tuesday, July 22, 2014

22/7/2014: Remember that Fiscal Compact? Well, Don't Remind Europe...

Remember the Fiscal Compact? Yes, the one where debt/GDP ratio should be at 60% and the countries with ratios in excess of 60% must take 1/20th of the excess in adjustment down in debt per annum? So a country with 130% debt/GDP ratio is committed to an annual reduction of (130-60)/20=3.5% of GDP in year 1 and so on...

Oh, yes, the Fiscal Compact underpins the macroeconomic stability in the Euro area, making the euro as a currency 'sustainable'…

Oh yes, and the latest figures from the Eurostat on Government debt show that…

  1. 18 out of EU28 countries have seen increases in Government debt/GDP ratios in Q1 2014 compared to Q1 2013.
  2. 9 countries have posted increases in excess of 5% of GDP.
  3. Year on year: the highest increases in the ratio were recorded in Cyprus (+24.6 pp), Slovenia (+23.9 pp), Greece (+13.5 pp) and Croatia (+9.9 pp), while the largest decreases were recorded in Poland (-7.7 pp), Germany (-3.2 pp), the Czech Republic (-2.2 pp), Latvia (-1.4 pp) and Belgium (-0.9 pp).
  4. 15 EU28 countries had Government debt/GDP ratio in excess of 60%
  5. EA18 Government debt in Q1 2013 stood at EUR8.793 trillion or 92.5% of GDP. In Q1 2014 this was EUR9.056 trillion or 93.9% of GDP. That is excluding intergovernmental debt. Adding this, Q1 2013 debt/GDP ratio was 94.6% and this rose to 96.3% in Q1 2014.

Good to see the Fiscal Compact holding so much better than the Maastricht Criteria.

So in the Age of European Austerity, savage cuts to public spending are resulting in rising debt at a rate of 1.7 percentage points of GDP per annum. One might wonder, were it not for the savage Austerity, where the debt levels might have been?

Full Eurostat release here:

Sunday, March 25, 2012

25/3/2012: Irish GDP and Structural Deficits - forecasting unpredictable?

The pitfalls of forecasting Irish GDP and structural deficit in handy charts...

First - the range of forecasts and outruns for annual GDP growth in constant prices:

Not only the range of forecasts is wide (exclude the 2008-2009 period for obvious reasons), but what is worse is that there is virtually no agreement within the WEO database on past rates of growth. For example, take year 2000:
  • WEO September 2011 claims 2000 saw growth of 9.298%
  • WEO April 2011 and September 2010 state it was 9.665%
  • WEO April 2010 and October 2009 claimed it was 9.447%
  • WEO April 2009 and October 2008 set it at 9.237%
  • WEO April 2008 at 9.15%
  • WEOOctober 2007 at 9.1%
  • WEOApril 2007 reported it to be 9.4%
  • WEOOctober 2006 and April 2006 showed 9.2%
So which is the real growth rate, then? And how long do we need to wait to confirm it? Of course, much of the above is due to referencing to different prices bases - in other words, inflation 'target' changes' but you do get the point - even past rates are changing over time, implying the difficulty of actually comparing past performance.

Meanwhile, the range of forecasts is outright massively all over the place. Take this year forecasts (and we exclude the fact that between WEO database releases twice a year, we have intermediate updated forecasts published in separate documents without actually updating the database. So back in 2009 the IMF predicted 2012 rate of growth to be 2.325% to 2.337% (April-October versions). By April 2010 it was 2.306% and by October 2010 it was 2.446%. InApril 2011 the forecast for 2012 was revised to 1.908% and in September 2011 it was revised to 1.484%. So much for planning: the range over just 1.5 years is 2.446% to 1.484%.

Structural deficits - the reverse is true. Forecasts are tighter (as potential GDP assumes away cyclical effects) and outrun estimates are all over the place instead:

There is also a strangely strong correlation between conservative estimates of the structural deficits and the average estimates of the structural deficit and the IMF reported and forecast GDP growth rates. In other words, the models used by the IMF appear to produce more consistent lower end deficit estimates.

Which, of course, begs a question. You see, per IMF, Ireland's structural deficits were on average and at the minimum levels strongly outside the fiscal sustainability in 2000-2006 and well outside the Fiscal Compact bound of -0.5%. Over the same period of time, EUCommission reported structural deficits were actually within the parameter bounds for Fiscal Compact. Given that the IMF min and average estimates closely reflect the growth estimates and reported outruns, it appears that the IMF metric is probably a more reasonable reflection of the fiscal realities than that of the EUCommission.

Which is not exactly the great news for the Fiscal Compact as far as the treaty expected ability to achieve any real impact on fiscal discipline goes.

Monday, February 6, 2012

6/2/2012: Fiscal Compact Treaty - Sunday Times 05/02/2012

This is an unedited version of my Sunday Times article from February 5, 2012.

In medical analogy terms, this week’s Fiscal Pact signed by the 25 EU Member States, is equivalent to a misdiagnosed patient (the euro area economy) receiving a potent cocktail of misprescribed medicines.

In other words, the Fiscal Pact is neither a necessary, nor a sufficient solution to the ongoing crisis of the euro area insolvency. Moreover, it saddles the euro area with a choice of only two equally unpalatable alternatives. The first choice is compliance with the Pact that will lead to a situation whereby a one-policy-fits-all monetary framework will be coupled with an equally mismatched one-policy-fits-all fiscal framework. The second choice is business as usual, with continued reckless borrowing, internal and external imbalances and ever deepening links between the sovereign finances, the ECB and the banking sector balancesheets. In other words, there is a choice of either pushing Euro area down the deflationary, stagnation-inducing deleveraging spiral, or leaving it in the current modus operandi of reckless borrowing.

Both alternatives are internecine for Ireland, and both increase the probability of an eventual collapse of the euro over the next 5-10 years.

Suppose the EU member states, opt for the first alternative. As a whole, to comply with the Pact parameters, the Euro area economy will have to shrink by some €535-540 billion every year between now and 2020 – an equivalent of reducing euro area growth by a massive 3.9% annually. Just for the purpose of comparison, during the 2009 recession, Euro area experienced a real decline of overall income of 4.25%.

Ireland will be one of the worst impacted economies in the group courtesy of our excessively high structural deficits, debt to GDP ratio and cyclical deficits. In 2012, Ireland is forecast to post a structural deficit in excess of 5.5% of potential GDP – the highest structural deficit in the entire Euro area. To cut our structural deficit to 0.5% will require reducing annual aggregate demand in the economy by some  €7-8 billion in today’s terms. Debt reductions over the period envisioned within the pact will take an additional €12 billion annually. For an economy with huge private sector debt overhang, paying some 12% of its GDP annually to adhere to the Fiscal Pact is a hefty bill on top of the already massive interest bill on public debt.

Ireland’s fiscal performance under the Fiscal pact constraints, 2012

Sources: author estimates based on the combination of data from the Department of Finance, Budget 2012, IMF World Economic Outlook database, and author own forecasts

Crucially, the idea of the Fiscal Pact as a tool for resolving the structural crisis faced by the Euro area is equivalent to doing more of the same and expecting a different outcome.

The crisis arose because the Euro area combined vastly heterogeneous and complex economies under a one-policy-fits-all monetary umbrella. This has meant that no matter what policy the ECB pursued, interest rates and money supply will never be in synch with all economies within the Euro. The modern economic theory suggests that fiscal transfers can act as automatic stabilizers, correcting for monetary policy disequilibrium.

In European case, this theory is a pipe dream. Firstly, fiscal transfers cannot happen with the same timing as monetary policy changes, especially given the bureaucratic nature of the EU and its institutions’ detachment from the member states’ realities. Take one example – Ireland and other euro areas have been experiencing severe unemployment problems since 2009. Yet, only this week did the EU wake up to the problem and thus far, there are no tangible plans for dealing with it. Automatic stabilizer of fiscal policy will never be timely and responsive enough to undo damages caused by the unsuitable monetary policy. Secondly, fiscal transfers are an imperfect substitute for private sector adjustments to dislocations that monetary policy generates. No need to go beyond the current crisis to see this with aggressive monetary policy interventions since 2008 yielding not an ounce of real economic impact on the ground. Which means that the theoretical stabilizers are not really that effective in stabilizing the economic disruptions caused by monetary policy misfiring. Lastly, neither the current Pact, nor any other institutional arrangements within the Union provide for any automatic fiscal transfers.

Yet, when it comes to the penalties that apply to member states breaching the Pact conditions the new agreement are automatic and very tangible. This imbalance – with the Pact being all stick and no carrot – risks destabilizing economic systems struggling with shocks.

Take for example a country like Ireland. Suppose ECB policy in the future leads to high interest rates – a scenario consistent with the current monetary policy developments. This would imply that our terms of trade will deteriorate, reducing our exports and driving our economy into an external deficit. Simultaneously, slowdown in the economy will put pressures on our fiscal balance. This deterioration will not be consistent with a cyclical recession, implying that we are likely to simultaneously breach the twin deficits targets under the Fiscal Pact, triggering automatic penalties. Economy brought to its knees by the monetary policy mismatch will be forced to pay additional price through fiscal penalties.

In other words, the Pact is now attempting to create another policy system that will risk further detaching fiscal policies within the Euro area from the monetary policy.

When it comes to dealing with the current crisis, the new Pact contains no tools for achieving structural reforms required to arrive at sustainable public finances. Paying down the debts and cutting back deficits requires simultaneously running surpluses on the Exchequer side and the current account side. In other words, both external and internal surpluses must be achieved simultaneously. As international research shows, the likelihood of any state moving from long-term external imbalances to a sustainable current account surplus is extremely low.

Matters are worse when it comes to both fiscal and external balances. My own research based on the Euro area data shows that during 1990-2008, only two euro countries – Finland and Malta – have complied with the Fiscal pact criteria more than 50% of the time. The rest of the member states, including Germany and France, have run sustained deficits more than 60% of the time. Once a euro state found itself stuck in twin current and fiscal deficits in one decade (the 1990s), transitioning to a twin current account and fiscal surplus in the next decade (the 2000s) was virtually impossible. For example of all states in EA17 who were in current account deficit throughout the 1990s, only 2 have managed to achieve current account surpluses during the following decade. Only one country that experienced fiscal deficits in the 1990s has managed to generate fiscal surpluses over the following decade. No country has been successful in restoring fiscal and external balances after a decade of twin deficits.

The Fiscal Pact implies even less flexibility in adopting structural reforms necessary to achieve an already highly unlikely economic transition to the long-term sustainability path for many euro area states, including Ireland.

Consider for example two economies currently in a crisis – Ireland and Portugal. Portugal requires severe and substantial cuts in all public spending and then deep reforms in the private sectors of its economy. The country does not need a debt restructuring, but it needs huge capital injections to put it onto the path of capital investment convergence with the euro area average.

In contrast, Ireland needs restructuring of the private sector debts, deep reforms on the current expenditure side of the Irish exchequer, and more gradual reforms in the private sectors. Ireland has a functional exports generating economy, it has achieved current account surpluses on external side and balance on its Government spending side in the past. During the adjustment, Ireland needs structural reductions in the current spending best timed to start concurrently with the pick up in private sector jobs creation to offset adverse effects of these reforms on the most vulnerable – the unemployed. Ireland also needs to boost its after tax returns to human capital in the medium term – something that Portugal has no need for at this point in time.

There is nothing within the Pact that would facilitate either Portuguese or Irish economic stabilization and recovery. Neither will the Pact improve the chances of Spain, Belgium and Italy ever reaching real growth paths that imply sustainability of fiscal and external balances. In short, the Pact our Government so eagerly subscribed to is at the very best a continuation of the status quo. At its worst, Ireland and other member states of the Euro are now participants to a fiscal suicide pact, having previously signed up to a monetary straightjacket as well.


Last two weeks marked two significant milestones on Ireland’s economic performance front. Despite the adverse newsflow on the real economy side, Irish bond yields for 5 year bonds have dipped below 6% mark last week for the first time since the beginning of the crisis. This week, spreads on the 5 year Credit Default Swaps (the cost of insuring Irish bonds) also fell below 6% mark. For the first time since the crisis began our implied cumulative probability of default (CPD) – the probability that the Irish Government will default on its debt at some point over the next 5 years has touched 40%, down from over 46% at the end of 2011. Although the CPD is a mechanical function of CDS yields and not a statistical estimate of the true risk of the Government default, the CPD is an important metric for the markets. The significant decline in our CDS spreads this week, was prompted by the Irish banks buying into longer maturity bonds in the recent NTMA-led bond swap, plus the overall improving sentiment for sovereign debt in the euro area markets. The later itself was driven by the artificial forces, such as the ECB extending €497 billion to the banks in 3 year money. Nonetheless, our bond yields and CDS spreads declines are starting to show some improvement in overall markets risk-pricing for the Irish Government debt – a much needed stabilization and a moment of respite from the relentless crisis dynamics of the recent past.

Thursday, April 26, 2012

26/4/2012: One interesting point on Fiscal Compact 1/20 rule

One interesting point on Fiscal Compact, folks. The 1/20th adjustment rule has been interpreted widely as the rule requiring states with debt/GDp ratio in excess of 60% to reduce their debt levels by 1/20th of the gap between their existent debt level and the 60% bound. However, the Treaty itself states: "the obligation for those Contracting Parties whose general government debt exceeds the 60 % reference value to reduce it at an average rate of one twentieth per year as a benchmark" (page T/SCG/en5). In other words, there is a big gap between interpretation and reality.

Hat-tip for this discovery goes to Peter Mathews, TD.

Say, Ireland's debt/GDP ratio peaks at 120% GDP (I am rounding up the actual forecasts here). Under 'interpreted' adjustment mechanism, we would be expected to reduce the overall debt by 1/20th of 120% minus 60% or by 3% of GDP in year one. Under the actual Treaty, we are expected to reduce it by 1/20th of 120% or 6% of GDP in year one. Say our GDP is 175 billion in that year. Under interpreted rule, we have to find €5.25 billion to reduce debt levels, under actual Treaty language, we are expected to come up with €10.5 billion. To put this into perspective, the average level of gross investment in the Irish economy is forecast by the IMF to be around 10%pa between 2012 and 2017 or ca €17.5 billion under above assumptions. This means that the Fiscal Compact adjustment path would take out 60 percent of the entire annual investment in the economy. That is hardly a chop-change of a difference.

Updated: Thanks to Prof Karl Whelan for pointing this:

Applying the 1/20th to the full amount is not consistent with the Treaty.

Article 4 ...makes reference to  “as provided for in Article 2 of Council Regulation (EC) No. 1467/97 of 7 July 1997 on speeding up and clarifying the implementation of the excessive deficit procedure, as amended by Council Regulation (EU) No. 1177/2011 of 8 November 2011”

And Regulation 1177/2011 states“When it exceeds the reference value, the ratio of the government debt to gross domestic product (GDP) shall be considered sufficiently diminishing and approaching the reference value at a satisfactory pace in accordance with point (b) of Article 126(2) TFEU if the differential with respect to the reference value has decreased over the previous three years at an average rate of one twentieth per year as a benchmark, based on changes over the last three years for which the data is available.”

So it’s the gap to 60%.

Sunday, October 27, 2013

27/10/2013: Financial Repression, Economic Suppression & Budget 2014

This is an unedited version of my Sunday Times article for October 20, 2013.

With fanfare of media appearances and fireworks of Dail statements, Budget 2014 was pushed off the dry dock and into the turbulent waters of reality. Full of political sparkle on the outside, overloaded with hidden taxes and charges and yet-to-be-fully-detailed painful cuts on the inside, it sailed off into the future. It will take at least 9-12 months from now to see what adjustments will have to be made in 2015 to compensate for the 'savings' on cuts delivered this week. It will take us longer to find out if the Budget 2014 will have a positive or negative effect on our ability to fund our deficits in the markets.

Yet, one thing is beyond the doubt: Budget 2014 was a significant gamble by the Government that could have done better by avoiding taking any gambles at all. Minister Noonan has decided to buy some political capital in the Budget. This capital came in the form of reduced rate of overall budgetary adjustment, compensated for by the hope-based increases in public sector efficiencies, plus some symbolic handouts to middle class families. Majority, such as the free GP visits for children under the age of 5, were poorly targeted and economically inefficient – extending scarce resources not to where they are needed most (such as, for example, long-term care provision or means-tested provision of health services) but to where political expediency leads. Many fail the core Budget objectives of making our fiscal policies more robust to adverse shocks that may occur in the near-term future.

In the end, Budget 2014 delivered virtually no real departures from the past Budgets. Predictably, there were no 'new' taxes. Instead the Budget put forward a list of new 'revenue raising measures'. The State will claw out of the banks EUR150 million in levies. Given that our banking sector is being reduced to a Three Pillars oligopoly, the levies will come straight from charging customers more for the same services. Pensions funds levy - a form of expropriation of private property - is to raise additional EUR135 million. This is a tax on present income, and in the case of pensions funds levy a tax on current wealth, plus a tax on future incomes foregone due to reduced levels of pensions funds. EUR140 million will be pumped out of the banks’ customers by taxing interest on savings. All in – financial sector will take a hit of EUR425 million on a full year basis, reducing its ability to lend, invest in the economy and to deal with mortgages distress. The measures will also weaken the quality of Irish banks' deposits base by reducing incentives to save. Carmen Reinhart and Kenneth Rogoff aptly termed such measures ‘financial repression’. De facto, we are bailing in ordinary banks customers and savers to pay for the past sins of the banks. Cyprus redux, anyone?

Cuts side of the Budget was also predictable. At the aggregate level, departmental expenditure as the share of GDP continues to run above 1990-2007 average. Instead of real cost reductions in Health we got some EUR250-300 million worth of new charges to be levied on services to insurance holders. And reduced insurance deductibility on the revenues side should do even more to reduce insurance coverage in the market. Net effect will most likely be falling transfers from private patients to public services, and higher demand for public health.

From businesses perspective, whatever the State added on one side of the budgetary equation, the state took out on the other. Thus, for all incentives for construction and building trade, overall capital spending by the Government in 2014 is projected to fall by some EUR100 million. As we stand, in 2013, capital spending by the Government barely covers amortization and depreciation of the total stock of public capital. Next year, things are going to get worse.

Much of the business stimulus schemes are geared toward supports for the property markets, including the incentives for foreign investors to put money into Irish REITs. Aside from the property-related measures, other business stimulus polices are either extensions of the already existent ones or more promise of doing something in the future. One example is the issue of Trade Finance supports. We are now five years into talking about the need to help smaller exporters with the cost of and access to trade insurance and credit.  Still, there is no tangible delivery on this.

However, the real question, left unanswered by Budget 2014 is: what's next for Ireland? The Government is rhetorically focused on our 'exit' from the Troika-led funding programme. This objective is a policy epicycle designed to ease public attention off the realities of bad domestic governance during the crisis. Exit from the bailout, financially, fiscally and economically, means a public recognition that Ireland has run out of funds we can borrow from the IMF and the EU. It also puts forward a commitment that, unlike Greece, we will not be asking for another bailout. Being not Greece does not make us Iceland, however, since Iceland repaid its bailout loans. In contrast, we will be carrying our debts to Troika for years to come.

The Government is promising that once we exit the bailout, we will regain our control over fiscal policies. This is a gross over-exaggeration. Having ratified the Fiscal Compact, Ireland is now subjected to heavy EU oversight as long as our fiscal performance falls short of the targets set in the treaty. It will be long time before we meet all of the conditions.

The scrutiny of our targets will increase, while our performance will remain under serious pressures arising from the crisis. Most recent IMF forecasts assume full EUR5.6 billion adjustments taken over 2014-2015 period, and economic growth averaging over 2.1 percent per annum (almost 6 times the average growth in 2012-2013 period). These forecasts imply that in 2014-2015 Ireland will still face the third highest cumulative deficits in the euro area ‘periphery’. And the debt levels of Irish state are set to continue rising. In 2013, the Department of Finance projects the level of Irish Government debt to be at EUR205.9 billion. By 2018 this is projected to rise to EUR211.6 billion.

And here's another kicker. The Fiscal Compact sets the target for long-term structural deficits (in other words deficits that would prevail were the economy running at its long run sustainable growth potential) at 0.5 percent of GDP. IMF projections out through 2018 put Irish structural deficits declining from 5.1 percent of potential GDP in 2013 to 2.0 percent in 2018. In other words, in 2018 Ireland is expected to be the worst performing 'peripheral' state in terms of structural deficits and operate well outside the criteria set in the Fiscal Compact.

Worse, comes December 15, we will lose a strong supporter of our efforts to restructure legacy banking debts and the only member of the Troika that promotes structurally more important economic and markets reforms.

On foot of our weak fiscal position, the politicisation of the Irish economy is already building up, driven primarily by our European partners and – until December 15 – resisted by the IMF.

The pressure is rising on Ireland's corporate taxation regime. The Government admitted as much by promising to close the loophole that allows some MNCs to nearly completely avoid paying Irish corporate taxes.

The pressure is also growing on blocking Ireland’s chances to restructure legacy banks debts. Germany, the ECB and the Eurogroup are angling to block Ireland's potential access to the European funds set up to deal with the future banking crises.

We are going into 2014 self-funding mode with all the costs of the bailout in place, including the Dvoika (Troika less one) oversight and substantial deficit and debt overhangs. It now appears that there will be no credit line to cover any increases in the cost of borrowing that might arise in the future. There will be no precautionary fund to cushion against any risk to market demand for Irish Government bonds. There will be no system in place to deal with any future banking problems or with the legacy debts should such arise. The ECB, the IMF and our forecasters are all warning us that we still face potentially significant downside risks to growth and banks stability. The IMF has been for months raising the issues of the SMEs insolvencies and poor quality of banks capital.

In other words, we are boxing ourselves into a high-risk game with little to show for this in terms of a positive return from our 'exit' from the bailout.

History suggests that prudence, not pride should be our guide. Back in 2010 we pre-borrowed aggressively in the markets prior to the state finances collapsing under the poorly structured banks bailouts. Now, we are gunning for the 'exit' without having secured any support from our 'partners' once again. The hope is that this time it will be different: the markets will lend us at decreasing costs, while growth lifts the entire domestic economy out of stagnation. This might not be an equivalent of playing Russian roulette, but it is certainly a game of chance with high stakes on the losses side and little tabled on the potential winnings side.

The latest OECD research on basic skills across the advanced economies puts to a serious test our claims to having a highly educated workforce. Ireland ranked eighth in terms of the proportion of younger adults with tertiary education. In terms of problem solving proficiency, both our college graduates and adults with only secondary education rank below their respective OECD averages. In problem solving in a technology-rich environment – a proxy for skills related to internationally-traded services, the sole driver of our economy today – Ireland ranks 18th in the OECD. Our younger workers score below their OECD peers in basic literacy and in numeracy. When it comes to introduction of new processes and technologies in the workplace Ireland is ranked between such premier divisions of the global innovation league as Cyprus and Belgium. Given our poor performance in digital economy-specific skills, exposed in October 2012 report by the OECD and covered in these pages before, it is high time for us to get serious about reforming our education and training systems.