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.
Box-out:
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.
and few banks:
