3/4/2014: Draghi's Put and Ireland's Woes

This is an unedited version of my Sunday Times article from March 16, 2014


To those who lived through the tropical storms annually ravaging the Southern Atlantic coast of the US, calm is not always the tranquility beyond the storm. Often, it is the tranquility in the eye of a hurricane.

The current state of economic affairs in Ireland, the sunshine washing across the markets, the warm-ish glow of a recovery, the steady diminishment of the crisis rhetoric - all are the sign of a fragile state of affairs brought about by the extraordinary monetary policies of the ECB since the beginning of 2012. As such, the change in economic weather we have experienced to-date can be a temporary respite rather than a permanent rebound.

In October 2012, three months after declaring that the ECB will do whatever it takes to save the euro, Mario Draghi noted another worrying regularity - the problem of differential pricing of debt across the euro area. At first, he was referencing government debt markets. Later, he started to show concern for the same trends emerging in all credit markets, including those for corporate debt.

Ever since then, the ECB has signalled that the Central Bank's core policy in dealing with the crisis will remain accommodative. Historically low policy rates, the promises of the Outright Monetary Transactions and the structuring of the Banking Union – together constituting what is known as the Draghi Put – were the Frankfurt's attempts to break down the fragmentation across various euro area economies. These measures were successful in reducing the differences in sovereign bonds yields between the euro area member states. First Ireland, Italy and Spain, then Portugal and Greece, all peripheral countries have seen their bond spreads over the German benchmark 10 year bunds come down dramatically in the course of the last 20 months.

Since mid-2012, therefore, the Draghi 'Put' underwrote historically low policy rates. It is this 'Put' that has been credited by the researchers at the ECB and the IMF, as well as by a number of academics, as the main driver behind the decline in euro area peripheral countries cost of borrowing, saving Irish taxpayers billions in interest on Government debt, helping hundreds of thousands of Irish borrowers to lower tracker mortgages costs and supporting our exit from the Troika programme.

But, in effect, the Draghi Put has also thrown a veil of ignorance over the core problems still working through the euro area economies: problems of excessive legacy debts, lack of structural drivers for the recovery and the transfer of public and banking debts onto the households' balance sheets through fiscal austerity. ‘Whatever it takes' monetary policies might have been effective in alleviating the immediate pressures on European governments, but they did not cure the underlying disease.


In effect, the Draghi Put is not a solution to the crisis, but a potential problem of its own. It is a cure that is risking making the disease stronger.

Draghi Put has forced ECB rates (and with them the rates charged in the inter-banks markets) down to their historical lows.

Current repo rate, the main rate set by the ECB, is at 0.25 percent - the lowest since the ECB records began in January 1999. Over the period prior to the crisis, the already low (by individual nations' standards) ECB rates averaged 3.1 percent. And the duration of the ECB rates deviation from their historical norm is unprecedented: 62 months and counting. Prior to the current crisis, the longest period over which ECB rates deviated by more than 0.5 percent from their norm was 38 months. That happened in the period that created a massive financial bubble across the euro area – January 2003 through June 2006.

In general, the longer the rates rest below their long-term trend, and the further they deviate from the trend, the faster they tend to rise back toward trend levels. Exception to this norm is Japan, but hardly anyone would argue that Japanese scenario is even remotely desirable.

In simple terms, the current environment of historically low interest rates is not going to last forever. Indeed, it is unlikely to last for as long as the rates have been depressed to-date.

Alongside the above facts, there two more notable observations worth making. Darghi Put has led to a significant decline in the inter-bank lending rates. For example, Euribor 12 months contract rate has declined from the crisis-period average of 2.1 percent for the period prior to the Draghi Put to the average of 0.6 percent since July 2012. Similarly, there was a massive decline in the margin charged in the interbank markets relative to the ECB repo rate. At the same time, retail interest rates charged on new loans for Irish households and non-financial corporations have shut straight up to historical highs, when compared against the ECB policy rates. Ditto for the rates charged on existent loans.


All of this leaves our economy vulnerable to any normalisation in the interest rates policy.

Should Signore Draghi start reversing the policy rate, while Irish banks remain dependent on high lending margins to rebuild their balance sheets, Irish SMEs will face significant increase on the cost of financing their legacy loans, including the very same troubled loans that relate to property investments. Beyond triggering potential arrears and cost saving measures by the SMEs (involving layoffs), this will put strain on any growth in the SMEs sector. Capital investment costs will go up. Credit risk ratings will go down. Investment in the economy will be under severe pressure relative to the already exceptionally low rates.

Households currently working their way through arrears resolution process are likely to face high risk of relapsing into arrears. To-date, some three quarters of all restructuring deals done by the banks involve either temporary arrangements or ‘permanent’ deals that involve increases in debt carried by the households. They will face increases in the cost of restructured mortgages, impacting not only those on variable rate (the segment of the mortgage holders already heavily hit by the banks), but also trackers. Depending on how fast and at what time in the recovery process rates increases occur, the effect can be devastating. Households that are not in trouble with their lenders today will face a major hit on their incomes, depressing once again their consumption and investment and triggering a renewed bout of precautionary savings.

Counting existent loans alone, reversion to historical averages in ECB rates can take some EUR5.7 billion annually out of the real economy in higher interest costs. This would be roughly equivalent to a loss of double the annual contribution to our GDP by the Agriculture, Forestry and Fishing sector.

The above factors can also pose a threat to the Exchequer in form of lower VAT, income tax, stamps and excise receipts, exacerbated by the potential increase in the cost of borrowing that goes hand-in-hand with higher policy rates.


The good news is that given Mr Draghi's current pronouncements, we are still months, or even years, away from higher interest rates. Better news, yet, Mr Draghi has communicated that he will provide 'forward guidance' on rates policy. This commits the ECB to supplying in advance clear signals as to its intentions. Even better news is that last week Mario Draghi clearly identified output gap (the shortfall in current economic growth relative to long-term potential rates of growth) as one of the parameters watched by the ECB. This strongly suggests that Frankfurt is likely to take into consideration structurally weak economic conditions prevailing across the euro area in setting its policy rates. Such a consideration further extends the period over which low rates are likely to remain in place.

The bad news is that the only way the rates can remain low is if the euro area core remains mired in a near-deflationary Japanese economic growth scenario.

In other words, we have a choice: either the economy remains in the doldrums, unemployment stays high and incomes growth remains subdued; or the rates will go up.

Mr. Draghi Put is not based on the smaller peripheral economies conditions, but on France, Italy, Spain, Belgium, Finland and Austria as drivers of credit demand and low interest rates, and Germany as a break on low interest rates. Meanwhile, German lending constraints for non-financial companies have been at record lows for months now. There is a glut of credit in the euro area's largest economy. Thus, Germany will be ripe for rates hikes, as soon as inflation pressure picks up even moderately. The countries with shortages of credit supply are seeing their economies gradually pulling out of a recession. One can relatively safely assume that, barring new shocks, by the end of 2015 the ECB will start contemplating the end of Mr Draghi's Put.

Put conservatively, anyone with business loans or mortgages of duration greater than 5 years should be concerned. By last Central Bank of Ireland count, these loans amounted to 65 percent of all loans outstanding in the economy.


There is little we, in Ireland, can do about the direction of the ECB interest rates or the timing and the speed at which the rates increases will happen. About the only two things in our power are to ensure that current process of restructuring of SMEs loans and household mortgages is robust enough to withstand the shock of higher interest rates in the future, and that our households incomes retain the necessary cushion to absorb such increases. The former requires much more through and independently verified restructuring of our legacy debts. The latter requires lower tax burden, deep reforms and faster economic growth anchored in our real economy, not in the tax optimising MNCs-led sectors.

Absent these measures, Irish economy is a weak athlete swimming into a storm surge. The eye of the hurricane might make us feel better about our perceived strengths, but the clouds on the ECB’s horizon, no matter how distant, warn of a possible storm to come.

Box-out:

ESRI’s latest research paper on the impact of the banking sector competition on credit availability to the SMEs across the EU sheds some light on the urgency for Ireland to abandon the banking sector policy based on the Twin Pillars model.  “Does Bank Market Power Affect SME Financing Constraints?” published in an influential Journal of Banking & Finance argues that banking sector retrenchment across the Eurozone towards domestic markets and reduced competition between the banks “will lead to an increase in financing constraints for SMEs”. Such constraints “will inevitably lead to lower investment and potential output. “ According to authors, “the structure of the banking system has changed dramatically following crisis... This has substantially lessened competition for business credit in Ireland with only three main retail business banks remaining. This reduction in competition poses serious questions regarding the ability of the financial system to transmit credit to SME borrowers in a recovery scenario.” In short, given Irish SMEs’ heavy reliance on bank financing, we need more than a new pillar bank. We need a fully competitive financial system operating across the economy. This will be hard to deliver on. Irish Pillar banks continue to rely on state protection for even trivial market considerations, such as deposits rates setting by their competitors, e.g. An Post. And our regulators and policymakers are still clinging to the erroneous belief that competition in the banking sector in 2001-2007 has fuelled the boom and caused the crisis.

3/4/2014: Few links for this week...

Couple of recent media comments on a range of topics:

On Irish gas and oil exploration and production: http://monitorglobaloutlook.com/news-story/ireland-renews-push-for-offshore-oil-and-gas/

An interview (in Portuguese) on ECB's dilemmas: http://expresso.sapo.pt/o-mercado-espera-que-o-bce-acelere-a-politica-de-estimulos=f863259

On IMHO's latest initiative announced this week: http://www.irishexaminer.com/business/one-stop-shop-for-mortgage-customers-263976.html and http://news.ie.msn.com/business/they%E2%80%99re-back-bank-executives-to-face-tds-on-mortgage-restructuring

3/4/2014: Learning from the Irish Experience – A Clinical Case Study in Banking Failure

Our new paper on the future of banking based on Irish experience and lessons from the crisis:

Lucey, Brian M. and Larkin, Charles James and Gurdgiev, Constantin,

Learning from the Irish Experience – A Clinical Case Study in Banking Failure (September 23, 2013).

Available at SSRN: http://ssrn.com/abstract=2329815

Abstract:  
 
We present a review of the Irish banking collapse, detailing its origins in a confluence of events. We suggest that the very concentrated nature of the Irish banking sector which will emerge from the policy decisions taken as a consequence of the collapse runs a risk of a second crisis. We survey the literature on size and efficiency and suggest some alternative policy approaches.

3/4/2014: Reforming Economics? Try Politics First...

This is an unedited version of my article for Village Magazine, February 2014


The Global Financial Crisis and the Great Recession are actively reshaping the public discourse about the ways in which we analyse social phenomena, and how our analysis is shaping public policies choices.

In many ways, these changes in our attitudes to social inquiry have been positive. For example, more critical re-appraisal of the rational expectations-based models in macroeconomics and finance have enriched the traditional policy analysts' toolkits and advanced our understanding of choices made by various economic agents and governments. Shift in econometric tools away from those based on restrictive assumptions concerning underlying probability distributions and toward new methods based on more direct integration of the actual data properties is also underway. The result is improved analytical abilities and more streamlined translation of data insights into policy famework. The launching of the public debates about how we teach economics in schools and universities and how economic parameters reflect social and cultural values (as evidenced by the ongoing debate at the OECD and other institutions about introducing measures of quality of life and social well-being into economic policy toolkits) are yet more examples of the longer-term positive change. Absent such discussions, the entire discipline of social sciences risks sliding into complacency and statism.

However, in many areas, changes in our approaches to social studies have been superficial at best, and occasionally regressive. And these changes are not limited to economics alone, spanning instead the entire range of social sciences and related disciplines.

For the sake of brevity, let me focus on some comparatives between economic analysis and one other field of social policies formation: environmental policy. The same arguments, however, hold in the case of other social policy disciplines.

Prior to the crisis, environmental sciences largely existed in the world of mathematical modeling, with core forecasts of emissions paths and their effects on the environment relying on virtually zero behavioural inputs. These technocratic models influenced both public opinion and policies. The proverbial representative agent responsible for production of emissions, was not a human being requiring age, gender, family, income and otherwise differentiated supplies of energy, goods and services. In a way, therefore, environmental policy was further removed from the realities of human and social behaviour than, say, finance, monetary or macro economics. Where economists are acutely aware of the above differences as drivers for demand, supply and valuations of various goods and services, environmental policy analysts are focused on purely aggregate targets at the expense of realism and social and economic awareness.

The same remains true today. Over recent years, the thrust of environmental policies has drifted away from local considerations of the impact of pollution on quality of life and economic environment considerations. As the result, environmental policies and programmes, such as for example wind energy development or localised incineration of waste, are becoming more orthogonal, if not outright antagonistic to the  interests of consumers. Rhetoric surrounding these environmental policies considerations is also becoming more detached from the demos. For example, Ireland's attempt to make a play at European wind energy generation markets, replete with massive wind farms and miles of pillions, is now pitting our imagined (or mathematically-derived) exports potential, fuelled by nothing more than massive subsidies and consumer rip-off pricing for electricity, against all those interested in preserving the countryside's natural amenities, cultural heritage and other economically and socially meaningful resources.

Whereby behaviourally-rich analysis is now moving into the mainstream in finance and is starting to show up within the macroeconomic models, it is still wanting in the environmental policies research. The result is distortion of public responses and reshaping of political landscape around the environmental movements.


In most basic terms, there are three core problems with the current state of social sciences and policies formation mechanisms. None of these problems are new to the post-crisis world or unique to economics. In fact, in many case economics as a discipline of inquiry is years ahead of other social sciences in dealing with these shortfalls.  In summary the core problems are: insufficient modeling tools, poor data, and politically captive analytics and decision-making.


The first problem is the lack of rigorous modelling tools capable of handling behavioural anomalies. Put differently, we know that people often make non-rational choices and we occasionally know how to represent these choices using mathematical models. But we are far from being able to incorporate these individual choice models into macro-level models of aggregate behaviour. For example, we know that individually people often frame their choices in the broader context of their own and collective past experiences, even when such framing can lead to undesirable or suboptimal outcomes. Yet we have few means of reflecting this reality in economic models, although we are getting better in capturing it empirically. We can model habitual and referenced behavior of individual agents and we can even extend these models to macroeconomic setting, but we have trouble incorporating this behavior into explicit policy analysis. We also face mathematical constraints on our ability to deal with the more advanced and more accurate models extensions.

The problem of insufficient tools is often compounded by the problem of over-reliance on technocratic analysis that marks our policy formation. Put simply, we live in the world dominated by policy-making targeting aggregate performance metrics (such as global emissions levels or nation-wide GDP growth rates). This implies that we often aim to create policies that are expected to deliver specific and homogeneous outcomes across a number of vastly heterogeneous geographies – physical, cultural, political, social and economic systems, nations and societies. The only feasible approach to such policymaking is via technocratic reliance on ‘hard’ targets, often with little immediate connection to everyday life, and prescriptive policy designs. The core pitfall of this approach is that when a harmonised policy fails, it fails across all heterogeneous locations and environments. There is nothing more erroneous from risk management perspective than attempting to introduce a harmonised response to such systemic failures. Yet this is exactly what the policymakers strived to achieve in the setting of the euro area crises. The more reliance we place on technical models-driven solutions being right all of the time in all of the locations, the more harmonised and coordinated our responses to shocks are, the higher is the probability that a policy failure will be systemic, rather than localised.

The only alternative to this fallacy of reliance on technical analysis and hard targets-based modeling is to permit local innovation and differentiation. This historically-validated approach of the past, however, is not en vogue in the world where global institutions and aspirations dominate local objectives and systems, and where pseudo-scientific fetishism for technical knowledge dominates social sciences and policy making.


Beyond technocratic fallacy of over-reliance on mathematical models and the shortage of some key tools looms an even larger problem.

Consider the most recent example of a systemic failure by the economics profession to predict the current financial crisis. Instead of tools shortfalls, this failure rests with the problem of analysis and policy capture by political and economic interest groups that firstly determine the agenda for policy analysis and research, then define parameters and scope of such research and, finally, set bounds for measuring, monitoring and actioning data on policy outcomes.

With the onset of the financial crisis, economists working outside regulatory offices, ministries and central banks have gotten a much greater access to data than ever before. Still, even with data in public domain, analytical resources come at a cost premium, as anyone attempting to compete with, say the Department of Finance, finds out very quickly. By the time it takes an independent analyst to compile and analyse data, the Department of Finance can deploy dozens of staff to flood the media and public domain with own reports and papers. The asymmetry of resources drives the asymmetry of power in analysis and this fuels the asymmetry in policymakers’ perception of data insights. For example, lone voices of dissent or single pieces of contrarian analysis are pushed aside by the sheer magnitude of consensus, often representing little more than one agency replicating the insights of the other agency.

We might be able to produce better insights into the workings and risks of the banking sector today than before the crisis, but this does not mean that the actions of regulators and Governments are going to be any better informed or better tailored.

Even when independent analysis and scrutiny are available, regulatory and policy responses largely ignore empirical insights. In a recent study, myself and a co-author looked at asset prices across the number of advanced economies prior to and after the crisis. Using a very simple econometric model, we showed that data prior to 2006 was providing clear and loud signals as to the emergence of a number of crisis-level risks. However, to derive this result we had to calibrate the model using a parameter that was set at ten times the levels assumed to be likely by the banking regulators. Thus, by regulations, by own governance and remuneration standards, our public servants simply were not required to do this analysis. As the result, regulators around the world sleepwalked the entire financial system into the latest crisis and found themselves utterly unprepared for the fallout.

This is not unique to our study conclusions. Back in 2005-2006, inside the Irish civil service there were several senior voices raising concerns over the direction of our economy. These were echoed by a number of research papers and analysts warnings coming from the ranks of independent and academic economists. They were ignored not because they lacked empirical basis, but because the policymakers were captive to consensus view aligned with their own political objectives.

Nobel prize winners, Robert Shiller (2013), and Edmund Phelps (2006) economists such as Nouriel Roubini, Roman Frydman and Michael D. Goldberg repeatedly warned about systemic problems in the US property and financial markets back in 2004-2007. The NYU Stern School of Business research centre did the same for the banking sector. Last, but not least, in academic economics, research into non-rational, non-representative agent models has been on-going since the start of the 1990s, largely unbeknown to the general public and politicians. In fact, since the mid-1990s, majority of the Nobel Memorial Prize awards in economics went to researchers who pushed aside the bounds of rational expectations and/or representative agent frameworks.

Still, the problem of policy capture by the often poorly informed adherents to specific schools of thought is  hardly unique to economics. Let's take two examples of policies that have seized public imagination and policymakers' attention, while sporting only tenuous empirical foundations.

One is wind and wave energy. Although it appears that there is a near-consensus in academic and policy circles that these two sources of energy offer preferred alternatives to traditional fuels, in reality, such consensus can and should be questioned. The latent energy stored in water and wind is huge. However, wind energy harvesting is also subject to own externalities. One key one is the transfer of cost of pollution abatement from the commons relating to energy production and use, to the commons relating to land and natural amenities use. This externality was already mentioned above and its discovery credit goes to economics, not to environmental sciences. Another one is the transfer of the cost of energy-related pollution to consumers. In the real world, different consumers access energy through different channels. Some channels offer energy users a subsidy over the other. Some channels come with a choice that a consumer can make to substitute between different service providers based on environmental and economic costs considerations, other channels do not. Again, credit for pointing this out goes to economists; environmentalists are all too often simply opt to ignore these realities in pursuit of aggregate emissions targets over and above the consideration of their feasibility or their effectiveness in the face of social, cultural, political and economic realities.

For example, state-owned public transport is commonly priced differently from the privately-owned public transport and both are priced distinctly from private transport. Unless use of energy is explicitly and uniformly priced across all modes of transport and unless all modes of transport are perfectly substitutable, some consumers of public transport will receive subsidies at the expense of others and majority will be subsidized relative to private transport users. Thus, a suburban family is likely to pay a higher price for pollution per mile travelled than an urban one. The fact that in many cases a suburban family might have been forced (by planning, zoning, pricing and other systems operating in a heavily distorted markets) to make a choice of living outside the areas with dense cover by transport alternatives does not enter into the determination of pollution-linked taxes and prices. Any decent economist can be expected to understand this much. Yet the simplified worldview that public transport subsidies and private transport taxes are always good persists among our policymakers and within environmental lobby.

Another example of the policy that is empirically shoddy, yet politically heavily supported is electrification of transport. Recent research shows that in the US, even if electrical vehicles made up over 40 percent of passenger vehicles in the, there would be little or no reduction in the emission of key air pollutants. Now, consider the case of Ireland, where ESB has been running multi-billion euro investment programme aimed at developing EVs networks since the early days of the financial crisis. Just as the value of private sector investment shot through the roof, Irish semi-state sector, encouraged by policymakers and subsidized by high prices on consumers, launched into a major investment programme based on questionable benefits to the economy and society at large. The Government of the day even announced back in April 2010 (with the country rapidly hurtling toward an IMF-led bailout) a EUR5,000 grant to EVs buyers. That Ireland’s electricity supply comes from environmentally damaging sources does not phase the environmental policy advocates.


The debates about the current state of economics and social sciences in general are a welcome departure from the pre-crisis status quo, where such discussions primarily took place in the marbled halls of academia and beyond the scrutiny of public attention. However, it is worth remembering that the core problems faced by social policies analysts today are the ages-old ones problems of insufficient modeling tools, poor data, and politically captive analytics and decision-making. We might be able – with time and effort – to fix the first one. Fixing the other two will require a paradigm shift in the ways we collect and publish data, and in the ways our political and public service elites approach policy formation. Two thirds of economics and social sciences problems are political, not scientific.

3/4/3014: Tax or Not: Sunday Times, March 9, 2014

This is unedited version of my Sunday Times article from March 9, 2014


Speaking at last week's Fine Gael Ard Fheis, Minister for Finance, Michael Noonan, T.D. noted that "As a Government, we know that there are further opportunities in the years ahead for us to build upon the initiatives that have worked.  It is in this vein that …I will consider the introduction of targeted tax reductions that have a demonstrable effect on employment growth."

With these words, Minister Noonan finally set to rest the debates as to the Government intentions with respect to core policies for 2015 and thereafter. Whether you like his prior policies or not, he makes a good point: Ireland needs a tax-focused policy intervention. And we need an intervention that simultaneously addresses the declines in after-tax household incomes endured during the current crisis, and does not trigger rapid wage inflation and jobs destruction that can be associated with centralised wage bargaining. The window for an effective intervention is now, in part because as recent evidence shows, fiscal policy effectiveness is greater at the time of near-zero interest rates. But beyond an intervention, Ireland needs a longer-term reform of taxation system.


In general, any economic policy can be judged on the basis of two core questions. Firstly, does the policy offer the most effective means for achieving the stated objective? Secondly, is the policy feasible in economic and political terms?

Reducing income tax burden for lower and middle class earners yields an affirmative answer to all three of the above questions. No other alternative proposed to-date – a cut in VAT rate, a reduction in property tax burden, or an increase in public spending on core services to alleviate cost pressures on families – fits the bill.


Starting from the top, cutting income-related taxes in the current environment makes perfect sense from the point of view of economics.

The three stumbling blocks on our path to the recovery are anaemic domestic consumption, high burden of household debts, and collapsed domestic investment. All of them are interlinked, and all relate to low after-tax disposable incomes. But the last two further reinforce each other. High levels of household debt currently impede restart of domestic investment by both households and firms. They also act as partial constraints on our banks ability to lend. Meanwhile, low domestic investment implies depressed household incomes and high unemployment. In other words, reducing private debt and simultaneously increasing domestic investment should be a core priority for the Government.

On the other side of the national accounts equation, stimulating private consumption offers a weak alternative to the above measures. Due to high imports content of our average consumption basket most of the discretionary spending by Irish households goes to stimulate foreign exporters into Ireland. And it is this discretionary imports-linked spending, as opposed to consumption of non-discretionary goods and services, that has taken a major hit during the Great Recession. Beyond this, higher domestic consumption will do little to raise our SMEs exporting potential, in contrast with increased investment.

Take a quick look at the top-line figures from the national accounts. Based on data from Q1 1997 through Q3 2013, cumulative decline in personal consumption of goods and services over the current crisis amounts to roughly EUR5 billion, when compared against the already sky-high 2004-2008 trend. For gross fixed capital formation - a proxy for investment and capital spending - the cumulative shortfall is EUR50 billion against the 2000-2004 trend, which excludes peak of the asset bubble period of 2005-2007. Put differently, compared to peak, private consumption was down 12 percent in 2013 (based on Q1-Q3 data), while gross investment was down 65 percent. If in 2013 our personal consumption is likely to have returned to the levels last seen around 2005-2006, our investment will be running closer to the levels last witnessed in 1997-1998.

More significantly, lending to Irish non-financial, non-property SMEs has fallen 6.2 percent year-on-year at the end of 2013, as compared to 5 percent for the same period of 2012, according to the latest data from the Central Bank. Meanwhile, value of retail sales was down only 0.1 percent in 2013, according to CSO. Things are getting worse, not better, in terms of productive investment.

It is, therefore, patently clear that an optimal policy to support domestic growth in the economy should target increases in the disposable income of households and incentivise investment and savings ahead of stimulating consumption. It is also clear that such increases should be distributed across as broad of the segment of working population as possible.

To achieve this, the Government can reduce the burden of personal income taxation.

Alternatively it can attempt to target a reduction in the cost of provision of non-discretionary services, such as childcare, health, basic transport and education. In fact, the main arguments against lower taxes advanced by the Irish Trade Unions and other Social Partners are based on the idea that such costs reduction is possible were the state to invest taxpayers funds in further development of these services as well as provide subsidies to supply them to the broad public.

Alas, in practice, Irish public sector is woefully poor at delivering value-for-money. Since 2007 through 2013, inflation in our health services outpaced the general price increases across the economy by a factor of 5 to 1, in transport sector by 3 to 1 and in our education by 12 to 1. Pumping more money into provision of public services might be a good idea when it comes to achieving some social objectives. It is certainly a great idea if we want to stimulate public sector employment and pay, as well as returns to various consultancies and state advisers. But it is not a good policy for helping households to pay down their debts, increase their savings, investment and/or consumption.


Which brings us to the questions of economic and political feasibility of tax reforms.

This week, the Finance Minister confirmed that he will "try to begin the process of making the income tax code more jobs friendly" starting with Budget 2015. Most likely, the next Budget will consider moving the threshold for application of the upper marginal tax rate, currently set at EUR32,800. Minister Noonan described this threshold as being "totally out of line with the practice effectively all over the world, but particularly in Europe." And he's got the point. Across a sample of twenty-one advanced economies, including Ireland, the average effective upper marginal tax rate, inclusive of core social security taxes, currently stands at around 44.4 percent. In Ireland, according to KPMG, the comparable upper marginal tax rate is 48 percent. But an average income threshold at which the upper marginal tax rate kicks in is EUR136,691 in the advanced economies, or more than four times higher than in Ireland.

Widening the band at which the upper marginal tax rate applies to double the current Irish average earnings will mean raising the threshold to EUR71,500 per person per annum. This should be our policy target over the long-term, through 2019-2020.

However, given current income tax revenues dynamics delivering this target today will trigger significant fall-offs in income tax revenues. Data through February 2014, admittedly a very early indicator, shows effectively flat income tax receipts, despite large increases in employment in recent months. In other words, brining our upper rate threshold closer to being in line with the advanced economies average is, for now, a non-starter from fiscal sustainability point of view.

But gradually, over 2015-2016, increasing the 20% tax rate band to around EUR38,000-40,000 should be fiscally feasible, assuming the economy continues to improve as currently projected. This will leave those at or below the average earnings outside the upper marginal tax rate. But it will also provide relief to all those earning above average wages. In other words, widening the lower rate band will generate a broadly-based measure, with likely support amongst the voters.

At the same time, it will also yield significant gains in economic stimulus terms. At the lower end of the targeted band, such a measure would be financially equivalent to a tax rebate of around double the average residential property tax bill.

More importantly, widening the lower tax band will provide for an effective stimulus to the economy compared to all of the above measures. The reason for this is that unlike property tax and VAT, income taxes create economic disincentives to supplying more work effort in the market place. This effect is most pronounced for second earners, self-employed, sole traders and small business owners – all of whom represent core pool of potential entrepreneurs and future employers.

In addition, reducing income taxes, as opposed to consumption and property taxes provides both financial and behavioural support for investment, and savings for ordinary families. A number of studies of consumer behaviour show that savings achieved from the reductions in consumption taxes are commonly rolled up into higher consumption. On the other hand, higher after-tax labour incomes are associated with greater savings, investment and/or faster debt pay-downs.


Beyond widening the standard rate band, the Government can do little at the moment to stimulate disposable income of the households. Yet, in the longer term, we face the need for a more comprehensive and deeper reform of our tax system. Critical objective of such reform is to achieve a new system for funding the state that relies less on income tax and more on direct user-fees charges for goods and services supplied to consumers, plus taxes on less productive forms of capital, such as land, property and speculative assets. Changes in the underlying drivers for growth in the Irish economy will also necessitate tightening of corporate and income tax loopholes. This should lead to increased reliance by the state on corporate tax revenues, while freeing some room for the reduction in tax rates. In targeting these, the Government should focus on the upper marginal tax rate itself.

Designed with care and delivered with caution, such reforms can put Irish economy on the path of higher growth well anchored in the underlying fundamentals of our society: indigenous entrepreneurship, domestic investment and skills-rich workforce.

Box-out:

This week, the EU Commission published its 2014 Innovation Union Scorecard showing comparative assessment of the research and innovation performance across the EU. The good news is that Irish rankings in the area of innovation have improved from 10th to 9th over the last twelve months - not a mean task given our tight economic conditions and scarcity of funds across the economy. The bad news is that we are still ranked as 'innovation follower' and that our performance is still weak when it comes to developing a thriving innovation culture in the SME sector. As experience from the UK shows, just a couple of simple changes to Ireland's tax codes can help us enhance the incentives for SMEs to develop a more active innovation and research culture. We need to reform our employee share ownership structures to make it easier for smaller companies and entrepreneurs to attract key research personnel and promote innovation within enterprise. For example, in Ireland, employees securing an equity stake in the business employing them currently face an immediate tax liability, irrespective of the fact that they receive zero financial gain from the shares until these as sold. This applies also to smaller start-up ventures, particularly the Universities-based research labs. Thus, a researcher working in Ireland's high potential start-up or a research lab can face a tax liability on owning the right to a yet-to-be-completed research they are carrying out. This is not the case across the Irish Sea and in the Northern Ireland. In 2012-2013, the UK Government adopted 28 new policies aimed at promoting various forms of Employee Financial Involvement (EFI) in the companies that employ them. The UK has allocated £50 million through 2016 to promote public awareness of the EFI schemes and is actively working on reducing the administrative burden for companies and employees relating to EFI. It is a high time we in Ireland have followed our neighbours lead, lest we are content with remaining an 'innovation follower' in the EU for years to come.

3/4/3014: Latest Country Risk Updates: April 2014

Latest updates to ECR Euromoney Country Risk scores (higher score implies lower risk):

Two notable sets of changes:

1. Russia and Ukraine scores continue to fall, with Ukraine still leading Russia
2. Euro area 'periphery' scores continue to rise, with Portugal and Ireland showing biggest improvements.

2/4/2014: Global Manufacturing PMI in Two Charts: March 2014

Having posted on Irish Manufacturing PMI (http://trueeconomics.blogspot.ie/2014/04/242014-irish-manufacturing-pmi-march.html) here are two interesting charts plotting PMIs for a number of countries. Both via BusinessInsider:

and

2/4/2014: Irish Manufacturing PMI: March 2014

We now have Manufacturing PMI for Ireland for Q1 2014, so here are couple updated charts:

Few notable things in the above:

1. PMI now solidly above the 'statistical significance' range for the first time since October 2013. Also, March 2014 marks eighth consecutive month of PMI ahead of its post-crisis average (from January 2011).
2. The post-crisis average is still lower than pre-crisis average.
3. PMI continues to trend up with new short-term trend running from around June 2013.
4. 12mo average is at solid 52.1 and 3mo average through March (Q1 2014) is at 53.7 which is basically identical to 3mo average through December 2013 (Q4 2013) which is 53.6. 
5. Q1 2014 average is above same period reading for 2011 (49.8) and 2012 (50.1), but it is below same period 2010 average (56.1).

Key takeaway: solid PMI reading for Irish manufacturing - a good thing. As I noted before, Manufacturing PMI has stronger link to our GDP and actual industry output than Services PMI, so this is a net positive for the economy.

1/4/2014: An ECB challenge...

A quick chart plotting euro area's challenge on deflationary side. Taking annual average HICP indices rebased back to 100=1996 for a number of countries and positing the data against the same for the US:

You can clearly see downward divergence in the euro area starting from 2010 on...

29/3/2014: WLASze: Soul v Science in a Corporeal Juxtaposition

This is WLASze: Weekend Links on Arts, Sciences and zero economics.


Nothing can be as inspirational as real artistry and craftsmanship. And few examples of both stand head tall over the endless horizon of time than the works of Antonio Stradivari.

This week, Sotheby's announced that it is selling "what is regarded as the finest viola in existence – the "Macdonald" made by Antonio Stradivari in 1719." The 295-years old instrument is expected to go for more than £27m, "a figure that would easily surpass currently standing auction record for an instrument – the Lady Blunt Stradivari, which sold for £9.8m. It would (if achieved) also be higher than any known private sale." Per Sotheby's VC: "The instruments of the Stradivari are in a class of their own among the pinnacles of human craftsmanship and the Macdonald viola stands at the unquestioned summit."

Source: http://www.theguardian.com/uk-news/2014/mar/26/stradivarius-sothebys-macdonald?CMP=twt_fd Announcement: http://www.sothebys.com/content/sothebys/en/news-video/videos/2014/03/the-macdonald-viola-by-stradivari.html and you can read about the sale of Lady Blunt instrument here: http://www.newser.com/story/121578/stradivarius-violin-sells-for-16m.html

There is little doubt Antonio Stradivari (1644-1737) was the greatest maker of violins and violas of all times, having authored at least 1,116 instruments, although only around half still survive today.

There is a host of arguments attempting to capture the Stradivari's unique character. Here is an example:

"A Stradivarius in a good condition emits high-frequency sounds in a range where human hearing is the most sensitive. These frequencies become more audible in larger rooms. That makes the Stradivarius ideal for concerts in spacious concert halls and for performances together with big philharmonic orchestras.

The sound of these sublime instruments is so very characteristic that an observant listener can distinguish their superior tone when hearing the same artist playing on different instruments.

The sound of the old master instruments is not only superior in the vivacity of the tone; it is also insistent and captivatingly beautiful. The lustre and beauty of the instrument’s tone is as close you can come to the immaculate voice of a great opera diva." (Source: http://stradivariinvest.com/instruments/luthiers/)


But the magic, the allure, the raw emotional connection to Stradivari instruments - wether by public, critics or performers - also raises questions. The most pressing and the longest running one is: What makes Stradivari unique? And the less pressing, but probably more important one is: Is Stradivari unique?

Here is a note about one attempt to answer the first questions - a paper using the x-ray imagery to study the instruments: http://www.telegraph.co.uk/news/worldnews/europe/netherlands/2230123/Secret-of-Stradivarius-violins-superiority-uncovered.html

In contrast to physical qualities, some researchers have argued that chemical qualities to the wood used by Stradivari grant his instruments the power of uniqueness. Here is the paper looking into that aspect: http://www.scientificamerican.com/article/secrets-of-the-stradivari/ and http://www.sciencedaily.com/releases/2009/01/090122141228.htm

But there are doubts about both the existence and the source of Stradivari's violins performance compared to other outstanding works by contemporary and later craftsmen.

Here is an example of the scientific work performed by Colin Gough over the years that attempts to identify unique properties of Stradivari sound and fails to find them:
http://www.fritz-reuter.com/articles/physicsorg/Science%20and%20the%20Stradivarius%20(April%202000)%20-%20Physics%20World%20-%20PhysicsWeb.htm

And a more recent, brilliantly structured (albeit small sample and restricted spatial dimension) double-blind test study attempting to assess the ability of top violinists to discern the instrument they play: http://blogs.discovermagazine.com/notrocketscience/2012/01/02/violinists-cant-tell-the-difference-between-stradivarius-violins-and-new-ones/#.UzRD3a1_uzg

But may be the science of all of this is simply missing one core point: an artist is more than just a collection of physical properties - be they of her/his instrument or her/his own making. May be art is an intimate expression or at least a reflection of the soul (let me be old-fashioned here and surmise that soul exists without having to resort to attempting to explain what it might be). If so, then who cares if technically Stradivari's greatest achievement might have been in his instruments ability to trigger a (scientifically) placebo effect. The core result is the effect itself, as far as we are concerned with art. And that effect is undeniable. Virtuoso violinist Anne-Sophie Mutter likened playing her Strad for the first time to meeting her soul mate: "It sounded the way I (had) always been hoping," she said. "It's the oldest part of my body and my soul. The moment I am on stage, we are one, musically."

You might smile and say 'But studies show…' or you might marvel at her music and remember that is some intangible, non-scientific, quasi-religious way, it is a product of the Strad and thus a product of some guy who lived 300 years ago in a town called Cremona and had no computers, no state-granted labs, no complicated supply chains to procure and deliver rare varieties of wood, no precision equipment to mix his glues, lacquers, dyes and so on… and yet was able to give us something that no scientist to-date was able to explain...

Not bad. 300 years old… yet to be surpassed by anyone or anything, short of Stradivari's younger contemporary: Bartolomeo Giuseppe Guarneri del Gesù…  yet to be explained by anything or anyone... yet to be definitively established as anything beyond being sublime...

29/3/2014: Almost Armageddon? WorldBank Forecasts for Russian Economy

This week World Bank published their outlook for Russian economy. Here are two core forecast scenarios:

High-risk:

Low-risk:

And a summary of the Government fiscal policy framework, covering adopted budgetary targets:

Key takeaways:

1. Ugly 2014 one way or the other (high and low risk scenarios)
2. Ugly non-oil balances on Government side
3. More conservative budgetary basis (oil price) than media allows
4. Highly conservative deficit targets despite economic growth slowdown (should EU want to find a fiscally responsible neighbour to match own 'austerian' ethos - Russia is a good candidate)
5. Gross capital formation is ugly and showing no sign of uplift on investment side which offers policy room for supporting some growth momentum
6. Capital account is assumed to be really, really ugly in high risk scenario (USD133 billion outflows) which is likely to trigger capital controls should things deteriorate this much

Russia comparative to the rest of the world:

It does look like 2014-2015 are being set (in World Bank view) as trend-breaking years for Russia

Note: Capital outflows tracing back few years:

29/3/2014: Russia's Competitiveness Challenge & What Needs to be Done...

In Russia, state sectors (non-market services) are the main drag on competitiveness. The chart below shows the gap between real wages & productivity growth by sectors, y-o-y growth. Higher values imply that wages are growing faster than productivity.

So three things to note:

1. Non-market) services drive decline in competitiveness (wages growth in education health, public services, civil service etc outstripping productivity growth in every year since 2008 and by a huge margin compared to other sectors in H2 2011-present. 
2. Trade sectors (agriculture, mining and manufacturing) are facing up to competitive pressures and are showing improvements in competitiveness since the start of 2011 despite general labour markets tightness.
3. Non-tradable sectors (market services, construction, transport, etc) are showing increasing rate of decline in competitiveness in line with the rest of economy. However, the deterioration rates are shallower than those recorded in 2009-2010.

The most urgent policy objective for Russia, is to find a reforms mix to drive up productivity growth in non-market sectors. Cutting bureaucracy and introducing professional management in education, health and public services would be a natural step forward. Upskilling and creating performance-linked pay systems will help as well. Reforming health and education to 'money follows user' system of costs recovery can also work, especially in urban areas, where there is meaningful choice of providers. Centralising and making paperless (digitalising) social welfare, pensions and core public services payments systems is another 'must' (although this is partially on its way)