Much ado about nothing

With a lot of hope and more than a little expectation, at 4pm yesterday the Minister for Finance made a statement to the Dail on the €3.1 billion payment to be made this weekend on the Promissory Notes to the Irish Bank Resolution Corporation (IBRC).  It turned out to be a bit of a damp squib.

The key issue in this whole sorry saga is the rate at which the Exceptional Liquidity Assistance provided by the Central Bank of Ireland to the IBRC is repaid.  The 2011 Annual Report from the IBRC shows that this stood at €42.2 billion at the end of December.  This money was ‘printed’ by the Central Bank of Ireland and given to the IBRC, and it now needs to be returned by the IBRC so the Central Bank can ‘burn’ it.  Nearly three-quarters of the money to meet this requirement will come via the Promissory Notes.

It is hard to see any change at all.  The IBRC needed to get €3.1 billion of cash this weekend;  the IBRC is getting it.  The IBRC needed this money to give to the Central Bank; the Central Bank is getting it; the Central Bank will burn it.  A statement from an ECB spokesperson makes clear that they don’t see any change either.

“It is very important that the Irish state will honour the 3.06 billion euro amortisation of the promissory notes. This will reduce the emergency liquidity assistance which IBRC receives from the central bank of Ireland and thus the Eurosystem.

We certainly expect that also in the future the promissory notes will be served according to the schedule to which the government has committed itself.

As Ireland strives to regain market confidence, it is of utmost importance that the commitments of the Irish state are met in line with standing contracts and agreements.”

The Governor of the Central Bank, Patrick Honohan appeared before the Oireachtas Joint Committee on Finance last Tuesday.  The transcript is here.  In response to a question from T.D. Stephen Donnelly he said

Professor Patrick Honohan: “The question I noted in particular related to how much cash IBRC needs. In fact, the objective of the plan is to eliminate the cash need by postponing it.”

This would seem to suggest the plan was to defer the cash payment.  That could be the cash payment into the IBRC or the cash payment from the government.  The first is significant and the suggestion it that this was the “objective of the plan”.  Reducing the cash needs of the IBRC can only come about through a reduction in the cash it needs to repay its ELA obligations.  This is not how things have panned out.

The €3.1 billion cash payment to the IBRC will be made but there has been a slight change in how this payment is being funded. Instead of coming from the current funding arrangements of the State (the EU/IMF loans) it will come from a 'new' government bond.  

As a result of this there has been an increase in funding of €3.1 billion. This appears to be only for 12 months which is of little benefit given that we have funding in place for the next 21 months.   In the Minister’s statement it says:

Ultimately, it is intended that this long term Government bond will be financed for one year, on commercial terms, with Bank of Ireland who may in turn refinance the bond with the ECB.

Ultimately means “in the end; at last; finally”.  There is nothing after “ultimately”.  One year is not long term.  There has been mention of a bond maturing in 2025 but this was not included in the Minister’s statement yesterday, in his statement last Wednesday, nor by Governor Honohan this Tuesday.  I cannot find a primary source for the claim that a 2025 bond would be used but it did enter the public domain somehow. 

If the arrangement ends after one year as the Minister’s statement indicates the impact on the January 2014 funding cliff is negligible (possibly even slightly negative).   As it stands, this time next year we will need to make the next €3.1 billion payment on the Promissory Notes and also a repayment on the bond issued to Bank of Ireland.  This is clear in the statement from Bank of Ireland.

Under the terms of the Repo, IBRC will have an obligation to repurchase the Bonds from the Bank for approximately €3.06bn in cash not later than 364 days after the effective date.

Where is the IBRC going to get €3.1 billion in 12 months time?  There may be some attempt  to further extend the actual repayment of this bond but no solid information on this has been provided. There is no indication who might replace the Bank of Ireland if the arrangement was to be extended.  As it stands in 12 months time the Bank of Ireland will give this bond back to the IBRC and the IBRC must find €3.1 billion to pay for it.

If the actual cash payment can be further delayed there would be a funding gain into 2014 and, according to Governor Honohan, a minor improvement in debt sustainability.

Professor Patrick Honohan:  “In the discussion, the use of a long-term bond has already been mentioned. This is a major step forward from a sustainability perspective. The idea of a long-term bond being used in lieu of a cash payment is a very considerable step forward, considering it puts off for a long number of years the actual need to refinance those payments. In addition, the net cost of this - we can speak about complications later - will be quite low relative to alternative sources of finance. There is a very definite gain in debt sustainability. We are only talking about a fraction of the total promissory notes so we cannot say it is a decisive change, but relative to this amount, it is a considerable improvement.”

I don’t think yesterday’s move sits well with this analysis.  To sum: instead of making with the Promissory Note payment with money borrowed from the EU/IMF at 3.5% to be rolled-over over the next three to ten years, we made the Promissory Note payment with money borrowed from the Bank of Ireland at 5.4% to be rolled over next year.

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The changing nature of our budget deficits

From 2008 to 2015, Ireland is set to rack up around €100 billion of general government deficits excluding direct payments made to the banks and the initial creation of the Promissory Notes in 2010.  These are detailed here.  The following is a table that provides some insight into the deficits excluding the bank payments.

The “underlying deficits” (deficits excluding direct payments to banks) from 2008 to 2010 are taken from this PQ and the figures for 2011 to 2015 are taken from the Economic and Fiscal Outlook published with last December’s Budget.  These sum to over €103 billion but as can be seen not all deficits are created equally. 

The sum for the four years to 2011 is €64 billion with the cumulative deficits over the coming four years forecast to be about 40% lower at €39 billion.  However for the first four years the sum of the primary deficits was €49 billion; for the next four the cumulative primary deficit will be just €3 billion.

We borrowed huge amounts between 2008 and 2011 as a result of the collapse in tax revenue that followed the bursting of the property bubble.  In these four years we lived beyond our means to the tune of nearly €50 billion.  This has been reducing and by 2014 it is envisaged that we will be running a primary surplus for the first time since 2007.

Over the first four years interest expenditure summed to over €15 billion; for the four years from 2012 to 1015 it will be €35 billion.  It should be noted that the large jump in our interest costs in 2013 (of €2.5 billion) is due somewhat to the end of the “interest holiday” on the Promissory Notes. 

Although calendar year figures are not available it is likely that this interest will add €1.8 billion, €1.7 billion and €1.7 billion to the interest bill in the years 2013 to 2015.  These interest payments add to the general government deficit as the IBRC is currently not classified as part of the general government by Eurostat.  The IBRC is state-owned so the money does not leave the government unless the IBRC spends it.  The interest on the public debt over the next four years excluding the Promissory Notes will be around €30 billion.

Over the entire eight-year period we will have generated general government deficits of €103.3 billion.  Using current forecasts and the existing structure of the Promissory Notes it can be seen that €51.6 billion of this is due to primary deficits (government expenditure exceeding government revenue) and €51.6 billion is due to interest costs (the legacy of government expenditure exceeding government revenue).

It is extremely difficult to identify the portion of the interest cost which is due to the bank bailout.  The Promissory Note interest is a standalone feature but the interest on the direct payments we have made to the banks and the annual payments on the Promissory Notes is hard to determine.

In 2007, the general government debt was €47 billion and this generated the €2.4 billion interest payment we carried into the crisis in 2008.  €52 billion of primary deficits, €46 billion of injections to the banks, and €52 billion of interest payments (from a combination of the debt we started with, the large primary deficits of the last few years and the injections into the banks) means our expenditure will have generated around €196 billion of debt by the of 2015.

By 2014 we will have returned to living within our means with a small primary surplus.  In the absence of a significant increase in growth and/or inflation we will have to go beyond that and run large primary surpluses in order to control the debt ratio because of the interest burden the massive borrowing we have undertaken will have created.

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Presentation to Social Media Conference

The European Commission Representation in Ireland organised a conference for social media practitioners on ‘The Economic Challenges Facing Ireland’ that was held in NUIG on Saturday.  Here are the slides used for a presentation on Ireland’s Public Debt Crisis (pdf here).

Presentation to Social Media Conference

UPDATE: A video of the presentation can be viewed here.

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Evening Echo 15/03/12

Here is the text I submitted for an article that was published in tonight’s Evening Echo.

Voting ‘no’ to Treaty will not stop this austerity

After a few weeks of uncertainty we now know that there will be a referendum on the EU’s Fiscal Stability Treaty.  We still don’t know what the proposed change to the Constitution actually is but we do know what the referendum isn’t.  It is not a vote on the rules in the ‘Fiscal Compact’ element of the Treaty. 

Ireland has already signed up to these rules, and some more besides, as part of the revised Stability and Growth Pact agreed last year.  The ‘balanced-budget rule’ in the Fiscal Compact has actually being part of the fiscal rulebook since 2005.

The main addition is that the Treaty requires the rules in it, including an automatic correction mechanism of excessive deficits, to be introduced in national law “through binding, permanent and preferably constitutional provisions”. 

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Greek 10-year bond yield

Here is the Greek 10-year bond yield as calculated by Bloomberg for the past month.

The impact of the ‘default’ finalised last week is very evident.  But even with that the yield remains at 18%.  The Bloomberg nine-year equivalent for Ireland is at 6.9%.

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The Expenditure Rule

The upcoming referendum on the Fiscal Stability Treaty (FST) has brought the fiscal rules contained in the treaty to the forefront of our attention.  However, as has been said a number of times when it comes to the numerical rules in the Treaty there is nothing new.

The ‘balanced-budget rule’ has been in place since 2005 and actually in the guise it was originally proposed was even more stringent than the current version.

The range for the country-specific MTOs for euro area and ERM II Member States would thus be, in cyclically adjusted terms, net of one-off and temporary measures, between -1% of GDP for low debt/high potential growth countries and balance or surplus for high debt/low potential growth countries.

High debt countries are actually allowed a structural deficit of 0.5% of GDP under the Treaty.  The ‘debt brake rule’ is from the revised Stability and Growth Pact (SGP))agreed last year.

What is perhaps of interest is the fiscal rules in the revised SGP that did not make it into the FST and it is not clear why some elements of the SGP were omitted.  The focus of the Fiscal Compact is on debt and deficits but the focus on the SGP is much broader.  The revised SGP includes a government expenditure rule and a Macroeconomic Imbalance Procedure.

The rules in the Fiscal Compact would not have had any impact in Ireland were they in place from 2000 to 2007.  Ireland ran overall budget surpluses, the EC estimated at the time that Ireland was running structural surpluses and the debt ratio fell to 25% of GDP by 2007. 

The fiscal rules in the Treaty would not have limited fiscal policy in Ireland in the run up to the crisis in any way.  Under the terms of the Treaty Ireland would have been fiscally sound.  However, this would not be the case if the full gamut of features of the SGP are considered.

When the Six Pack was agreed last October by the EU Council it was stated that:

the reform introduces an expenditure benchmark, which implies that annual expenditure growth should not exceed a reference medium-term rate of GDP growth.

When the new workings of the Stability and Growth Pact were announced in January it clarified what this meant:

The reference-medium-term rate of potential GDP growth is based on regularly updated forward-looking projections and backward-looking estimates, taking into account the relevant calculation method provided by the EPC. The reference-medium-term rate of potential GDP growth will be the average of the estimates of the previous 5 years, the estimate for the current year and the projections for the following 4 years.

The government expenditure aggregate to be assessed should exclude:

• interest expenditure,
• expenditure on EU programmes fully matched by EU funds revenue, and
• non-discretionary changes in unemployment benefit expenditure.

Due to the potentially very high variability of investment expenditure, especially in the case of small Member States, the government expenditure aggregate should be adjusted by averaging investment expenditure over 4 years.

It is unlikely that this rule will be assessed retrospectively but we can provide a crude analysis using some existing data.  Here is a summary of the findings.  Click to enlarge.

 
The adjusted government expenditure is found by starting with total general government expenditure in the eurostat government finance statistics subtracting interest expenditure, investment expenditure and EU receipts (taken from Table 10 here) and adding in the four-year moving average of investment expenditure.  No adjustment is made for non-discretionary changes in unemployment benefit expenditure. 

The potential growth rates are taken from the archive of estimates provided on the CIRCA website of the European Commission: Economic and Financial Affairs.  The estimates for each year are the Autumn estimates provided by the Commission in that year except for 2001 and 2002 both of which are based on the Spring 2002 estimates.

The results are clear.  In each year from 2001 to 2007 the increase in government expenditure was above that which would have been allowed under the proposed expenditure rule.  Over the seven years adjusted government expenditure increased by 130%, with an increase less than half of that allowed under the rule.

The 2001 Budget led to the first official rebuke of a eurozone country’s budget by the Commission and the Council of Ministers declared:

… the Council finds that the planned contribution of fiscal policy to the macroeconomic policy mix in Ireland is inappropriate. The Council recalls that it has repeatedly urged the Irish authorities, most recently in its 2000 broad guidelines of the economic policies, to ensure economic stability by means of fiscal policy. The Council regrets that this advice was not reflected in the budget for 2001, despite developments in the course of 2000 indicating an increasing extent of overheating. The Council considers that Irish fiscal policy in 2001 is not consistent with the broad guidelines of the economic policies as regards budgetary policy. The Council has therefore decided, together with this Opinion, to make a recommendation under Article 99(4) of the Treaty establishing the European Community with a view to ending this inconsistency.

Charlie McCreevey did not change the budget and although the rate of expenditure increase was tempered, for each year after 2001 expenditure increased by more than would be allowed by the rule.  Of course, even if the rule were in place there is no guarantee that it would have been respected.  There is always a get-out clause and for the expenditure rule the SGP further states:

A Member State that has overachieved the MTO could temporarily let annual expenditure growth exceed a reference medium-term rate of potential GDP growth as long as, taking into account the possibility of significant revenue windfalls, the MTO is respected throughout the programme period.

Though I’m not sure that breaking the rule for at least seven years would be considered temporary. Tweet

The End of Public Debt

The previous post looked at some possible implications of the forthcoming EU fiscal rules on budget balances.  In theory, counter-cyclical deficits are allowed but it remains to be seen how this will work in practice.  Following on from Prof. Karl Whelan (here and here) it is also useful to examine the impact of the rules on the overall level of public debt. 

Again the focus will be on the ‘balanced budget rule’ (structural deficit < 0.5% of GDP) rather than the ‘debt brake rule’ (reduction of 1/20th in the debt to GDP ratio of the excess over the 60% threshold).  The debt brake rule has got a lot of attention but it is the balanced budget rule that will have the biggest impact.

Here are actual and forecast general government debts in the eurozone from 2001 to 2013.  Click to enlarge.



Data to 2010 are from Eurostat and forecasts to 2013 are from the European Commission. Yellow indicates that a country is in excess of the 60% of GDP limit and red indicated that the country also fails to meet the numerical debt reduction target of the debt brake rule.  From the perspective of the proposed rules this is not a pretty table.  A table of the government deficits for each year can be seen here.

Under the proposed rules, when a country gets below the 60% of GDP limit it is allowed to run a structural deficit of 1% of GDP.  If we assume that the output gap averages zero over the economic cycle, this means that a country is expected to run average overall deficits of 1% over the cycle.  As Prof. Whelan has shown in a situation with 4% nominal GDP growth this means that the general government debt will converge on a level equal to 25% of GDP.

This is well below the 60% of GDP benchmark level but it is important to remember that this 60% benchmark is not a target to be aimed for, but is a level that the debt “does not exceed”, in the words of the Fiscal Stability Treaty.

Thus the 60% of GDP is an upper limit.  In order to stay within this limit it would be necessary that countries be below the 60% of GDP level to absorb the debt effects of a downturn and remain below the 60% of GDP limit. 

So how far below the 60% of GDP level is required to satisfy this?

We can use some examples from the above table.  Consider the case of Spain which in 2007 had a budget surplus of 2% of GDP and a debt of 36% of GDP.  On the basis of the original 3% deficit and 60% debt rules Spain was in a very healthy position in the run up to the crisis.  Just three years later Spain had breached the 60% threshold and the general government debt ratio is forecast to have more than doubled to 78% of GDP by 2013.

This might suggest that a debt of 36% of GDP does not offer a sufficient buffer to allow a country to stay below the 60% of GDP benchmark in response to a downturn.  However, Spain may not be an appropriate example as the relative health in the public finances was not reflected in the overall economy. 
This can be seen if one examines Spain’s Macroeconomic Imbalance Scorecard for the past ten years.  This is not an economy that was “in balance”.  For example in 2005, Spain exceeded the balance threshold for seven of the ten measures in the scorecard. Click to enlarge.


A better example might be the Netherlands which in 2007 ran a small budget surplus of 0.2% of GDP and had a general government debt of 45% of GDP.  The Macroeconomic Imbalance Scorecard for Holland shows an economy in reasonable shape.  The only significant imbalance is private sector debt and that is mainly a result of the structure of mortgages and pension savings for Dutch households (net debt is much lower than the gross figures given here).  Again click to enlarge.



The Netherlands looked to be in a reasonably strong position in 2007 but breached the 3% of GDP limit in 2009 and exceeded the 60% of GDP debt limit in 2009.  The debt is expected to stabilise quickly and is forecast to be 66% of GDP in 2013.  The point is though, that running budget surpluses and having a debt ratio of 45% of GDP is not enough to keep a country below the 60% of GDP threshold in response to a downturn.

And the downturn in the Netherlands was relatively mild compared to what we have experienced here.   Between 2007 and 2009, real GDP fell 1.8%.  By 2011 real GDP is expected to be 1.1% up on its 2007 level.  In nominal terms GDP was down 0.1% between 2007 and 2009 and up more than 6% from 2007 to 2011.  When compared to the Irish performance over the same period this is a mere speed-bump.
The implication drawn by those who devised the fiscal rules is clear.  Small budget surpluses and a debt of 45% of GDP are not sufficient buffers to ensure that a country in a relatively good economic position will stay within the 3% of GDP deficit and 60% of GDP debt limits.  Bigger surpluses and smaller debt are required.

The proposed budget rules seem designed to force balances to levels that will see public debt levels approach 25% of GDP (assuming 4% nominal GDP growth).  In general, this seems a remarkably low level of public debt to target given that countries rarely have to repay debt but can merely service the interest into perpetuity.

[It is perhaps a little ironic that Ireland had a debt ratio of 25% of GDP in 2007 and now has one which ended 2011 at 108% of GDP and is rapidly hurtling towards 120% of GDP. Maybe the target should be lower than 25%.]

It would be useful if economics had empirical evidence to support the 25% of GDP level as an appropriate target, or the 60% of GDP level as an appropriate limit, or (in the case of Greece in particular) the 120% of GDP level as an appropriate danger threshold.  No such benchmarks exist.  It has been suggested that a government debt above 85% of GDP harms growth but we do not know what is the wrong (or right) level of debt.

The proposed rules in the Fiscal Stability Treaty, and more particularly in the revised Stability and Growth Pact, are designed to bring public finances in the EU to an extreme level of fitness rather than a level that might be considered “normal”. 

In particular, it is the structural deficit rule that has the biggest impact.  Targeting deficits that are created by political decisions is a useful move, but setting a limit on these of 1% of GDP on these may not be.  As Prof. Whelan said in a presentation to the ICTU “there is no need for a balanced budget [ ] as long as GDP is growing”.

Of course, the above is a very mechanical interpretation of how the rules will be applied in practice.  When the rules come into force there will be country-specific Medium Term Budgetary Objectives (MTO) that each country will have to target.  Although some guidelines have been provided on the formula to be used to create the MTOs we are still awaiting the specifics.

In order to operationalize this formula, explicit parameters will be made public through a Commission services paper, endorsed by the EFC.

This may outline how the flexibility built into the rules will be incorporated and whether it is likely that average deficits of more than 1% of GDP and debts of more than 25% of GDP will be allowed. Tweet

Killing Keynes

There have been some suggestions recently that the revised fiscal rules which all 27 EU members have already agreed to as part of the revised Stability and Growth Pact and which 25 of the 27 are proceeding to “transpose the ‘balanced budget rule’ into their national legal systems, through binding, permanent and preferably constitutional provisions” via the  Treaty on Stability, Coordination and Governance is the death of Keynesian-style fiscal policies in the EU.  That is not the case.

Keynesianism, as it is typically described now, is a counter-cyclical policy that allows governments to run deficits in bad times is respond to downturns with “sufficiently large” surpluses run in the good times to fund these deficits.  Virtually all countries are very good at achieving the former, but very few accommodate the latter.  Rather than outlawing counter-cyclical policy the fiscal rules are actually an attempt to formalise it as is said in the SGP.

Member States should achieve a more symmetrical approach to fiscal policy over the cycle through enhanced budgetary discipline in periods of economic recovery, with the objective to avoid pro-cyclical policies and to gradually reach their medium-term budgetary objective, thus creating the necessary room to accommodate economic downturns and reduce government debt at a satisfactory pace, thereby contributing to the long-term sustainability of public finances.

Of course, this is not to suggest that Lord Keynes himself would be a devout advocate of this approach to fiscal policy.  Keynes did favour a counter-cyclical pattern of expenditure but his emphasis was on the confidence effects that increased government capital expenditure can offer in a downturn, rather than current expenditure which has become the emphasis of government expenditure.
In one of his more whimsical moments in the GT Keynes wrote:

"If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez faire to dig the notes up again . . . there need be no more unemployment. . . . It would indeed be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing."

Although the government is essentially giving away the money it is doing so in a manner to stimulate private-sector investment in order to obtain the money.  Anyway, away from Keynes and back to Keynesians.  Here is a table which shows how the proposed ‘balanced budget rule’ incorporating a 0.5% of GDP limit on the structural deficit is counter-cyclical.

The first column is the output gap: the difference between the forecast actual GDP and the estimated potential GDP.  We will not go into the difficulties of determining this here.  The next column is the sensitivity of the budget balance to the output gap.  The figure used here is 0.5 which is not too different from the EU15 figure of 0.49 used by the European Commission.  The figure for Ireland is 0.40.  All the current sensitivity estimates can be seen here.

Multiplying the first number by the second gives the cyclical-component of the budget balance, i.e. the impact of the economic cycle of the budget.  For example, if the economy is growing above its potential rate and has an output gap of 2% of GDP this is forecast to lead to an improvement in the budget balance of 1% of GDP.
If a country has a debt of greater than 60% of GDP the allowed structural balance is 0.5% of GDP.  Adding the two together gives the overall balance the country should be aiming for at different stages of the economic cycle.

If should be clear that the allowed overall balances are counter-cyclical. When the economy is growing above its potential it is required to run overall surpluses, and in a downturn it is allowed to run deficits.  In the case of a very large output gap of –4% of GDP it can be seen that the rule allows a deficit of 2.5% of GDP. 
Counter-cyclical government spending has not been outlawed.  The intention is to try and ensure “sufficiently large” surpluses in the good times.  There is no guarantee of that but this is not the attempt to kill Keynes, or more specifically Keynesianism, that some have been claiming. 

For those who are making this claim it would be useful if they could provide references to their calls for fiscal restraint and a reigning in of government expenditure during the good times. Tweet

Presentation on Fiscal Compact

Here are the slides from a presentation I gave yesterday in UCC on the fiscal compact.  I hope to post the audio at some stage during the week which will provide more of an explanation of the simplifying assumptions used.

Fiscal treaty

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Different views

This is from page 30 of the European Commission’s Winter 2011 Review of the Economic Adjustment Programme for Ireland which was released last Friday.

Although the fiscal forecasts incorporate some small buffers, a further deterioration of the macroeconomic backdrop could require additional fiscal tightening later in the year, which could have pro-cyclical contractionary effects.

The same day the IMF released their Fifth Review of Extended Arrangement with Ireland which beginning on the bottom of page 23 says:

… the 2012 targets remain within reach despite the weakening in growth prospects. In the event of significant further reduction in growth projections, automatic stabilizers on the revenue-side should be allowed to operate to avoid jeopardizing the fragile economic recovery as envisaged under the program.

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