This is very worrying.
Jim O’Leary had a piece yesterday in the Irish Times which was worth reading for a couple of reasons. First, he has a nice account of the incentives facing economic forecasters. Second, he draws attention to a truly astonishing forecast, or assumption, in the Central Bank’s recent Quarterly Bulletin: that, while domestic demand will collapse in 2009 (which makes sense: the Central Bank assumes that gross domestic expenditure will fall by 7.6%), our exports will only decline in volume by 0.7%. If true, this would obviously mute the overall fall in Irish GDP, and the Central Bank is forecasting a decline of just 4%.
Jim convincingly shows why the assumption regarding exports is implausible. Here are a few more facts. According to the CPB Netherlands Bureau for Economic Policy Analysis, the volume of world trade fell by 6% last November. That’s right: by 6%, in one month. US imports fell by 7.8%; Japanese exports fell by 10.8%.
The CPB cautions that monthly world trade figures are volatile, and that one should focus on moving averages. Of course, that becomes a less useful strategy when one has just passed the peak! More evidence of the extraordinarily rapid collapse in world trade comes from IATA, which reports that the volume of international cargo shipped by air was 22.6% lower in December 2008 than in December 2007 (HT Calculated Risk).
By way of comparison, the volume of world trade fell by a little more than a quarter over the 3 years 1929-1932.
As Jim says, it seems safe to assume that exports will contract by a lot more than the Central Bank is currently forecasting, and that the same will therefore be true of GDP and employment as well.
Paul Sweeney is today’s contributor to the Irish Times series: you can read his article here.
There is much in his article that would be commonly accepted across the economics profession. However, I discuss below a few points of potential disagreement.
His article seems to suggest that those who advocate cuts in public sector pay are necessarily against the elimination of tax breaks for businesses, farmers, property development etc . Rather, I would think most of those who have written on public sector pay would also agree with the elimination of most of these subsidies (see, for example, my own paper.)
He also argues that our low-ish international ranking in earnings means that labour costs are not a major problem. However, it is important to make a distinction between ‘movements along the labour demand curve’ and ‘shifts in the labour demand curve’. If we can boost productivity, we can raise wages and employment at the same time through an outward shift in labour demand. Everyone is in favour of this, of course. However, boosting productivity growth is complex and is really a medium-term process (few instantly effective policies).
However, at the current level of productivity, we can still raise employment by accepting a wage cut (a movement along the labour demand curve). At a time of sharply rising unemployment, this seems like a sensible approach.
The article suggests that the economic model must “shift rapidly from Boston to Berlin: from the Anglo “shareholder value” system, to the European “stakeholder” model“. It is certainly true that the crisis should lead to a deep and critical re-assessment of how we should regulate the banking sector and, more generally, the appropriate extent of government regulation across the economy. However, the recession is now getting to be as deep in Europe as in the United States, even if the origin was American-made. The appropriate analytical framework also needs to be wider than ‘US v Europe’ in view of the rising share of world output that is generated by the emerging markets.
Finally, the article refers to ‘conservative economists’. I am not sure exactly what he means by that term, but I doubt that the political preferences of academic economists can be easily inferred from their views on topics such as public sector pay. It is possible to analytically conclude that public sector pay cuts would be a good idea for the overall economy, while holding a very diverse range of views concerning the appropriate level of redistribution in society and other dimensions that differentiate ‘conservatives’ from others.
In similar vein, the article suggests that a neoclassical approach to economics requires a belief in ‘efficient markets’. This is at odds with the evolution of the profession, with much of the last two decades devoted to using neoclassical economics to analyse market failures (very long list of contributors).
I am interested in the readership’s opinions on how to increase the tax take in ways that respect the advice of Jean Baptiste Colbert (1619-83), finance minister to Louis XIV: “The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.”
Ireland can learn much from the new Mirrlees Report in the UK that commissioned studies from the world’s leading tax experts. See the material here.
It is also interesting / entertaining to read about some novel taxation strategies: taxes that vary with age, gender and height at least do not suffer from moral hazard, since it is quite difficult to change these personal attributes!
Alberto Alesina’s propsal to condition tax rates on gender is explained here.
The logic of conditioning tax rates on age is explained in this post by Greg Mankiw.
His proposal to condition tax rates on height is explained here.
In this article in today’s Irish Times, I explain why EMU is neither a primary source of our current woes nor an obstacle to recovery.
Danny McCoy of IBEC is today’s contributor to the Irish Times series: you can read his contribution here.
My thanks to my Bruegel colleague Zsolt Darvas for an interesting set of charts showing GDP per capita in Purchasing Power Standards. If the European Commission’s projections pan out, living standards here will take a hit for sure, but it could be worse: We could live in Austria, Finland or Spain. Of course, GNP per capita is lower.
The Draft Partnership Pact referred to in today’s Irish Times states, in the section on “Stabilising the Financial and Banking Sector”, that government action will seek to “assist those who get into difficulties with their mortgages. In early 2009 a new statutory Code of Practice in relation to mortgage arrears and home repossessions will be brought forward and the mortgage interest scheme will be reviewed”. I’d be interested to hear people’s opinions on this.
Rossa White is today’s contributor to the Irish Times series: “The Time to Take Hard Decisions on Public Pay is Now“.
He concludes by advocating a new system that will avoid fiscal procyclicality in the future, through a ‘golden rule’ policy, plus the establishment of a rainy-day fund.
Institutional reform along these lines is highly important. Indeed, I post a link below to a 1998 article I presented at Kenmare and published in the now-defunct Irish Banking Review, in which I advocate a similar approach. However, I wonder about the political incentives to establish such institutional restraints on the conduct of fiscal policy. Again, the current crisis may provide the right environment for undertaking such reforms.
Philip R. Lane, “Irish Fiscal Policy under EMU,” Irish Banking Review, 1998.
VOX has launched a new initiative that is intended to act as a central forum for an open-format discussion of the global crisis. This promises to be quite interesting (I am acting as moderator for the macroeconomics theme; Luigi Zingales on regulation; Francesco Giavazzi on institutional reform; Dani Rodrik on development; and Richard Baldwin on open markets). You can read more about it here.
The media reports suggest that ICTU has proposed a new top income tax rate of 48 percent. If various levies are added to that, the effective marginal income tax rate for high-ish earners could exceed 50 percent.
I am interested in the views of this blog’s readership on the extent to which a top tax rate in this range might adversely affect economic performance, in the specific context of the Irish economy and the Irish labour market. For myself, I think it is important that the top tax rate in Ireland does not deviate too much from the UK top rate, which is due to be raised to 45 percent after the next election, in view of the high labour mobility between Ireland and the UK.
Richard Tol is today’s contributor to the Irish Times series: “The Right Cuts in Spending Will Not Hit Recovery‘” . Richard moves beyond the ‘broad parameters of adjustment’ approach by specifying a detailed list of expenditure items for pruning. Let us see if ‘An Bord Snip Nua’ follows his advice.
With the massive hole in the public finances, it seems unavoidable that the tax take will rise sharply. On the positive side, Ireland at least has more tax room than other countries. On the negative side, near-term, large-scale increases in taxes will further harm demand leading to a further turn in the vicious cycle. Indeed, the expectation of lower after-tax income must already be curbing household spending. Moreover, higher taxes will undermine the incentives-based model that has underpinned Irish growth.
What to do?
I have previously thought Ireland was fortunate to have avoided an unfunded earnings-related state pension system. But it is time for some new thinking in what is now a full-blown economic emergency. Weighing the benefits against the costs, I think a “notional defined contribution” unfunded system would be a large net positive. Under this system, benefits are rigidly linked to earlier contributions. For a given contribution rate, contributions receive a “notional” rate of return equal to the growth rate of the wage bill. But the system is unfunded, so that the revenues are made available to the government today. There is effectively a “free” period where the government receives revenues but does not have to pay out benefits.
Why is this a good idea?
First, and most immediately, it would allow for a sizable inflow of funds to the exchequer. With a contribution rate of 6 percent and a base equal to the entire wage bill, the government would raise roughly 4 percent of GNP (assuming a labor income share of GNP of two thirds—hopefully someone can fill in the correct labor share). This would largely meet the massive correction penciled in for 2010 and 2011 (though it might make sense to phase it in more gradually).
Second, the disincentive effects of higher marginal tax rates would be greatly diminished by the strong link from contributions to benefits. Indeed, it is reasonable not to refer to the contribution rate as a tax rate at all. The alternative of dramatically higher income tax rates is likely to be a huge drag investment and enterprise going forward.
Third, the adverse effect of the fiscal correction on expected lifetime income would be minimized as today’s contributions lead to higher future benefits This is critical in an environment where household confidence in their future after-tax income has collapsed.
Fourth, the decimation of many private-sector defined-benefit schemes has left many workers dangerously exposed. At least for those earlier in their careers, this scheme could help build pension “wealth.”
One way to view the policy is as a form of long-term borrowing from current workers. It is a response to the fact that traditional borrowing through the debt markets is, many believe, reaching its limits. In return for their contributions, workers under this policy receive a special form of asset–a promise of future benefits that is tightly linked to their contributions. While there is a risk that the government will renege on its benefit promise. The recent experience with losses on financial wealth should be borne in mind in assessing the extent of risk in this system.
A word of caution: I think it would be critical to avoid turning this into a redistributive scheme. Lifetime redistribution should continue to take place through the flat rate pension/proportionate PRSI contribution system. Blurring the link between contributions and pensions would greatly undermine both the incentive and relatively benign income expectation effects of the policy.
I think it would also be a mistake to demand employer contributions. Unlike the employee contributions, employer contributions would be a pure labour tax, the last thing that is needed right now. It would probably also make the policy a political non-starter in the current climate.
I don’t pretend this is a free lunch—future generations would be stuck with it. But it may be the closest thing to a free lunch we have. As a general rule, it is not wise to make long-term policy such as pensions policy to deal with a crisis. However, it is worth remembering the US Social Security system was introduced during the Great Depression.
It is far from perfect. But what are the alternatives?
I found this quite depressing. He doesn’t want to cut interest rates further for fear of falling into a liquidity trap???
In addition to harming the overall Eurozone economy, this sort of attitude, if it prevails, will be particularly damaging to Ireland because of its implications for exchange rates. And it will I think set in motion serious protectionist forces in this continent, with the potential to do great damage to the international economy in the years ahead.
Alan Ahearne is today’s contributor to the Irish Times series: “Income Tax Rates Will Need to Rise.” (As usual, headline does not give full flavour of the article.)
The fiscal plan of Fintan O’Toole is also worth reading: “Government Reaction to Crisis Needs to be Credible.” A longer version of this article would have been even more interesting, in which the economic consequences of the pay element of his plan might be explained in more detail.
I am pleased that Dan Donovan (a highly-experienced trader in the financial markets) has taken the time to write an explanatory note on some of the most important features of the sovereign CDS market. See his contribution below.
From Dan Donovan:
As the current malaise in the credit markets unfolds one of the rapidly emerging issues has been the markets concern about various sovereign solvency issues, most particularly with regard to the ability or otherwise of countries to be able to pay for the varying forms of bank guarantee’s they have proffered.
Most agents seeking to express views that sovereigns would be unable to meet their commitments and or that the cost of doing so will escalate have been doing so via the Credit Default Swap market; buying “insurance” against the default of the named sovereign. It is note worthy how quickly and dramatically the cost of this insurance has escalated.. Ireland as can be seen below (ex Iceland) has borne the brunt of this position taking.
Port 134/144 130/150
Ital 177/187 172/182
Gree 260/290 255/285
Spa 148/158 145/160
Irel 260/300 240/290
UK 140/150 137/147
Denk 109/119 108/120
Swe 110/125 115/130
Aust 145/155 145/145
Ger 56/66 56/66
Fran 63/73 64/74
Finl 55/65 57/67
Belg 115/135 113/133
Neth 105/125 105/120
Iceland 925/975 800/1000
Source JP Morgan.
It is tempting to dismiss such moves as merely a thin market overreacting to the current zeitgeist, for instance it now costs roughly 3 times as much to insure against a default of the UK government as it does to insure against the default of Cadburys! There are however some important issues to consider regarding the implications of such moves.
Price Setting: Many participants in the market are able to switch between writing CDS insurance and buying Government bonds. As such the CDS market which is more active than the underlying market can have the effect of defining the cost of borrowing for sovereigns despite the fact that there is very little in the way of transparency regarding who the agents in this market are and what volumes have been traded. Governments could be forced by virtue of this market to pay unnecessarily high (perhaps punitively high) borrowing costs.
Agency Issues: The existence of the Sovereign CDS market may change, considerably, the motivation of traditional suppliers of credit extension to sovereigns.
Whilst the CDS market is a zero sum game, it is however conceivable that certain groups can accumulate considerable positions in the CDS (buying insurance) of a given Sovereign without holding any underlying positions in the securities referenced by such a CDS. It would then be optimal for such agents to fail to support the issuance programmes of the country in question. The reason being that this will benefit the CDS they own via the spread moving wider or in the extreme technical default of the Sovereign triggering the CDS contract. Under normal circumstances this issue would be so remote as to be irrelevant, but these are far from normal times and as such these issues need consideration.
Possible Solutions: It is certainly arguable that CDS contracts have been far from a force for good in these times and have done more damage than good and should be outlawed. It would be difficult to “put the Genie back in the bottle” however and as is the case in banning short selling may have severe unintended consequences. One simple strategy would be to enforce disclosure of all agents Sovereign CDS positions. Such transparency could be delivered in a very short time frame and would enable Issuers and the market in general to understand and interpret the actions of the varying market constituents more clearly.
I wrote a short piece in yesterday’s Sunday Independent that illustrates why bank regulators must think beyond International Financial Reporting Standards in judging the health of the banking system. The link is here.
Today’s installment in the Irish Times is written by John McHale: Minimising the Pain.
In response to my earlier post on the nationalisation of Anglo Irish, Enrique DeLucas writes that “as Anglo was also an active syndicator with the other Irish commercial banks, any impact of large scale writedowns of their loan books would have a collosal impact on the remaining listed Irish banks”. In response to a further comment from Alan Ahearne he writes that “under IAS39, if a fire sale of Anglo’s assets gives specific evidence of a diminution in value of these assets, they must be marked down accordingly. As a result, this creates a requirement under Balse II to increase the capital adequacy reserve by this amount, thus impinging on the banks liquidity position and tier one capital ratios further”.
Do we know the extent of Anglo’s syndication with the other Irish banks, so that the importance of this effect could be assessed?
By the way, some info on who is advising the government: http://www.irishtimes.com/newspaper/finance/2009/0124/1232474679313.html
The CSO Index of Retail Sales had been rising to mid-Summer 2007, flattened for a few months and has been falling since October 2007, which was (just marginally) the sa peak. November 2008 was 8.1% off the peak, and October plus November combined down just under 8% on the same two months of 07. Today’s Sunday Business Post reports a survey by Retail Excellence Ireland and CBRE for the full fourth quarter. They believe that value of sales was down 10.7% over Q4 2007, and that the figure would have been even worse (14%) if the DIY and electrical sectors had been included in their survey, which seems to have a somewhat narrower coverage than the CSO’s inquiry. Nonetheless, the survey confirms anecdotal evidence that December was dire, and that Q4 volumes could be down anything up to 10% on Q4 2007. Some sales were brought forward into December, and the January figures could well be pretty poor too.
Notwithstanding the diversion of trade into NI retailers, consumer spending must be falling faster than household disposable income. There will have been a hit to income in Q4 from job losses, but not yet from tax increases. Pay rates (outside the construction sector) were still rising in Q4 so far as I can see, although they may fall in the private economy overall in Q1 2009. The implication is that the household savings rate rose sharply in Q4 08, and that the marginal propensity to save must be high. This is also consistent with the historic lows in the consumer confidence indices.
If the consumer has decided that it’s time to repair the balance sheet, the case for fiscal stimulus is even weaker than normal, which in Ireland is pretty weak to begin with. The corrolary is that fiscal tightening has even less output cost than the macro models indicate.
(Cliff, an SBP headline today contains the coinage ‘oversaturated’. Is this overexaggerated? When will the slaughter cease?).
Here is a picture, taken from a paper by Ben Bernanke, which anyone resisting wage cuts in the Irish context today needs to take seriously. These are countries which (mistakenly) stuck to gold until the bitter end. Like ourselves, therefore, they did not have the option of devaluing. (No, I am not saying we should leave EMU.) The more wages fell, the less output declined. (And yes, the result comes through in regressions which control for other stuff.) The question today is, do we want to end up looking more like Belgium, the Netherlands or Poland, or like France and Switzerland?
This is interesting.
The Irish Times has a new series on this topic, with articles commissioned from ‘leading’ (always that word) economists. Today, it is John Fitzgerald: you can read his views here.
A series with a similar theme but a very different set of contributors ran back in August. Here is a partial list:
Sean Quinn (August 11 2008): here.
Derek Quinlan (August 12 2008): here.
Philip Lynch (August 13 2008): here.
Denis O’Brien (August 14 2008): here.
Michael O’Sullivan (August 20 2008): here.
Mark Fitzgerald (August 21 2008): here.
An indication of the pressures on Ireland’s competitiveness is provided by the Harmonised Competitiveness Index, the December figure for which has recently been released on the Central Bank website. While the real HCI had been falling gradually since the early part of the last year (a rise in the indicator implies a disimprovement in competitiveness, while a fall in the indicator indicates an improvement), the December figure jumped upwards by 4.0% over the previous month, largely due to the appreciation of the euro particularly against sterling. The Dec 2008 value of 126 puts us back where we were at the beginning of last year.
The FT reports that a big shift to the left is predicted.
If the Chinese have any sense, they will let their currency appreciate now.
Update: Willem Buiter is also concerned about the looming threat to world trade that this would seem to imply. He displays an extreme scepticism about whether nominal exchange rates ever matter for the trade balance, writing that
only the most bone-headed of ultra-Keynesians believes that a country can influence its effective real exchange rate in a lasting manner by managing/manipulating its effective nominal exchange rate, let alone some bilateral nominal exchange rate.
I guess the key phrase here is “in a lasting manner”, and I defer to Philip about what sort of time scale this implies empirically. I guess that not all economists will agree with Buiter on this particular point. But the broader point, which is critically important, is that we can’t take the maintenance of an open trading system for granted.
It appears that the fear of a deflationary spiral is being used as a major argument against wage cuts. My impression is that the idea is gaining traction out there in the real world, and so it seems worthwhile restating the reasons why it is wrong.
‘The’ price level in the Irish context is the European price level, which is determined by policy in Frankfurt. Nothing that happens in Irish labour markets will move this price level by one iota in either direction, and so nothing that we do here will set off a deflationary spiral. What we can influence is a relative price, namely the relative cost of living and doing business here. This relative cost exploded during the bubble, and it will eventually come down. The only issue is whether this happens quickly, or whether relative Irish costs will be ground down by unemployment and stagnation over the course of many years.
David Begg is right to fear a deflationary spiral, but what will determine whether we get one or not is the relative supply of ideologues and pragmatists in the ECB, not anything that happens here. And the sort of intertemporal logic which explains why deflation is so damaging can be turned on its head in the Irish context: as Philip points out, it implies that wage cuts need to happen all at once, now.
The Government should announce that all public sector wages, which it controls, be cut by x%, where x is determined by real exchange rate considerations. It should strongly suggest that all private sector wages be cut by the same amount. Ideally we would all jump together, and so the wage cuts would come into effect simultaneously on a given date. St Brigid’s Day would seem appropriate.
Jim O’Leary discusses Ireland’s EMU membership in his Irish Times column today. An interesting question is whether Ireland would have avoided a bubble had it opted not to join EMU. The issue here is the relevant counterfactual. Since quite a number of non-member European peripheral countries that were growing quickly for convergence reasons also enjoyed credit booms due to the global decline in risk aversion and compression of spreads, it is not so obvious that staying outside EMU would have delivered stability (think of Iceland and various CEE countries).
If expectations of price appreciation grip the housing market, small differences in the level of interest rates do not make too much difference. To the extent that high levels of immigration helped to fuel perceptions of strong fundamentals in the housing market, that dimension is orthogonal to EMU: the two other countries that were early liberalisers were also not members of EMU (Sweden and the UK).
Accordingly, if the relevant comparison set is composed of other non-advanced European countries (in terms of income levels relative to potential in the late 1990s), then it is not clear that EMU was a fundamental factor. Rather, key differentiating factors may include the quality of banking regulation and the probity of fiscal policy.
Clearly, this is a very open debate that calls for more research!
From the frontiers of knowledge (yes, it’s grading time again): “Fiscal contraction was first noticed in the 1960s by a man by the name of Fiscal and it was him who derived the short, medium and long run effects of it and how they would occur and the reasons for it…”