Fiscal Folly?

The speed of the fiscal deterioration is truly alarming—all the more so given Ireland’s fiscal history.  But, observing from a distance, I am still surprised that the wisdom of discretionary fiscal contraction is not subject to more public debate.   (I realise I may be missing much of the actual debate.)  Ireland is now in the throes of an extreme domestic demand-deficient recession.   On its face, it is tragic to pursue a contractionary discretionary fiscal policy with such a demand collapse and no monetary policy instrument.   Of course, the fear of a large increase in the risk premium on Irish debt and associated explosive debt dynamics could validate such a tragic choice.    But is the fiscal caution being overdone given Ireland’s modest debt and ability to borrow in its own currency?  The marginal value of stimulus should be high with the economy operating well below potential.  Thus the fact that debt is being piled up at an alarming rate does not necessarily mean it is bad policy.    I would be grateful for any thoughts on the extent of the risk of explosive debt dynamics and the likely size of fiscal multipliers in the current depressed environment.   

13 replies on “Fiscal Folly?”

Unless of course you view the actions of the government as steps on the way to burying the public service and accelerating privatization to create a true neo-liberal state.

Gross GGB debt at end-2008 is about 41% of GDP, a ‘low’ figure. Net debt (net of readily-saleable State holdings of equities and shares in State companies) cuts this by maybe 12 or 15%. But we have guaranteed €440 bn of bank debt.

It would be prudent to think of the net and gross debt as being 41%. The deficit for 2009 will be c. 10% on unchanged policies, and in the 10 to 12% area for the next few years on unchanged policies.

You are off to the races fairly quickly when you start borrowing 10 to 12% of GDP per annum. We have been here before, in far friendlier sovereign debt markets. John McHale raises a fair point, but the lessons of the 1980s are pretty straighforward.

The list of countries which need to expand demand for Irish output through fiscal expansion, if one were capable of a wee bit of selfishness, might best be confined to countries starting from lower prospective deficits than ours.

Dan O’Brien had a piece in today’s SBP that I couldn’t find online, but which if John could get a hold of it might help him understand why the consensus here at the moment is to do precisely the opposite of what you would do in a well-run state, which Ireland is not

Thanks Kevin for the lead on the O’Brien piece. While it is essential to think about worst case scenarios, is the tail risk being allowed to wag the dog? The rising spreads on Irish paper is of course a cause for concern, but this is still a low interest rate environment, with the yield on two-year German paper at its lowest level in 18 years and even the five-year note yielding 2.26 percent. Colm’s fiscal arithmetic makes it clear that serious adjustment will need to occur. But does that adjusment really need to be front loaded as the economy is spiralling downwords. An alternative is to work hard to put in place a credible medium-term fiscal adjustment program combined with short-term stimulus. This framework would almost certatinly need to include a major broadening of the tax base and a shift away from reliance on transacton taxes. Implicit in the argument for extreme austerity now is that fiscal consolidation is not credible without up front demonstrations of virtue. These arguments are familiar from the Asian crisis, and it is now widely believed that excessive austerity and deteriorating domestic conditions worked to undermine confidence rather than enhance it. It is true that somce economies are so lacking in credibility that they have no choice but to don the hairshirt. But are things really that bad for Ireland?

The elephant in the room here is the need to sort out the banks. The Irish Government has already committed €5.5 billion to just three of the six indigenous institutions. It isn’t enough, and it’s probably too late.

The Department of Finance forecasts the government debt to GDP ratio will rise to 53% this year. Standard & Poor’s says 228%. My money is on the markets going with S&P’s forecast.

The scary thought in relation to the size of fiscal multipliers is that, in the case of a bank bailout, it could be … negative.

Government debt as a percentage of GDP of 228% seems excessive. Are S&P including some net estimate of the liabilities arising from the bank liabilities guarantee? If so, then its a wild guess. Nobody knows at this point what the fair value of the banks’ assets are.

John, I think most people agree with you that the adjustment should not be front loaded and that as you say what is important is establishing a credible medium-term adjustment trajectory. Also, most people agree about the need to broaden the tax base. But ‘not front loading’ may not be the same thing as not doing anything at all in 2009. I agree that the Asian analogy is in many ways apt, but given that that implies we need a real devaluation, maybe the current focus on cutting pay rates in 2009 is not so stupid (although there are unknown risks here associated with large household debts).

The fact that we find ourselves in this position is of course a damning indictment of the governments of the last 10 years, and especially the last 5, but for now that is not the most important point.

PS John, I also agree with you that an excessively tight fiscal policy in 2009 could undermine credibility, for example by causing excessive damage to the real economy, causing massive social unrest, and making the markets think we were Greece. Again, the medium term is what matters. And I do think that if we could cut wages (devaluation would be better of course, but is not an option) using the instruments of social partnership, that would also enhance credibility. Whether that is going to be possible is the big open question right now.

Thanks again Kevin. For what it’s worth, I tend to agree with the need for public sector wage cuts. Restoring competitiveness is essential, not least to raising the return on inward investment. And the demonstration of consusus-based economic management would surely be a boon to credibilty. But observing from the outside, I have been struck by Ireland’s apparent version of class warfare, which seems to show up as extreme antipathy towards the public sector by the private sector (or at least tby he employer bodies). If I were a private sector employer, I would be concerned that remaining sources of stable domestic demand were not undermined without alternative sources of demand being put in place. Cutting public sector wages now makes sense but only as part of a broader strategy that provides compensating stimulus now and puts in place the credible medium-term framework you discuss.

I agree with most of that John. On the class warfare: there are an awful lot of very right wing people in Dublin who are probably suffering from collective cognitive dissonance at this stage. Their wonderful mid-00s boom was just a bubble; their wonderful market was underregulated, not over-regulated; those dangerous continentals who argued for more regulation were 100% right, while les anglo-saxons who derided them were 100% wrong. So, out current crisis is obviously due, not to the shysters in Anglo, but to…yes! that must be it! the nurses! the guards! the teachers! make them pay now!

Which is not the sort of rhetoric that is conducive to the type of simulated devaluation that we would like achieve now via wage cuts, which is going to be incredibly difficult anyway.


I attach the Dan O’Brien piece from the Sunday Business Post


Urgent action needed to restore government’s fiscal credibility
Sunday, January 11, 2009 By Dan O’Brien
There is now a risk – small, but worryingly real – that by next year, the government will run out of cash to pay public servants, welfare recipients and those who supply it with goods and services. By the middle of last year, well before the international financial crisis exploded, it had become clear that the government had lost control of the public finances.

The awful implications of that loss of control became clearer with each passing month: the economy would be hobbled for many years to come with a large public debt burden; Ireland’s international reputation would be damaged by the scale of the mismanagement; and the country’s position in Europe would be undermined by the egregious breaching of EU budget rules.

As if these self-inflicted injuries were not bad enough, a new, more awful threat has arisen. The domestically-generated collapse in the public finances has combined with the deepening of the international economic and financial crises to generate a risk of the government simply not being able to borrow the large sums it needs to finance its deficit spending.

This spectre has arisen because governments in many countries have committed to ramping up public spending in an effort to halt, or at least slow, the shockingly rapid slide into recession. In order to finance this spending, they will have to issue bonds (IOUs with interest, effectively) in unprecedented quantities. By some estimates, global issuance of new bonds over the course of this year will be three times higher than last year.

Such a massive increase in issuance raises questions about the capacity and appetite of investors to take on government debt, and at what price.

In recent months, eight countries have had undersubscribed bond auctions, including a €6 billion issuance last Wednesday of German ten-year bonds – probably the safest investment in the world. Such failures, which were barely conceivable even a few months ago, are one of many indications of the scale of the crisis the world is now facing.

Increased demand for funds is likely to lead to higher costs of borrowing for all governments. It will also accelerate the process of investors differentiating between the fiscally weak and the fiscally strong, as they seek higher returns from governments they believe to be at greater risk of not repaying them.

Within the euro area, bond buyers judge Ireland to be second only to Greece in its risk of default. It is instructive that, in terms of riskiness, Ireland has even overtaken Italy, and the gap is widening by the week, despite that country having a public debt-to-GDP ratio four to five times that of Ireland.

Just last Friday, Standard & Poor’s, the rating agency, while maintaining Ireland’s rating as a AAA borrower, changed the outlook from ‘stable’ to ‘negative’. This means that it may downgrade us in future, if measures to correct the public finances and recapitalise the banks are not successful.

Given that public indebtedness is normally the most important determinant in default risk for developed economies, why is Ireland perceived to be so risky? The reason is the much diminished credibility of the Irish government, not only because it created such a fiscal crisis in the first place, but because of its quite astonishing mix of inaction and ineptitude in dealing with its errors.

The price of this dithering is already being paid by taxpayers in the form of higher debt servicing costs, as was demonstrated last Thursday, when investors could only be enticed to buy five-year paper with a premium far above German bonds of equivalent maturity.

The price could become much greater. Although it is important to stress that the risk of the following scenario coming to pass is small and 12 months away at the earliest, it is so serious that it requires highlighting, not least because it is not at all clear that the government and officials recognise the gravity of the situation. The starting point is Athens. What happens in Greece may appear to have little relevance for Ireland, but it does because, if any euro area government were to default on its debt, two things would quickly happen.

First, much of the perceived safety of being a euro area participant would disappear, as questions would arise about the currency’s very existence. Secondly, because shocks in financial markets tend to cause panic, and panic is contagious, investors would then look to the next weakest country.

Because Ireland is the second domino in the line, the risk of it falling would jump if Greece were to topple, which is looking increasingly possible. Greece has a long history of fiscal incontinence, a very large public debt by international standards and a government on the brink of collapse. Simmering social unrest is merely adding to fears.

Over the course of this year, Greece will need to issue bonds equivalent to 20 per cent of GDP simply to pay back existing debt that is scheduled to mature.

Add to this a rapidly-growing budget deficit and its position looks precarious. By one, admittedly not terribly reliable, measure – the credit default swaps yield – there is a 10 per cent chance that Greece will default over the next five years. If there is any positive aspect to all of this, it is that Ireland will have leeway during this year, even in the event of investors shunning new issues of Irish government bonds.

The government is sitting on a €20 billion pile of cash, the National Treasury Management Agency (NTMA) raised a further €6 billion last week and, provided it succeeds in rolling over €5 billion of maturing treasury bonds in April, there is no significant scheduled refinancing required until the end of 2011.One can’t help wondering whether, if the NTMA were not as competent as it is, its political masters might have less cash to squander.

But in a worst-case scenario internationally and for the domestic economy and financial system, the government could run out of cash next year. In that eventuality, it could go to the IMF, but there are issues with that route (which are too long and complicated to explore here, given limitations of space).The alternative is that the government could spend only as much as it can collect in revenues.

The contractionary effect of fiscal cold turkey on an already feeble economy would be appalling. There would also be implications for the financial system. If the solvency of the state is in question, the credibility of its commitment to guarantee the main banks’ liabilities would be undermined. It needs to be stressed again that, at this time, there remains only a small risk that this scenario will come to pass. But that should not breed complacency. Recent events have shown that what was inconceivable six months ago is now reality.

With the landscape of the world economy changing before our eyes, it is essential to prepare for worst.

There is simply no greater imperative for the government than to restore some semblance of credibility to its management of the public finances. It must urgently formulate a fiscal stabilisation strategy that is realistic and durable.

If the social partners can be part of that formulation process, then so much the better – the chances of effective implementation will be increased. But haste is needed – there is no time for further dithering. The cost of delay could be almost too awful to contemplate.

For what it’s worth, I tend to agree with the need for public sector wage cuts. Restoring competitiveness is essential, not least to raising the return on inward investment..

The issue of ‘competitiveness’ is one of those great unchallenged terms that is often used but rarely explained. Why is it that competitiveness is directly related (and only ever related) to wage levels when Ireland is has quite low wages levels within the EU-15.

It is interesting too that John McHale refers to the inverted class warfare, where private workers ‘seem’ to have an antipathy towards public sector workers. Is it not the case that such ‘class warfare’ has been stoked by IBEC and other ’employer bodies’. On the competitive point, I’d be interested to know what you think of this:

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