Economic Performance

Credit card sales

Among the many interesting bits of data in today’s release of the Central Bank’s monthly statistics are the February 2009 data for credit card spending. I haven’t paid too much attention to these before, but they seem like a useful early indicator of retail sales, and they may include cross-border purchases.

Not surprisingly, the February figures are very weak — indeed it seems that January and February 2009 are about the same as the same months in 2006. And these are in nominal euros — not inflation adjusted.

I thought readers might like to see this seven year chart which I have drawn. Of course February is generally the lowest month of the year (though it wasn’t in 2008), but the drop is very striking.

Update: OK, so I’d better deflate this by the CPI as below (Average in 2002=100). I leave it to someone else to seasonally adjust.

Economic Performance

Profile of Brian Lucey

The Irish Times profiles Brian in today’s edition: you can read it here.

Economic Performance

Stimulus for Development

Commentators across the spectrum have worried that the April budget will tax and cut so much money out of the economy that we will face serious deflation. There has been a shift in emphasis from the over-riding importance of minimizing the budget deficit to recognizing the need to minimize the deflationary effects of fiscal measures. We are seeing an increasing number of proposals in that regard.

This is not unrelated to a second major political shift – the re-opening of partnership discussions and the potential for working through more complex and multi-layered ways out of this crisis. I can’t see any other institutions that can put together a combination of measures to promote a growth strategy that would accompany fiscal measures.

Without that growth strategy, the fiscal measures will not achieve their desired goal. We will simply end up chasing our tails, raising tax rates on a declining tax base and promoting deflation by combining tax increases, employment reductions, spending and wages cuts in a single year. Immediate measures to restore a degree of fiscal stability and reduce the budget deficit are necessary – but require a strong countervailing growth policy to restore the economy, and even to maintain those narrow fiscal goals.


Avoiding confusion on the structural deficit

It appears the government will formulate its fiscal adjustment plan around a target path for the structural deficit.  This is a good idea in principle.  But unless carefully managed it could be a recipe for confusion in practice, especially if assumptions differ from those in the Commission’s Stability Programme (March 2009). 

At present, there are differences in estimates of the structural deficit between the Department of Finance’s Addendum (January 2009), the Commission’s Stability Programme Opinion (March 2009) and the recent ESRI analysis.   Such discrepencies are not surprising given the difficulty of measuring potential output and the rapidly evolving revenue estimates.  Although the Commission’s estimates of potential output strike me as overly pessimistic, it would be wise to use Commission’s figures (suitably updated to incorporate revised tax projections) to anchor the fiscal plan.

The important point is that the government should try to achieve as much clarity as possible on its analysis of and projections for the structural deficit.  

Illustratrive contours of a possible plan:  The Commission projected a deficit of 9.5 percent of GDP for 2009.  They also estimated a structural-cyclical split of 8.1-1.4.  I assume the recent disappointing revenue numbers have added 2.5 percentage points to the ’09 projection.   In addition, the real GDP growth forecast for ’09 has been revised from -4 percent to -6.5 percent.  Using the standard methodology, the new structrual-cyclical split is 9.6-2.4. 

It is useful to distinguish between two elements in the fiscal plan.  First, the adjustment required to correct for the slippage in the structural deficit from the 8.1 percent target.  This is 1.5 percent of GDP.   Second, the plan for reducing the structural deficit from the 2009 target of 8.1 percent to 3 percent by 2013.

Fiscal Policy

Fine Gael Stimulus Plan

The Irish media has referred a lot in recent days to the Fine Gael stimulus plan, so I decided to go take a look at it. A one-sentence summary of the plan is that it would see the government borrowing an additional €11 billion over the period 2010-2013 and spending this on a set of energy, environmental and communications projects.

The plan is, to put it mildly, puzzling. The main source of funds is the Pension Reserve Fund, which our politicians (untrained in the sophisticated distinction between gross and net debt) apparently view as free money. In addition, the investments will be financed by a special bond issued to “the Irish public” and to “pension funds and international markets”. The plan states that the NPRF will be “replenished” with dividends from state companies carrying out these investments and from the sale of some state assets (of course, these state assets could be sold even without borrowing €11 billion).

I do not claim to be an expert in the microeconomics of Irish energy or communications markets, but it seems pretty far-fetched to think that these investments would pay back to the taxpayer at anything other than a very long horizon. I’d be interested to know what others think on this.

Next week’s budget will see the government raising taxes and cutting expenditure on front-line services, with painful adjustments totalling €4 to €6 billion likely to occur. However, few doubt that this adjustment is necessary. Against that background, the opposition’s plan to borrow an extra €11 billion to spend on a bunch of energy projects just seems to me to be very strange.

World Economy

Portfolio Magazine Profile of Dr Doom

Here is an interesting profile of Nouriel Roubini.

Banking Crisis

Sachs on the Geithner Plan

Jeff Sachs has a nice piece in the FT on the Geithner plan.  Sachs is against it and explains his objections with a very clear numerical example.  Of course, readers of this blog have seen this kind of thing here already but Sachs makes an additional useful point that hasn’t been discussed here.

It is no surprise that stock market capitalisation of the banks has risen about 50 per cent from the lows of two weeks ago. Taxpayers are the losers, even as they stand on the sidelines cheering the rise of the stock market. It is their money fuelling the rally, yet the banks are the beneficiaries.

This point is important in an Irish context because our government is discussing its own plan to overpay for bad bank assets.  It is natural for media commentators to interpret stocks going up as good news as usually this corresponds to good news about the broader economy. However, in this case, it should be remembered that stocks are just a claim of a particular group of investors on a particular sequence of future dividend payments.

Bank stocks rising on news that the government is likely to adopt such a plan—and probably rising a lot more if the plan is implemented—should be interpreted as good news for bank shareholders, but not necessarily as good news for the taxpayer.  There are better ways to solve our banking problems and analysis along the lines of “the market is reacting positively to the plan” misleads the public into thinking that plans like this represent good public policy.

Fiscal Policy

The Structural Deficit

Together with my colleagues Adele Bergin, Thomas Conefrey and Ide Kearney we have prepared a note that summarises the preliminary results of research under way at the ESRI examining the current macro-economic problems facing the Irish economy and the possible policy responses. The full analysis and results of this research will be published in the next ESRI Quarterly Economic Commentary to be published at the end of April. The note is available at

We estimate that the potential growth rate of the economy over the period 2005-2020 will average around 3 per cent a year. This estimate is derived from research undertaken using the HERMES macro-economic model. This estimate of the potential growth rate is substantially lower than the 3.6 per cent that was estimated as recently as last year in the Medium-Term Review, reflecting the damage done by the current crisis.

Over the period 2008-2010 the cumulative fall in output could exceed 10 per cent. Even with a potential output growth rate of only 3 per cent a year, this would result in a large output gap – the gap between the potential output of the Irish economy and the actual output. (Account is taken of the fact that there was a large positive output gap in Ireland before the recession began – i.e. output was above potential.) This means that when the world economy recovers the Irish economy would be expected to grow well above its potential for several years.

We estimate that the government structural deficit is in the range 6 to 8 per cent of GDP. It is important that the government in its April budget moves to substantially reduce this deficit. If such action is followed up with a further significant reduction in the budget deficit for next year, it could move to halve the deficit by the end of 2010. This would leave a quite manageable task of eliminating the remaining structural deficit by 2015. It would also provide room for manoeuvre if the world recovery occurred later than current forecasts would suggest.

While fiscal policy action this year and next year must substantially reduce the structural deficit, the total deficit could nevertheless be 10 per cent or more of GDP this year and next year because of the exceptional nature of the world recession and the resulting cyclical increase in the deficit. However, with rapid growth in the recovery period (2011-15) the cyclical element of the deficit would be eliminated by natural buoyancy in revenue and the reduction in unemployment consequent on a restoration of employment growth.

Economic Performance World Economy

The IMF and the Global Financial System

The first week of April sees two big economic events:  the April 7th Irish budget is preceded by the G20 summit on April 2nd.  There is an interesting article by Simon Johnson on The Atlantic’s website: you can read it here.

Economic Performance Environment

Greenspan on Irish Economic Recovery

Ronald Greenspan of FTI presented this paper to a Dublin conference this morning, with Brian Cowen in the audience:FTIgreenspandublin

Economic Performance Fiscal Policy

Improving the fiscal tradeoff

I apologise for yet another post on fiscal policy.  But it is better to err on the side of too much with crunch-time less than two weeks away.  I sense wide agreement on the two most pressing goals for the April 7 budget: minimise the contractionary impulse; and maximise the positive impact on creditworthiness.   Unfortunately, these goals tend to pull apart in terms of their implications for the optimal size of the adjustment.   I read much of the recent fiscal-related discussion on the blog as exploring ways to lessen this tradeoff.  It seems worthwhile to gather a number of the ideas together. 

(1)  Emphasise Type-1 adjustment (wage bill and transfer reductions) over Type-2 adjustment (tax increases and deferrals of positive net-benefit capital projects.  The international evidence (and arguably Ireland’s own experience) shows that Type-1 adjustments are better sustained and less contractionary.  This would allow either a smaller overall adjustment for any given target for creditworthiness, or a greater boost to creditworthiness for any given size of adjustment. 

(2)  Front-load certain structural deficit reduction measures but combine them with a temporary stabilisation offset.   Take immediate actions to lower the structural deficit to boost credibility.   Such actions could include increases in income tax rates or decreases in public-sector wages.   Combine these measures with explicitly temporary stimulus measures.   Possible measures include temporary reductions in VAT rates (which should move some expenditure forward in time) or temporary reductions in employer PRSI rates. 

(3) Pre-announce detailed plans for back-loaded structural deficit reduction measures.  In a post some time back I advocated a degree of “constructive ambiguity” on the details of out-year plans to raise taxes and cut spending.  I was rightly chastised for this economics heresy.   A detailed plan is critical to the credibility of the programme.  (I now put my hopes in liquidity constraints rather than myopia to lessen the contractionary effects of lower expected after-tax/benefit incomes.) 

(4) Reform fiscal institutions to enhance the credibility of future deficit reduction.   In general, credibility is improved by emphasising fiscal rules over annual discretion.   (An example would be a requirement to keep the pension system in balance over a long-time horizon.   Imbalances would require currently legislated actions such as indexing retirement age to longevity.)  It would also help to move to a system of multi-annual budgets. 

(5) Introduce a notional defined contribution (NDC) pension pillar.   This provides a long-lasting revenue injection with relatively benign demand- and supply-side effects.   Properly designed, it would not add to long-term fiscal imbalances.   It also meets a pre-existing need to improve retirement income security.   It should be a valuable component of an overall package from a union perspective.

(6) Formulate the plan in terms of a revised Stability Programme for the European Commission.  The plan should focus on achieving a 3 percent target for the structural deficit by 2013.   A focus on the structural deficit allows for a more politically robust programme and thereby enhances credibility.   It would also help to signal that the government takes its obligations under the SGP very seriously.

EMU Fiscal Policy

Trends and Cycles in the Irish Economy

The shift in the fiscal debate towards a focus on the structural deficit as the key target has thrown up some interesting issues about how to think about trends and cycles in the Irish economy, plus their implications for the fiscal position.  It is certainly true that the current downturn has a big cyclical component: Minister Lenihan this morning suggested a current forecast for 2009 of about negative 6.5 percent growth in GDP.

However, it is also important to appreciate that forecasts of potential output growth for Ireland have also deteriorated.  In Autumn 2008, the European Commission projected potential output growth for Ireland of 1.6 percent per year in each of 2009 and 2010.  In the March 2010 analysis of the Irish stability programme, the European Commission’s projections for Ireland’s potential output growth had declined to negative 0.4 percent in each of 2009 and 2010: a two percentage points swing in each year.

Accordingly, it is useful to bear in mind that the current downturn involves a substantial negative shock to supply capacity,  in addition to the level of aggregate demand.  One factor relates to unemployment: increases in unemployment are difficult to reverse.  For Ireland, another factor is out-migration. Through these channels, there is a feedback effect whereby sustained declines in activity negatively affect longer-term supply capacity.

There are several implications to consider.

1.   Since the cyclical sensitivity coefficient of the budget deficit in relation to the output gap is 0.4,  an output gap in 2009 of  6.1 percent (- 6.5 percent recession relative to potential of -0.4 percent) means that the cyclical component of the 2009 budget deficit is approximately 2.5 percent.  Everything about 2.5 percent is structural.  [By the way,  2008 output  is estimated as being just above potential output: the 2008 recession just returned Ireland from a level of GDP that was well above the estimated potential level of output.]

2.  Clearly, in a deep recession, it can make sense to run some level of structural deficit as a ‘discretionary’ fiscal impulse to counter the decline in other components of aggregate demand

3.  It is also true that initial conditions matter: since we entered the recession with a sizeable structural deficit, it does not make sense to eliminate it too quickly.

4.  The March 2009 European Commission document that records the 9.5 percent deficit target also projects the output gap for 2009 at 4.5 percent.  If we update the output gap forecast to 6.1 percent, then allowing the automatic stabilisers to work means that the same target for the structural deficit would mean a revised overall deficit target of 10.2 percent (approximately).

5.  The implicit target for the structural deficit behind the 9.5 percent overall deficit was 7.7 percent of GDP. This is the challenge for the government to bring that number down over the period to 2013.

6.   It is imperative that as much as possible can be done to improve potential output growth:

(a)  A key challenge is to get unemployment down.  The various ‘activist’ labour market policies to fight unemployment that are currently being debated are worth serious consideration.  As I have argued in several previous posts, fostering rapid wage adjustment is highly desirable.

(b)  In designing the new tax system,  the promotion of labour supply is a key consideration. This is relevant in terms of the integration of tax and welfare systems for low earners and in terms of the tax treatment of highly-mobile high-skill types (maybe not so mobile in 2009 but more outside options may arise in 2010-2013).


The Autumn 2008 European Commission data are here.

The methodology behind the estimation of potential output (plus the estimates of cyclical elasticities) is here.

Economic Performance

Implications of QNA Release for 2009

As I noted before, the Irish media and forecasters tend to focus on the year-average over year-average figure for GDP growth (averaging the four quarters of 2009 and comparing that to the average of the four quarters of 2008).   This figure is important for thinking about things like income tax revenue, which is levied on a calendar-year basis, but it can be misleading as an indicator of the economic growth taking place in the economy during a particular year.  This is because if GDP has fallen a lot coming in to the year, then the average level may be lower than the previous year, even if GDP starts to recover.

This situation exactly applies to measuring the Irish economy right now.  In news that will hardly be surprising to anyone who reads a newspaper, today’s QNA release shows that Irish GDP fell off a cliff in 2008:Q4, with seasonally adjusted real GDP falling 7.1% in 2008:Q4 relative to 2008:Q3—not at an annual rate.   This “base effect” will make the average-over-average figure for 2009 a very poor measure of underlying economic growth.  Here’s some quick calculations.  If Irish GDP stays at its 2008:Q4 level throughout the year (i.e. if we hit bottom in 2008:Q4 and managed to stay there for the year), then average-over-average GDP growth for 2009 would be exactly -5%.

Of course, all the incoming statistics suggest that the economy continued to contract rapidly in the first quarter this year—At 10.4 percent in February, the umployment rate has already risen by 1.8 percentage points since the December level, compared with an increase of 1.4 percentage points between September and December.  If GDP posted another 7 percent decline in 2009:Q1, then even a flat level of GDP for the rest of the year would imply an average-over-average growth rate of -11.6%.

An optimistic scenario would hope that the unemployment figures in the first quarter represent more of a lagged effect and hope to limit declines in the first half of the year to two percent in each of the first and second quarters, followed by a return to growth at, let’s say, a 3 percent annual rate.  This would still imply an average-over-average growth rate of -7.8% for 2009.

I think it’s time for those that use the average-over-average figures to revise their forecasts down.

Economic Performance

Q4 2008 Macro/BOP data from CSO

The CSO has released new data today in relation to Q4 2008 and preliminary annual data for 2008.  As per Karl Whelan’s preference,  I will briefly focus on the Q42008-Q42007 annual changes.  The year-on-year decline in GDP is 7.5 percent (GNP declined by 6.7 percent).    The current account has declined from a Q42007 deficit of 5.8 percent of GDP to a trivially-small deficit of 0.3 percent of GDP in Q4 2008.

The National Accounts data release is here.

The BOP data release is here.


Brian Lucey honoured

Brian made it into the global Top 200 Young* Economists according to IDEAS/RePEc

*Active for less than 10 years

Economic Performance Environment

Irish trade statistics still looking good, but…

Kevin O’Rourke has drawn our attention on a number of occasions in this blog to the collapse in world trade and its implications for the depth of the recession. Yesterday, the Financial Times reported that the World Trade Organisation was predicting a 9% drop in the volume of world goods trade this year, the largest drop since the second world war. Today, it reported that Japanese exports have halved compared to a year ago.

Against this backdrop, Irish external trade statistics have been remarkably healthy, albeit two caveats are in order. First, although Japan can report its February trade statistics today, the latest trade statistics on the CSO website (last updated 27 February) refer to December 2008. Presumably the January figures should be published in the next few days. Second, we only get monthly trade statistics for merchandise trade, even though the value of services exports is now about 75% of the value of merchandise exports, so the merchandise trade statistics only tell half the story.

EMU Fiscal Policy

The FT on Ireland

The Lex column in today’s print edition of the FT was pretty sniffy about the Irish public finances.  However, it is interesting to read the new contribution by columnist Quentin Peel who does a ‘compare and contrast’ between Ireland and Greece, praising the Irish government for at least trying to face up to its predicament.

Banking Crisis

A Geithner Plan for Europe

 The lending performance of Irish and other European banks might be improved by the creation of asset management companies to absorb banks’ toxic assets and replace them with cash or near-cash assets.  The types of toxic assets held by banks differ across European countries; they are mostly bad property loans and collateralized-mortgage-based securities.   

There will be a considerable decrease in banks’ accounting book value when it sells toxic assets for cash value since the toxic assets are being carried on the banks’ accounting books for more than their true market value.  The decrease in accounting book value, which will come out of the banks’ book value of equity, has to be modest enough so that the banks are not declared insolvent after the transaction.

The Geithner plan offers a valuable template for Europe in designing a toxic asset transfer scheme. The Geithner plan invites private firms to bid competitively for the toxic assets of US banks. The funding for the bids come from three sources: equity provided by the bidding firm of 3% to 10% of total capital provided, an equal amount of equity funding provided and owned by the US government, and a non-recourse US government loan for the remaining 80-94% of capital provided.  The required yield on the nonrecourse loan will be somewhat underpriced  relative to its risk, so there is some degree of subsidy.  This is necessary to make the plan work; this entire subsidy should in theory accrue to the selling bank and shore up its capital base.  This is the only subsidy in the plan.

Since the US government will own up to 97% of the asset management companies’ assets, there is considerable financial/administrative/legal expertise needed by the government to provide reasonable oversight of these asset transfers and subsequent management of the assets.  This could make such a plan problematic if implemented by Ireland on its own.  Also, it is critically important that there are multiple bidders, competing aggressively against each other in the toxic asset auctions.   Additionally, the nonrecourse loan must come from a government entity borrowing at risk-free rates (and then lending to the asset management company at a higher rate).  It is a clever type of “targeted quantitative easing” (my own term).  Ireland is not in a position to borrow vast sums to purchase the toxic assets of its own banks.  The targeted quantitative easing should come from the sovereign issuer of our currency.

This is a great opportunity for the European Central Bank to play a role as a true regional central bank.  It can easily provide the non-recourse debt in a European version of the Geithner plan.  National governments can be responsible for the matching equity investment, and the ECB can provide the oversight, along with national governments.  Implementing the Geithner plan in Europe would also appease the US government which wants to see some burden sharing by European governments in dealing with the credit-liquidity crisis.

Krugman feels that the Geithner plan, although moving in the right direction, is too weak to be effective. However if the EU joined the US and instituted a very similar plan there might be a positive-feedback effect on confidence and liquidity which could boost the global impact.     


Name a famous Belgian

As I was reading this excellent post by Brad Setser, I found myself thinking of Robert Triffin. And then I followed Setser’s link and found that that governor of the People’s Bank of China was explicitly stating that “The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists. ”

The Chinese are clearly getting worried, which is an important fact in itself. And what a world we live in, when a Communist central banker can come out so clearly in favour of Bancor!

Now, I guess you could argue that the role of China in the past few years has been much less passive than the Triffin analogy would suggest. Setser obviously thinks so. But it is good to see China putting proposals on the table whose ambition and multilateral orientation are appropriate to the scale of the current crisis. At one level, Zhou seems to be saying “give us some other reserve currency to hold, and the dollar can depreciate as much as it wants.” At another level, there is the proposal to partially pool reserves in the IMF, which would be “more effective in deterring speculation and stabilizing financial markets”. I would be fascinated to hear what people think.

Fiscal Policy

Retirement postponed

The English language has many ugly expressions about the Dutch. Most go back to the 16th and 17th century, when there was intense competition and armed conflict across the North Sea. Dutch Disease is a more recent expression. Having suffered the consequences first-hand, my definition is not the standard textbook one. The crucial elements, to my mind, are a bloated public sector that crowds out the private sector, a nasty external shock that exposes the weaknesses of the economy, and incompetent politicians who make things worse.

For the current predicament of the Irish economy, it may therefore be useful to look at the solutions offered by the Dutch government. Since the early 1980s, there has been a broad political consensus on how to run the economy, and the Dutch economy has fared well as a result. The plan announced last night is not particularly impressive. There are four options to partly restore order to the public finances, but implementing all four would be too much.  Three of the four options are politically tainted for one of the three parties in the governing coalition. In a coalition, all three have to swallow their price or none will. So, only one option will be implemented, and the fiscal balance will be worse than needed.

The one big measure is a clever one, though. The retirement age will be raised from 65 to 67 years. This increases taxes and reduces expenditures. It also means reduced trouble for pension funds, so that contributions (and labour costs) do not have to go up that much. It does of course increase unemployment in the short run, but on balance I would think this is a positive development.


Olivier Blanchard in Les Echos

Olivier Blanchard does not pull his punches here. European governments were too slow to realise how serious this crisis is, and they are not doing enough. Thanks to Eurointelligence for the pointer.

Banking Crisis

The Geithner Plan: Quick Numerical Example

Calculated Risk links to video of Austan Goolsbee of the White House Council of Economic advisers, discussing how the Geithner plan aligns the incentives of the public and private sector participants.  I had dubbed this idea a fib but Goolsbee makes it sound plausible: “if the private guy makes money, the government makes money. If the private guy loses money, the government loses money.”   CR links to an example that explains how this plan could still see the private guys make money and the government lose money but it doesn’t explain how the price gets set, which is sort of the crucial issue.  So, here’s a simple numerical example that shows how the price gets set.  The point is probably pretty obvious, but I found it self-instructive to work through the figures.

World Economy

A sign of conflicts to come?

Remember last spring? It seems an age ago now. The fear then was of resource scarcity: of rising oil prices, and of rising food prices, as biofuels crowded out food production and population continued to grow. Environmental worries also reflect resource scarcity, albeit of another type. Once this crisis is over, whenever that is, all these concerns will inevitably come back on the agenda, and could easily dominate it for the rest of the century.

In that context, one of the most alarming news stories, to me, of last year, was that involving Korea’s Daewoo Logistics leasing almost half of Madagascar’s arable land on a 99 year basis. Here is a pretty positive account of the deal in Time magazine. Why my alarm? Because the deal reflected the fact that

“[Food-importing countries] have lost trust in trade because of the price crisis this year,” says Joachim von Braun, director of the International Policy Food Research Institute in Washington.

Thus, from a Korean point of view,

“We want to plant corn there to ensure our food security. Food can be a weapon in this world,” said Hong Jong-wan, a manager at Daewoo. “We can either export the harvests to other countries or ship them back to Korea in case of a food crisis.”

The latter quote, taken from this FT piece, should send shivers down the spine of anyone with a sense of history. (The article also makes it clear that the agreement was far less positive for Madagascar than had at first been reported.) Markets are a political institution. The deal they represent is straightforward: if you are willing to pay the going price, then you can buy what you need. When countries start to doubt whether that deal will remain valid going forward, and in consequence act to carve out sources of supply for their own exclusive use, the geopolitical consequences can be catastrophic.

As I contemplated this story, I idly wondered what would happen if, in a decade or two, some African or Latin American country decided that it wanted to renege on such a deal which had been struck by a previous government with, say, China or India. And so it was with considerable interest that I read this from the BBC. I don’t suppose the Koreans will invade Madagascar! But one can predict that this will not be the only occasion on which such a domestic backlash occurs. Why on earth would anyone assume otherwise?

The moral is straightforward. In addition to tackling the underlying problems of resource scarcity, we need to credibly commit to keeping international markets open over the decades to come. And in order to be able to do that, governments need to get the macroeconomics right, now. Otherwise, as the example of the Great Depression shows, this will just be a taste of things to come. And that won’t just be bad news for the economy.

Banking Crisis World Economy

Geithner Plan Published

Official details here and here. It’s pretty much as I described yesterday and I’m no more impressed than before.  In particular, it hardly takes a corporate finance expert to figure out that “The equity co-investment component of these programs has been designed to well align public and private investor interests in order to maximize the long-run value for U.S. taxpayers” is a bit of a fib.   Funnily, toxic (or troubled) assets have now been renamed “legacy assets”!  This terminology might be appropriate if we were dealing with newly-cleansed banks with new ownership and management.  However, as I’m reminded every time I see this man’s happy smiling face, that just ain’t the case.

EMU Fiscal Policy

On the 9.5% Budget Deficit Target

In my comments on John McHale’s recent post and also on the radio at the weekend, I suggested that the government should probably stick to the 9.5% target set out in January’s Addendum document.  While the document did not contain details about how the government was going to make these adjustments, it was still a clear commitment to stick to a particular path to get back towards a 3% deficit by 2013.  If three months later, we were seen to already be well off these targets, the concern would have to be that the international bond market would judge us as being incapable of sticking to a plan.

However, having thought about this a bit, I’d be inclined now to argue that there probably has been so much slippage already this year that sticking to a 9.5% target for the calendar year 2009 may not be a good idea. My impression now is that the implementation gaps in getting the changes in the April 7 budget made effective will mean that we will only see about half of the budgetary improvement that these measures would bring in a full calendar year.  So, for instance, suppose that without adjustments the deficit is likely to be 13.5% for 2009. In that case, getting to 9.5% for the year would require 8 full percentage points of full-year-equivalent adjustments.

A better strategy would be to make adjustments that leave the government running an effective deficit in the second half of the year of 9.5%, and so facing into the 2010 budget in exactly the position that they had promised to be in.  In the example of a no-adjustments deficit of 13.5%, this would amount to running a deficit for 2009 of 11.5%, which could be interpreted as 13.5% for the first half of the year and 9.5% for the second half.

In a sense, this is a recommendation to government as to how to “spin” an outcome which looks like slippage from the January plan as still being, in a sense, consistent with it.  Beyond that, those economic commentators that will want to criticise the government for failing to meet its own plan, if indeed it announces a target higher than 9.5%, should keep in mind that meeting this target would require starting 2010 with a budget deficit well below what was envisaged in that plan.

Banking Crisis

Why Should Geithner’s Auctions Work?

According to the New York Times, pools of distressed mortgage-related assets of US banks have been 30 cents bid, 60 cents offered, in recent weeks. The bidders are hedge funds, the potential sellers under-capitalised, but State-guaranteed, US banks.

The Geithner plan appears to include a new type of investment vehicle with capital structure 3% private equity, 12% taxpayer equity, and 85% debt, also provided by the taxpayers. The holders of the 3% private equity would provide management and would bid for the distressed assets at auction. The expectation is that they would bid more than 30 cents on the dollar, thus improving banks’ balance sheets.

If the State equity is fully participating, it changes nothing from the standpoint of the fund manager. Only if the 85% debt is available at terms better than debt currently available to the hedgies (who will bid no more than 30 cents) can the plan work. The NY Times says that the 85% debt will be non-recourse, which certainly helps, and that it will be ‘cheap’, details to follow!. If it is provided at anything close to T-bill rates or short Treasury note rates, it’s a steal, and the Geithner hedge funds will of course bid more than 30 cents. I suspect that 85% non-recourse lending to distressed-asset hedge funds is not available at non-stratospheric prices right now. This is not a certainty-equivalent game since nobody knows the true value of the distressed assets, but cheap, non-recourse leverage will improve the bid price for any plausible distribution of returns.

The government could achieve the same objective by lending cheap non-recourse money to existing hedgies, unless I am missing something. But this would lack opacity. The critical economic component in all of these plans (including bad banks and insurance schemes) is the distribution of gains and losses. The critical political components appear to be fig-leaf involvement of private equity, the avoidance of overt nationalisation, and non-transparency.

Fiscal Policy

More on Cyclical versus Structural Components of the Fiscal Deficit

My previous post highlighted that the structural component of the budget deficit is relatively high. Right now, a return to economic growth will not deliver big revenue gains,  in view of the reduction of cyclically-sensitive income taxes over the last decade, such that the cyclical element in the budget is measured as low.

One feature of the upcoming fiscal adjustment could be to shift the attribution of the overall deficit between structural and cyclical components.  In particular, if cyclically-sensitive taxes are increased, then the cyclical component of a given deficit will increase and the structural component will decrease, since economy recovery will then ‘do more of the work’ in returning the overall fiscal balance to good health.

That is, a X percent deficit reduction package could translate into an X+Z improvement in the structural deficit and an X-Z improvement in the cyclical deficit.   This is relevant, since the key target should be to reduce the structural deficit.

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Thoughts on the Geithner Plan

Details of Tim Geithner’s plans for dealing with toxic assets at US banks have been leaked: The New York Times article is here. From an Irish point of view, these plans are of interest not only as an example of how another country is dealing with its banking problems (the Minister for Finance has explicitly stated that he intends to learn from the approaches taken elsewhere before launching an Irish plan) but also because a successful resolution of the US banking problems seems like an essential ingredient in getting a world economic recovery going.

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Some Guiding Principles for the April 7th Fiscal Adjustment

Without attempting to be comprehensive, here are a few principles that are worth considering in designing the April 7th fiscal package:

1.  The size of the multiplier.   The current empirical literature on fiscal policy throws up a lot of estimates. Some considerations:

(a)  Anticipated fiscal policy versus unanticipated fiscal policy.  For a few months, Irish taxpayers have been living with a firm expectation that taxes are set to increase, albeit with considerable uncertainty about the allocation of the tax increases.  The sharp fall in consumption that has occurred has many sources but expectations of future tax increases is one reason. Accordingly, the extra impact on aggregate demand of raising taxes on April 7th will be less than in the case of an ‘unanticipated’ fiscal shock (the bad news has already been digested to some degree).

(b) The composition of spending cuts and tax increases.  The short-run and long-run impact on the economy varies across the different spending and tax components:  the aggregate multiplier effect depends closely on the precise details of the package.

(c) A positive slope for expenditure taxes.  While it is certainly important that extra taxes are collected in 2009, it is also important to be as specific as possible about the tax schedules that will be in place in 2010 (and beyond). In particular,  2009 expenditure tax rates that are credibly below 2010 expenditure tax rates will be supportive of aggregate demand in 2009 (forward shifting of expenditure plans to 2009).

2.  The fiscal target.

(a) In line with the suggestion of Patrick Honohan, the key fiscal objective should be to reduce the structural deficit within a reasonable time period. While there is uncertainty about the precise size of the structural deficit, it is sensible to take the 9.4 percent of GDP estimate that is adopted by the European Commission. Pushing the structural deficit towards zero over a 3-4 year period should be the guiding principle.

(b) If the correction of the structural deficit is accepted as credible, then some passive fluctuation in the overall general government balance can be tolerated, in line with cyclical developments in the economy. Otherwise, if the government simply targets the overall balance, it faces the problem that further unexpected cyclical bad news will either force it to pursue more within-the-year adjustment or miss its announced target.

(c) In communicating its strategy to fellow European governments and the European Commission, this technocratic distinction between structural and cyclical components must be ‘front and centre.’  The good news is that the  set up of the Stability and Growth Pact and the monitoring conducted by the European Commission takes such distinctions very seriously and the ‘framing’ of the analysis in this way would be a very natural communications strategy in this context.

3.  Front Loading.  In an ideal world, it is better to make structural reforms during good times. It would also be better if Ireland had entered the crisis with a sufficiently large budget surplus that a large budget swing could be happily tolerated, with fiscal correction deferred until the recovery takes.  However, there are domesic and international factors that support making substantial inroads in the structural deficit in 2009:

(a) Funding Risk.  While there are arguments that can be made that Irish bond spreads are an over-reaction to the fiscal/banking situation, we have to live with the judgement of the bond market. Moreover, the risk of ‘contagion’ from possible problems in Central and Eastern Europe should be acknowledged.  While such risks are hard to quantify, the high costs of funding crises justify prudential action to mitigate these risks.

(b) Signalling.  While the government has implemented some degree of fiscal tightening since Summer 2008, a central source of scepticism in the international markets is whether Ireland can make the switch from a long period of easy fiscal conditions to substantial fiscal retrenchment. The most credible way to demonstrate this capacity is to implement tough decisions.

(c) Domestic Political Economy.  By now, the level of awareness of the fiscal problem is much higher among the electorate than was the case in Summer 2008. It is timely to make a significant step forward in the process of restoring fiscal stability.

4.  Commitments about the Future.

(a) The tradition in Ireland has been to focus on an annual time frame for budgetary policy.  It would greatly help if the April 7th package could include credible commitments about taxes and spending plans in 2010 and beyond.  To be credible,  the announced tax increases and spending cuts for 2010 and beyond should be as detailed as possible, in order to minimise ambiguity. Moreover, the more credible is the ‘2010 and beyond’ element in the adjustment programme, the smaller needs be the initial fiscal adjustment in 2009.

(b) It is here that the opposition parties have an important role to play, since the period of fiscal retrenchment will likely extend beyond the next general election (whenever that is called).  It would greatly calm the markets if the opposition parties could be clear about which elements of the spending/tax package would not be overturned if the composition of the government changed.  The historical example is the promise by ‘New Labour’ before the 1997 election to maintain the fiscal parameters of the outgoing Conservative government for it first few years in office.

(c) Credibility about future fiscal plans could be boosted by institutional reforms that would make it more difficult for the government to deviate from its fiscal commitments.

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The Path to Economic Recovery

In this article in today’s Sunday Business Post, I analyse some of the factors that are required to ensure that the economy resumes positive growth within a reasonable time period.  I focus on non-budgetary and non-credit elements, since those issues are receiving plenty of attention.  In turn, the restoration of fiscal and banking health will be greatly facilitated by more rapid real-side adjustment. (I will contribute to the fiscal debate in another post.)