Asset Booms and Structural Fiscal Positions: The Case of Ireland

Daniel Kanda has written a new IMF working paper on this topic: you can download it here.

Summary: Asset booms and sectoral changes can distort traditional estimates of structural fiscal revenue, and could lead to serious fiscal policy errors. This paper extends the estimation of structural revenues to take account of asset prices and sectoral changes, and applies this to the case of Ireland, where a property bust has revealed a large hole in the public finances. It is shown that excluding these factors led to a substantial bias in the estimation of structural revenues, and the structural balance prior to the crisis was much larger than earlier estimated.

19 replies on “Asset Booms and Structural Fiscal Positions: The Case of Ireland”

@ Philip,

I have a keen awareness of the fact, that property is very opaque. But I had often seen property as opaque only from the point of view of finance, i.e. borrower(s) and lender(s). But I had never considered the opacity of property markets, from a point of view of fiscal policies. I will look forward to reading the IMF working paper. I wrote a few words quickly about NAMA here today:

You will see a quote from late September 2009 at the end of that blog, where former Taoiseach Ahern expresses his regret for the build-er(s). At least NAMA does paint it on the wall, for all of those in government to understand. I.e. Don’t expect any cushions to come from property related activities any time soon. The danger I suppose then, is the minister for finance might cut things back too bare. This was former deputy Lee’s argument I think. We need to play more hard-ball with the EU in terms of our budgets, until we can figure out, how our financial system can be overhauled to plug back into the Euro zone, super-grid. Obviously, the management of Irish banks up until this juncture, were not trained or in a mind to overhaul anything. Just bonuses and perks, business as usual, as it had been for the past century. Different game now. BOH.

So, Ireland’s fiscal and GDP/GNP position was hugely and unsustainably inflated for many years, government spending became dependent on unsustainable revenues and not sustainable revenues, and this led to a gigantic fiscal disaster when the unsustainable did what unsustainable does – and ended. Is that the crux of it?

The article seems to say something that Michael Hennigan of Finfacts and others have been hammering on about for years….and which most people have only realised more recently…that the construction part of the economy was already too hot before 2002, and became entirely lunatic afterwards.

I’ve audited too many business models where fiddle factors were combined in ways intended to prove that pigs could fly to accept the detail without seeing the data, but overall an interesting read.

This is an interesting paper and it supplements the work undertaken in the Central Bank by Addison-Smyth and McQuinn, referenced in the paper. However, the output gap estimates used in the paper are not necessarily internally consistent. This is because they are derived on using a moving average process using forecasts out to 2014 to get over the end point problem. The calculations are done on a disaggregated basis.
The methodology used in the paper implies that in returning to “potential” there will be a substantial increase in the exports to GDP ratio (Figure 4), a small rise in the consumption to GDP ratio and a very big fall from peak in the housing investment to GDP ratio. Taken together these would imply a very big balance of payments surplus. This surplus would, in turn, reflect a big gap between domestic savings and investment. The counterpart to this balance of payments surplus would be a large net acquisition abroad of financial assets (or repayment of debt) by the private sector. While such a trend might be expected for a number of years after the bust, for it to continue indefinitely would not be consistent with past behaviour by the private sector.
If, as seems more likely, the balance of payments would revert to balance in the medium term this would imply a higher level of economic activity than is assumed in this paper. In turn, this would imply higher potential output, higher government revenue in the medium term and some reduction in the structural deficit as estimated in the paper.

@John Fitz.

Is it not the case that Ireland’s private sector debt is among the highest in the world and that there’s going to be many years where net debt repayment – mostly to non Irish creditors – is a feature of the Irish scene?

‘In Ireland’s case, this bias, which made the revenue prospects seem much rosier than they actually were, helped stimulate an expenditure relaxation that created a large hole in the public finances that
will take several painful years to close.’

Well, well! Who’da thought? Whose pain though?

@ HS: ‘Is it not the case that Ireland’s private sector debt is among the highest in the world and that there’s going to be many years where net debt repayment -…?

Yep! Can’t see it (the debt) ever being paid down. Aggregate output, which would generate a sufficient surplus, is not possible since that output surplus would have to be consistently above the level of the exponentially incrementing debt. This is the predicament which has been gestating for many decades now. Funny that so few commentators don’t mention this conundrum. They don’t know? – or won’t say?

Oh! That Knowledge Economy bit they keep on about. Rumour has it that China has as many un-employed PhDs as the population of Ireland.

B Peter

@ Hugh Sheehy,

EU structural grants to Ireland, were prevalent in the Irish economy in the 1980s, pettered out some time in the 1990s, because Ireland was deemed too wealthy by the EU. Those structural EU grants that came into Ireland and did not cause high levels of private sector debt. Even though they stimulated the economy a great deal. It was a more benign way, for Ireland to fund itself. It was a sustainable financial infrastructure of sorts. I think it underpinned much of the first phase of the Celtic Tiger. The early EU structural grants were Deutschemarks, plain and simple. The capital that poured into Ireland in the second phase of the Celtic Tiger, especially post 2002 and single EU currency, was also Deutchemarks. But it was a much different kind of stimulus. German banks, with savings buying Irish banking bonds. This allowed Irish banks to leverage more and to create more private debt fuelled growth. Bear in mind, that Dr. Peter Bacon’s reports on the housing market where published in 1998, at the end of the first phase of the Celtic Tiger. By 1998, there was evidence that first time buyers were competing with investors/speculators in the market. Then in the second phase of the Celtic Tiger, the government began to encourage the building boom (incentive-isation schemes). Because the Irish government were using the boom as a means of borrowing vicariously, through lop-sided, property related fiscal policies.

Nowadays the European Commission has retreated to some kind of high moral ground. One where their role is to prevent fiscal/financial disasters and penalise whole countries. This is the way I see things. Always ask a question, is it infrastructure, or is it innovation? Working along the lines of Vince Cable, author of The Storm. If it is infrastructure, assist through government. If it is innovation, allow it to wind down etc. Contrary to what Irish economists seem to think, shareholders in Irish banks fall into the category of infrastructure, (at this particular moment). You see you have to dispense with the default rules of economics and go back to first principles, what the default rules derive from. Small Irish shareholders were here supporting our banks long before the single EU currency. Many bond holders on the other hand, rushed into Ireland, post 2002, eager to open up the new market for debt. (Ireland is the country of the future and always will be) At the moment, I do regard bond holders as financial innovators. (The single EU currency itself was delivered as an innovation, rather than an infrastructure and therein lies the problem – for example, global positioning system is a platform upon which lots of companies innovate) There was nothing that small Irish shareholders in AIB or BOI did in last 50 years that was new. But when we sort out the mess, this will all revert back to how it should look – like in those text books that Irish economists read. I.e. Bond holders provide the safe infrastructure, and shareholders are the ones who fleet about and make opportunities possible. Moving on the faster parts of the financial system. If you look at it, the Irish government borrowing vicariously through the property bubble, which was fuelled by Deutschemarks which flooded in, post 2002 via bondholders and loose monetary policy by the ECB during the same period. I see that crazy post 2002 system as a woefully bad innovation, not an infrastructure. The ECB didn’t get it right then, and now they are afraid of egg on their faces. BOH.

(haven’t read the paper yet but commenting based on the extract) i think that the obvious answer is to shift the where revenue raising comes from to a less volatile, non-transaction based (in terms of the property element of revenue raising) system, having said that, a property tax – which will hopefully be based on site values as opposed to market or rental values – would need to be met by a reduction in income tax.

The structural issue extends beyond property alone, many of the revenue streams are tied into each other, VAT, income tax and other revenues have all dropped rapidly, so perhaps it is also about internal balance as well as shifting the tax base.

Karl Deeter says:

The structural issue extends beyond property alone, many of the revenue streams are tied into each other, VAT, income tax and other revenues have all dropped rapidly, so perhaps it is also about internal balance as well as shifting the tax base.

No doubt about that.

Of course, lets not forget that taxation has a dual function. (1) To collect revenues and, (2) to collect information. In relation to the property tax, I reckon that most advanced EU member states, have got wise to (2) a long, long time back. The tax on property has huge benefit, if I am not mistaken, in that it affords decent information to policy makers, and analysts. Allowing them to identify trends over time etc. I heard a comment made recently by sustainable energy Ireland, at a talk. You take the value added tax off of building materials, to help fuel growth in energy retrofitting – but then, heck then you don’t know what is being used to build anymore. There are huge dangers of products arriving in the country, that aren’t traceable. No small matter where living environments are concerned, and architect professionals etc have to sign off. Agriculture appears to suffer some of the same problems – was listening to a member of Teagasc talking about biofuels, biomass etc. Supply chains, cheap food, world markets etc. Food is very complex indeed, it seems multi-faceted. I described the kind of balancing act, the department of environment has to try and do to implement new green policies in the linked comment. Apologises to John McHale, if I was being blunt – it was probably a long day!

I didn’t know until recently that development levies attached to planning permissions from local authorities are a basic attempt to do land value taxation, to affect market behaviours somewhat. But going back up to the point I made above – that so much private debate was created in the post 2002 phase of the Celtic Tiger – I found it interesting, as easy as it was to borrow as a private company, (and they did rack up billions of euro) many of those private companies were reluctant to pay the development levies, seeing them as unfair. When in reality, the land tax, could help them as land was a factor of their production model – property development. A more stable land market could only be better from their point of view. But it is funny, they didn’t see it like that, I was amazed. It was often commented also, of one of the big, big retail businesses in Ireland – you couldn’t fool them, where pennies were involved. But in the bigger sums, they weren’t as clever. BOH.

The pension discussions on the radio, and in newspapers etc this week were quite interesting. A very fine balance to strike with those kinds of schemes too. How come everything is coming at us all at once here on this island? Maybe that is what has drawn so many economic brains together in one place? Shell shock mainly, I reckon. BOH.

apart from the fact that I have a big problem understanding your note since the commas confuse me, what I do understand of your “innovators” and “infrastructure” split seems to be nonsense….

@ Hugh Sheehy,

What I think is nonsense is the way the financial infrastructure of Ireland as a country has been allowed to collapse, and no one seems to care. That is what is really nonsense, whatever about the confused ramblings of a moan-y, overly political protests of someone such as myself. If you ever studied the battle of Waterloo, involving Wellington against Napoleon, you will notice the presence of 2 no. farm house structures either side, at the top of the hill Napoleon advanced against that day. Basically they were canon and musket foder, but they proved to be very effective on the day. The bond holders in the battle against the Irish taxpayer, have used the shareholders of AIB and BOI in the same way. We are diverting most of our time/resources, on 2 no. minor economic/political battles with €2.0 millions worth of shareholder capital – instead of removing them from the equation and getting on with the confrontation proper. BOH.

What I think is nonsense is the way the financial infrastructure of Ireland as a country has been allowed to collapse, and no one seems to care.

Put it another way – we are obsessed in Ireland with the effort to save the banks. We should not be trying to save banks. That is a big waste of time. Banks are entities which gain in value, because they do something special or clever on a pre-existing infrastructure. Our infrastructure in Ireland is shot. What we should be asking is why has our financial infrastructure collapsed? What are we doing to ensure this does happen again? Why isn’t some infrastructure (temporary or otherwise) in place to allow the economy to function? This attempt to save the banks in Ireland is misguided. Why? It will not work. Why? In order to re-float Irish banks, they would have to become innovative. So that someone, somewhere could deem them potentially valuable to invest in. The Irish banks are not innovative, nor will they be very soon. Hence, the effort to save them is futile. Even if they were, and we could re-float them, it is still the wrong way to go about solving the problem. The problem is building of a robust financial infrastructure, not re-building of banks. If the Irish hope they can get some kind of an infrastructure, by going about it the wrong way, by attempting to re-build the banks, then okay. But the effort is still misguided in my humble opinion, in 2010. In 2010, you can set up a bank, and have it up and running cheaply and very easily. That is not the hard part, like we are making it out.

A good book to study is Stephen B. Johnson’s, The Ghost Map. In the past, they did not understand how diseases such as cholera spread. They believed it happened through smell. But some clever person got an bright idea of making a map. Shortly after, the causes of the cholera outbreak were traced back to a single infected drinking well in the city of London. (In the 1850s, London was the biggest city in the world) Once the cholera problem was understood properly, it paved the way for safe development of cities in many parts of the world. Lots of innovation subsequently happened within cities. Once the drinking water problem was solved, people did not think of cholera as a major constraint upon urban life anymore. It is a similar story with the financial system in 2010 – we need the ghost map to figure it out. We are currently trying to attribute causes to smell, rather than making maps. The global positioning system, was set up as an infrastructure. Everyone can conduct business and drive innovations on that basic platform today, at much less expense. BOH.

B Peter
U crack me up!

BOH Just a punter
Deflation, guys look it up! Deflationary spiral. Look that up too since neither of you read my posts. Debts get worse and worse! And worse as all earnings go to debt repayment……

A quote from John McHale’s Irish Times article of March 5th 2010.

We should not compound the mistakes of a history of pro-cyclical fiscal policy by cutting capital spending just when it makes most sense.

It is also worth having to listen to this podcast, available to download on RTE’s website.

The Government’s Banking Strategy.
22 February 2010
Richard Bruton, Fine Gael Finance Spokesperson and Jim Power, Economist Friends First.

It is interesting to note, that for all of the billions invested in construction by private build-er(s) in Ireland, how little real collateral is attached to those loans now. As Brian Lucey and others have pointed out before, developers would often acquire a license to develop, instead of title. Which means, in the evaluation process for NAMA, we are discovering the brutal truth as it stands.

Does anyone find it interesting or annoying, the fact that so much private debt was accumulated for a small nation, in acquisition of licenses – derivatives BL calls them – which are now value-less. This is the point I am trying to make. If the stimulus to the Irish economy had come through more public structural grants etc, borrowed or whatever, by the state, chances are the money wouldn’t have been used in the manner it was. I am a big fan of private construction companies myself, but a study really needs to be carried out to look carefully at how various types of private construction companies operated. BOH.

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