McCarthy and Varadkar on Fiscal Strategy

I’m no economist but I like the idea of using the NPRF for productive domestic investment.

I am not sure about using the NPRF for capital expenditure either. Once you start building something you have to finish it. Thus we lose our flexibility as to how we use large parts of the NPRF very quickly.

I would love to know what criteria are used to define ‘strategic’ and ‘non-strategic’ assets and why the former, at all costs, must he kept in public ownership and why the latter could be sold.

It might be worth a full post to the lay out the debate on NPRF. Right now it looks like a massive source of moral hazard in the pre-crisis period — (1) huge kitty in case something went wrong and (2) ah sure we’ve taken care of public sector pensions with the NPRF.

Oh dear, we have a new monolithic Irish consensus. The Bigger the Austerity Package The Better. We have managed to invent a whole new sub-branch of economic theory.
Apart from the deflationary impact on the real economy what could the unintended consequences be? Could it be that we have a ragged banking system utterly dependent on growth in that economy for what is left of its chances of survival?
We are in this position because the interaction of the Guarantee, NAMA and Eu accounting rules have forced us to take our banking hit up front. We are no worse than some other countries but were much better with our initial debt position. As they do in all the hospital dramas, someone has to call it. This is nuts.

@John McHale,

Labour want €2bn from the NPRF to establish their ‘enterprise bank’ to loan to small businesses. Surely there has to be a concern about any so-called State bank mandated by any government of the day to shell out 2bn of taxpayers savings in this manner? Fine Gael want to the raid the Fund for their New Era 105,000 ‘green’ economy jobs’ creation effort.

On the face of it, I can’t see how either of these proposals can be shown to deliver a return to the Fund. Therefore, the terms of the 2009 amendment to teh operations of the Fund will have to be further amended to allow the NPRF invest in loss-making projects, at the direction of the next administration.

We’re used to ‘auction politics’ in the context of general election campaigns. Right now it appears we’re engaged in the same sort of politics about a fund whose value, I would have thought, we should carefully cherish and whose proceeds should be dispensed with the greatest of care.

That said, my reading of Colm McCarthy’s article is that he was trying to convey the scope of the current problem to the average IT reader like myself, no more nor less than that. Leo Varadkar’s SBP article is intriguing from a political perspective – Fine Gael appear to be entertaining several contradictory positions simultaneously. There’s an air of headless chickens surrounding the statements emanating from all cohorts of our political class.

Simpleton,

You speculated on another thread that an IMF/EU bail out might involve a kinder adjustment path, along the lines of that advocated by ICTU. Yet we have had a ratcheting up in fiscal virility since then. Why might this be?

Has someone already been in to see our new administrator to enquire about assistance only to be rebuffed? I think the evidence points this way.

Somebody may have looked at our GDP levels and concluded that the economy has rebased to 2003 levels so cut your spending accordingly. For reference, the dole was 127 euros in 2003 qnd the OAP was 157 euros. I think the current rates are E196 and E206 respectively. On the taxation side the PAYE tax credit in 2003 was 800 euros as compared to 1830 now. I would expect a wide range of benefits and tax credits to be reset to 2003 levels over the next two budgets at the behest of Brussels. Only then will our application be considered.

In talking about deflation in his article, Colm has stayed away from the competitiveness issue. He may have been wise in this, given that “they won’t lend” is a sufficient response to those who think we can spend our way out of depression.

Even so, it is an important issue. One would think, if one was to look at just implemented policy, as opposed to rhetoric, that the Government has been trying to prevent prices in the economy from falling.

This shows up in:
– Heavy public expenditure on construction
– The Croke Park agreement on public sector pay
– The continuing rise in employment in sectors dominated by public spending, despite the fact that public sector employment is supposedly falling
– Maintaining the nominal value of the minimum wage and many social welfare payments in the face of consumer price deflation (when there was still consumer price deflation)
– Piling on extra public debt to pay for the continued employment of bank staff the banks no longer need
– Interventions in the property market that have gone beyond preventing firesales, to prevent the market from reaching its bottom, and underpin property rental costs
– Very poor progress in reducing prices of services and utilities provided by the public sector

This was arguably decent enough policy as a holding action while we waited for the short term effects of the Great Shock on the global economy to pass. It makes no sense over the longer term. The focus has to be on building long term growth potential, much more than on playing fiscal games to soften the short term pain. Otherwise, we will condemn ourselves to high unemployment and high rates of emigration for a long time to come.

There are two aspects to this. One is the sort of capability building stuff that the Government is pursuing, to its credit, despite the flak it often gets on irisheconomy.ie for doing so. The other is getting our costs in order. The first will not deliver without the second.

In an SOE that systematically strangled its cost competitiveness by driving up prices far ahead of productivity gains between 2001 and 2007, that means cutting prices in the economy. Whether or not one puts a “deflationary” label on this makes no difference to its necessity.

Getting our prices back in line with those in comparable long-standing EU countries will not be sufficient. We need more growth than they do, so matching their price levels will not be enough. In my view, we need to get back to something like the *relative* price position we were in around 1995, when the Celtic Tiger kicked off. We are unlikely to have another ICT boom to ride, but an edge on costs should allow us to grow employment ahead of other EU countries.

We need to be cautious about using any single price measure in judging cost competitiveness, so we should look at a range of measures. In particular, looking at progress on unit labour costs alone risks giving Ireland credit for progress on aspects of productivity in FDI enterprises that do not in reality reflect improvements in Irish competitiveness.

For what it’s worth, my personal headline indicator of the results of competitiveness that is available reasonably frequently comes from the QNHS. Developments in the sum of employment in Industry and Information & Communication give a reasonably good indicator of the overall direction of employment in manufacturing and internationally traded services, which are the industries most immediately impacted by competitiveness, and which are the chief paymasters of the rest of the economy. The principal route through which these industries contribute to the Irish economy is through wages and salaries, so their employment is a fairly good “quick-and-dirty” indicator of economic impact. Employment is also likely to be fairly well correlated with local sourcing of inputs and services.

This measure fell by 5.3% in the year to Q2 2010, and by 1.6% between Q1 and Q2 2010, suggesting that we still have to cut prices in the economy significantly more before things stabilise, let alone before we start to get the recovery we so desperately need.

Maybe the “cut now, cut big” Austerians are motivated by the fact that the NTMA could not borrow a single cent on international bond markets without the “invisible” ECB back stop bid. Nor could the rickety old Irish banks fund their loan books without access to the ECB repo.

So, we are committed to the current rush back to 2003 expenditure levels as that is what our masters really want.

@Con

Absolutely. Even Krugman conceded a long toime ago that Ireland had probably no choice but years of grinding deflation to address the competitiveness problem caused by the boom – within the Euro and without default, that is.

The thing is though that the trick with deflation is to do it as quickly as possible otherwise it becomes habit forming and self fulfilling. In this respect Irl has a big problem. Everybody will play their hand to make sure their relative position moves up. You will not get synchronised wage cuts for example – it is part of the Irish tradition of being full of self-importance and getting someone to “fix” things in your favour.

The weakest therefore will bear the biggest adjustment and it is this “fixer” mentality that is the prime motivation for wondering whether the IMF might do it more appropriately.

One of the sentences in Colm McCarthy’s article is nonsense. Where he says:

“We are borrowing and spending €50 million of other people’s money every day.”

€50 million x 365 = €18,250 million.

In other words, he’s implying that the entire budget deficit is being financed by borrowing from ‘other people’, which I take to mean foreigners.

I’m afraid that the financing of budget deficits is a bit more complicated than such simplistic nonsense would suggest. Nearly every government in the world currently has a budget deficit. Are they all borrowing ‘other people’s money’ to finance it? If so, who are the ‘other people’? Is there a secret group of Martians lending money to all the governments of the world?

In the modern globalised world, financing budget deficits involves circular flows.

We can construct a very simplified model. I’m posting in a blog, not delivering a lecture at Harvard, so obviously what follows is the whole thing very simplified. In particular, I’m leaving out private sector flows. But, the principles involved are the same.

Governments borrow from their own people. Call that A.

They also borrow from ‘other people’. Call that B.

But, their own people also lend to other countries governments. Call that C.

A country’s net borrowing situation can be summed up crudely as: A + B – C

And emphatically not: A + B, which the Irish media seem to think it is.

And emphatically not: B alone, which Colm McCarthy seems to think it is.

The more closed an economy, the smaller B and C. In a totally closed economy, both B and C would be zero. In such an economy, a government could still have a larget budget deficit, but it would all be financed by A, ie by borrowing only from its own people. In open economies, both B and C will be much larger, but A will still be significant.

The bottom line of all these flows, A, B and C, is the balance-of-payments. If a country has a balance-of-payments surplus, that implies B C. Both the Central Bank and ESRI are forecasting that Ireland will be in balance-of-payments surplus next year. That is, by next year B becomes > C for Ireland. Even this year, B is just slightly < C for Ireland. To put it in plain English, by next year, while the Irish government will be borrowing lots from people abroad (B), people in Ireland will be lending lots to governments abroad (C).

We can get an illustration of how much people in Ireland lend to governments abroad by looking at the figures for holdings of US Treasury Securities. Here:

http://www.ustreas.gov/tic/mfh.txt

Ireland is one of the largest holders of these per capita in the world. As the table in the link shows, Ireland held €43.6 billion of these in July, compared to €56.4 billion for Germany (population 18 times that of Ireland), €30.5 billion for France (population 14 times that of Ireland) and €20.5 billion for Italy (population 14 times that of Ireland). China, Japan and the UK held by far the most, but, in per capita terms, Ireland held far more than any of them. I’m sure that figures for holdings of UK securities would show a similar picture, and possibly those of other countries as well. Ireland’s status as one of the most globalised economies in the world means a high proportion of its government’s borrowing is done abroad, but also a high proportion of Irish lending is to governments abroad. Considering only the former, and ignoring the latter, is nuts, like analysing a football team’s performance by considering only the goals it concedes, and ignoring those it scores.

I should make it clear that I’m not some Joe Higgins-type, railing against Irish people lending to governments abroad, when the Irish government could usefully do with the money. In fact, I have a few grand myself in US Treasury securities (at least that’s what my bank manager tells me). I’m merely explaining how these flows work.

That said, I’m in favour of deficit reduction in Ireland, as I believe that excessive government borrowing, even from its own people, is wasteful. But, it should be done on the basis of explaining things clearly, not on the basis of nonsense about the entire budget deficit being borrowed from ‘other people’.

Regarding the 3% target. This should not be set in concrete. Common sense is required, admittedly a scarce commodity among Irish economists. The target should be to get the budget deficit down to around the average EU level. Contrary to the hype we get in the Irish media. most EU governments have large budget deficits at present. It is the result of the global recession. The UK is around 11%, France around 8%, the others all vary. If the global economy booms, and all the other countries’ deficits come tumbling down to 3%, Ireland must follow suit. But, then that growth would greatly assist in doing so. If global growth is slow, then other countries’ deficits won’t fall to 3%. They’ll stay around 6%, 7%, 8%, or whatever. If that happens, it would be sufficient for Ireland to match them. Naturally, the global growth scenario is preferable, but not guaranteed. But, it would daft to be masochistic and to be obsessed with getting Ireland’s budget deficit down to 3%, if slow global growth left most countries in the region of 6% to 8%.

I almost fell off my chair today when I heard that the guy from Romania we tried to hire yesterday turned down the offer to interview for a job in Ireland because of the economy here.

@Con:
Was mulling over your idea of rapidly cutting benefits/pensions/public sector wages, as well as general wage levels, to 1995 levels.

It’s hard to see how prices can fall that quickly. You’d have to coordinate the cuts in benefits with cuts in ESB/gas bills. Banks would need to have to have a plan for people defaulting en masse. Supermarkets would need to stock lots of spuds, and way fewer organic mesquite fries. Businesses would have no notion of how to drop prices that quickly, because (a) they’re stocking a higher quality of inventory than people would be able to afford (b) the landlords of their premises will not be willing to drop rents, as they would be locked into repayment terms themselves (c) there’s this knock on effect of businesses realising that they need drop prices that just won’t happen overnight. I feel I’m missing the next 20 knock on effects here…

I’m sure the Aldi’s of the world would do well, and Exports would do well, but I don’t see how the plan avoids 100s of 1000s more unemployed and emigrating, because I don’t see how the private sector could absorb such a big shock all at once.

@ simpleton.

i think one of the biggest issues facing the banks and asset prices in the economy in general is the cost of funds and hurdle rate used to make investment decisions.

in a a close to zero overnight rate world, the current spreads irish banks should be charging for asset based lending (based on were they can raise money for term) or the current discount rate a rational investor should apply to an irish investment decision (based on the yield on ”risk free” govt or govt g’teed paper) has a big impact on asset prices and new economic actvity.

lots of chicken and egg here but i do believe a large front loading of cuts would not be as deflationary as you think if it lowers significantly cost of funds and discount rates in the economy.

@ Dave in Dublin

You illustratte part of the reason why everyone who can will resist deflation as forcefully as they can and there is no realistic prospect of effective political leadership on this. Politicians are so far behind the curve it isn’t funny, but then again who would listen to them now if they weren’t?

It is also easy to predict that those sectors that will be the most effective at resistance are the very ones that have become the most inefficient – by virtue of their political clout

@hoganmahew

You’ll find its elementary economics, to be found in any economics text book. If you are nice, I may buy you one for Christmas.

@David,
I’m not suggesting a return to 1995 prices. That would be impractical and excessive. I’m suggesting that we need to return the the same *relative* price position we were in, as of 1995, which is much less radical, although still very difficult. Even if it turns out to be impractical, whatever progress we make will stand us in good stead in rebuilding competitiveness.

If the economy was sufficiently competitive as of now, employment in internationally traded industries would be rising instead of falling.

@JtOs point about how Colm Mc was wrong when he says we’re spending other people’s money.

I don’t have anything more recent than this, but I suspect that we’re less locally supplied now than before. http://www.tribune.ie/article/2009/sep/06/revealed-who-owns-our-government-and-bank-debt/

82% of Irish govt debt was held by foreigners. We’re spending other people’s money.

The worst thing about this whole disaster is the raiding of the NPRF. We had an opportunity to create an economic powerhouse on the same scale as the major public sector funds in Canada who are busily buying up depressed infrastructure assets worldwide. Now the NPRF is being burned and the so called pension levy is being shovelled in the direction of bondholders.

Let’s bust up the slush fund for good – break the piggy bank. Start again, but this time, make the investment fund jointly responsible to the public service unions – with the union bosses held responsible by their members for performance. If money is being put aside for pensions in the future, it’s just not the government’s money any more.

Norway NATIONALIZED the oil and gas business off its coast. Statoil is one result. A sovereign wealth fund, 1 or 2 in the world, is also a result.

THEY DO NOT PERMIT INVESTMENT FROM IT WITHIN THEIR ECONOMY!

They still have an asset bubble but it would be worse if they further inflated by diverting this capital fund. They have also spread risk, something Irishmen and women are not familiar with!!

Michael Hennigan

+1 Shame to waste a good crisis. Too many vested interests and too little imagination at work. Gombeens only, need apply!

Mark Dowling

The NPRF was an attempt to siphon off from the bubble which all knew was growing, but too little, too late. A paltry counter cyclical fiscal measure. Now it is a fire fighting fund wasted in panic. How sad! Do we ever learn?

Hugh Sheehy

The money “came from abroad”! Well I can wash monmey through the Channel Islands or Switzerland if I had enough of it, too! I suspect much of this foreign money was previously in Ireland at a low rate of interest but ended up as bonds at a higher rate, to reflect the theoretical, exceeding faint, possibility that it might never be repaid!

@John McHale
I think I am arguing that whatever policy we pursue must be credible. We must take care that we do not substitute ‘sado-fiscalism’ for ‘credible’. Bond markets will not simply applaud our determination to eviscerate our economy; rather, they will ask, ‘will it work?’. We will be able to return to those bond markets only if the answer to that question is in the affirmative.

I worry about the macroeconomic consequences of fiscal austerity, given our starting output gap, unemployment rate, real interest rate and real exchange rate. During the four years of austerity, real interest rates will certainly rise (they are doing so already) and the exchange rate is also rising again.

I worry about second round consequences, particulalry the banking system. What is left of the Irish banking system depends exclusively on the performance of the Irish economy. I also think that, in part, the economy depends on the banks. So, not much (circular) joy in prospect there.

Your (and Tulls and..) demands for austerity are driven by the demands of the bond market. Why are we in this position when countries with as bad (or worse) non-bank-bailout deficits and inferior starting debt positions are funding themselves with consumate ease?

It’s entirely because of the perceived costs of the banking bailout: we, much more so than any other country, have been forced, by the unintended consequences of our own idiocy, to up-front (in an accounting sense) the bail-out. As others have pointed out on this blog and elsewhere, fiscal paragon Germany has as big a problem as Anglo, relative to GDP, with it’s Landesbanken. It’s just that those costs will be taken over decades and the tax payer is unlikley to ever find out about them.

I’m not making a judgement call on which policy is right or wrong. I am simply asking for some perspective and thought. We have a fiscal lynch-mob on the rampage. BE very careful.

@Simpleton

Your warning is well taken, even if the policy implication is not so clear. I do wnice, however, at being included amongst the big cutters. My point about Varadkar’s proposal is that when you put the elements together the overall front loading is more limited. I actuallly don’t see this as a successful political formula, but worthy of debate.

@simples
“I just don’t get how we think we can implement a four year austerity plan, without reference to the cycle, without reference to the probable consequences. We seem to think that provided we get the deficit down to 3%, everything else will be OK, all costs of this policy are acceptable.”
I think you are arguing with the government here. It is they that are saying that.

Most on here, all the austerians as far as I can see, are under no illusion as to the damage that will be caused. Indeed, it will be worse than the government like to say because there is little chance that we will be able to borrow at 3% of GDP beyond 2014.

The problem is that the level of growth required to avoid cuts is astonishingly high and, aside from anything else, unlikely in the current cycle. Worse, the evidence so far is that a jobless recovery is underway. The downside risks (or at least the lack of upside risks) weigh on future prospects.

Mr. Varadkar’s plan at least has an optimistic and counter-cyclical element to it; indeed, it could be argued it has two. By cutting early, the only way is up. By offsetting those cuts with investment, the damage of the cuts might be ameliorated. By reducing the deficit now, more fiscal room will be available later (as the national debt will be lower).

Getting fiscal consolidation right: Lessons from Sweden
Speaker: Anders Borg

http://www2.lse.ac.uk/publicEvents/events/2010/20100114t1800vOT.aspx

LSE European Institute – APCO Worldwide Perspectives on Europe Series
Date: Thursday 14 January 2010

Guys

Slighly off the point but i would like the opinion of economists.

Britain has announced more QE in order to encourage demand.

QE can be ineffective as the the cash is transferred through banks who might horde it (which i think has been the case)

What are the arguments againts the cash generated through QE to be used to fund capital expeniture?

The benifits are that it is more likly to end up on the hands of consumers and it would reduce unemployment.

@Niall

well they are buying gov debt – thats what qe is

Anyway, enough tittering.

For a true, but inconvenient, picture of the international investment position of Ireland at December 2009:
http://www.cso.ie/releasespublications/documents/economy/current/iip.pdf

Excluding the IFSC, a net liability of 141 bn…

It is interesting to note the establishment spin (e.g. as ably expressed by CMcC in his article) of “huge reputational damage” against any IMF involvement. Straight from the “Green Jersey” chapter of the government spin manual.

I wonder exactly who these people are that currently have the “good reputation” box ticked for Ireland in their scorecard, but would switch to “bad reputation” were the IMF to become involved. Whoever they are, I’m very impressed with their faith that the current set of politicians are the ones needed to reform public administration and create policies for economic growth. Given a choice between a report such as the IMF one referenced above (quantitative, fact-based, detailed) and the first public review of our home-grown effort at reform – the Croke Park Deal (oh wait, can’t seem to find it right now), I’m glad that our own effort is being viewed as much more effective than the one being driven by those IMF slackers. I guess they might slow us down or something if they were to become involved.

@Hogan
As a decided non-economist myself – I have always (well since I first heard of it) read QE as synonymous with printing money – just by more sopphisticated (electronic) methods. My bible (wikipedia) seems to agree, Some of the experts on this site better clarify so that maybe some of this stuff is comprehensible:

You seem to be suggesting something different – or do I misread?

“A central bank implements QE by first crediting its own account with money it creates ex nihilo (“out of nothing”).[1] It then purchases financial assets, “

@ Bryan G

I’m very impressed with their faith that the current set of politicians are the ones needed to reform public administration and create policies for economic growth.

I agree.

There would be a lot of hand-wringing if the IMF was to get involved and poor headlines across the world but it would be the shock to the system that is needed for long-term prosperity.

The official line that is largely supported, is that the jobs crisis will be solved when the international recovery takes hold and we can return to business as usual.

The IMF has been the best hope for an endemically corrupt country such as Greece with its closed shops and resistance to change.

There is support for some Irish reform such as fiscal rules but it’s striking that the political elite and others with a grip on the public megaphone, including academics, have little if anything to say on structural reform of patently failed systems.

It’s hard to see how the Labour Party would in government embrace reform and deliver home truths to its newly expanded base of supporters (some temporary refugees from FF) while limited reform in the public sector, would mean that the protected private sector which is significantly sustained from public funds, would also likely escape any significant change.

It’s interesting how Gilmore and ICTU refrain from any advocacy of reform across the economy because it would shed attention on the public sector.

It’s not even clear how the slow-motion process of the Croke Park Agreement is being implemented, if at all.

Whatever about talk of the NPRF being used to invest in capital projects, NAMA has been handed many of the potential construction projects in the country.

NAMA can finance these construction projects off the government balance sheet. If the projects are viable and prudent and NAMA is not financing them then we are missing a huge opportunity to generate/preserve economic activity in the country. Surely a prudent but nimble NAMA could be a big contributor to activity.

NAMA’s nimbleness is in serious doubt at a time when it is most needed. Lenders should behave like lenders, not like civil servants determined to keep their heads down, there bibs clean and not to make any ‘political’ mistakes.

Where is the incentive for employees of NAMA to lend money on commercially profitable terms. While bonuses were dangerous in bubble times, properly structured incentives may have their place now.

The government can either have a National Investment Fund which invests in directed national projects for the profit of the Treasury, or it can have a Pension Fund which invests in whatever the trustees decides provides a suitable return for their investors (subject to the usual bounds of legality etc.) irrespective of the project’s location. Telling NPRF they “must invest in Irish projects” is disingenuous at best, and I would be interested to hear whether it would pass EU legal muster.

I wonder how many capital project investors have contacted the government in the past months to say “we intend to withdraw from our awarded contracts because since Ireland’s downgrades our banking partners will no longer lend at the specified terms”?

How soon do we think it will be before the NPRF is ordering nameplates and stationery for their rebrand into the Irish version of the EIB?