I give my views on the Kelly-Honohan debate here.
Month: May 2011
Much of the pessimism about Ireland’s predicament has centred on the challenge of stabilising the debt to income ratio. Undoubtedly this will be challenging, with good outcomes on nominal GDP growth and fiscal adjustment capacity required. Of course, it has been made much more difficult by the massive bank losses the State has had to absorb. But I think a focus on the stabilisation challenge misses a critical issue, which is regaining market access at a high if stable debt to GDP ratio (probably somewhere in the region of 120 percent of GDP).
Martin Wolf’s column from last week provides a useful starting point for a diagnosis of the problem – an article that garnered all of one comment on the blog (from DOCM). It draws on Paul de Grauwe’s insightful work on the susceptibility of countries in a monetary union to a debt crisis (see here), where a country without its own currency and central bank to act as lender of last resort is vulnerable to self fulfilling expectations that it will not be able to roll over its debts. The EFSF/ESFM/ESM were put in place to help fill this LOLR gap, but have so far proven to be a poor substitute. It is understandable that Germany and other likely net funders want to eventually reinstate market discipline, and so demand losses are borne by private creditors as part of any new bailout. It is also understandable that they want to protect themselves from losses under the permanent bailout mechanism (the ESM) by demanding preferred creditor status. But it is becoming increasingly evident that crisis-hit countries will find it extremely hard to regain market access with a half-hearted LOLR facility in place given any doubts that they will not be able to pass a debt sustainability test under the ESM.
The official funders have to be willing to take on some additional risk if a mutually damaging combination of default and ongoing dependency is to be avoided. One element is to clarify the way the debt sustainability test will be applied. A current problem is that austerity measures weaken growth, thus making it harder to pass the test. A useful amendment would be to assess growth in the debt sustainability calculation assuming a neutral fiscal stance. Another useful amendment would be to set a ceiling on the size of any haircut, thereby limiting the uncertainty faced by potential new investors.
As a quid pro quo for these amendments the government could offer to speed up the fiscal adjustment (along the lines recommended by the ESRI in its Spring QEC). Of course, more fiscal adjustment is the last thing the economy needs as it struggles to pull out of recession. Yet a quasi-permanent loss of creditworthiness and dependency on unreliable official support looks to be the bigger threat, as it saps confidence and undermines the perception of the economy’s stability. Those resisting fiscal discipline must realise that the situation changed profoundly when Ireland’s creditworthiness disappeared in the second half of last year. Some observers are putting forward the same fiscal policy prescriptions as they did when bond yields were around 5 percent. They must see that the ground has fundamentally shifted.
It is hard to see how further public sector pay cuts could not be part of any balanced additional adjustment. A credible new regime for long-run fiscal discipline is also essential.
The government should take the offensive in pointing out the incoherence of the current international support approach, while avoiding playing a self-defeating grievance card. What is needed is a hard-headed look for a mutually advantageous set of policies that allow Ireland to shed its dependency. The first step is a proper diagnosis of creditworthiness challenge.
The saga over Ireland’s request for a reduction in the interest rate on its EU loans continues, with the French continuing to link this issue with Ireland’s corporate tax, a role they swap every so often with the Germans (media stories from today here and here). As Christine Lagarde’s recent comments show, having made such a big deal of the issue, the French are now motivated to achieve the crucial goal that “Everybody will have to save face.”
It is worth noting, however, that the French signed this document “Conclusions of the Heads of State of Government in the Euro Area” on March 11. It stated:
Pricing of the EFSF should be lowered to better take into account debt sustainability of the recipient countries, while remaining above the funding costs of the facility, with an adequate mark up for risk, and in line with the IMF pricing principles.
Note the absence of any mention of corporation tax or renegotiation of deals.
Despite the constant repetition of the line that Ireland is somehow looking to change the status quo, it seems to me that there is a strong case for the opposite position. Having agreed to change the pricing of EFSF loans on March 11, the EU’s principle political leaders have reneged on this agreement for the moment, most likely because the political kudos that come with appearing tough on Ireland outweigh those associated with honouring agreements made at Heads of State level.
Those who believe that Ireland’s situation will end well because European institutions have our best interests at heart may wish to consider how things have played out over the past few weeks.
For tomorrow’s Farmers Journal:
The government announced a package of measures, described as a jobs initiative, on Tuesday. There is to be a reduction in the VAT rate for tourism-related spending and the travel tax is to end. Both measures should help a recovery in this important sector. There are also to be some modest capital spending allocations for schools, road-works and home insulation. Employers’ PRSI is to be cut for low-paid employments.
These measures will be offset by a sharp increase in the minimum wage. In the United Kingdom, the minimum wage is £5.93 per hour, which translates to €6.74 at today’s exchange rate. The Irish minimum wage is currently €7.65, well ahead of the UK figure. The unemployment rate in the UK is only about half the Irish level, but the Irish government, while acknowledging the need to restore competitiveness, has decided to increase the minimum wage to €8.65, bringing the premium over the UK to no less than 28%.
The other eye-catching wheeze is a levy of 0.6% per annum on the capital amounts saved in pension funds. The retirement incomes of workers in the private and commercial semi-state sectors are paid out of the assets contributed over the years to occupational pension funds. Many of these funds are inadequate due to improving life expectancy and the weak investment returns of the last decade. As a result both employers and employees are facing higher contributions in future as well as reduced benefits. Those with the foresight to choose employment in the public service are exempt from the new levy, since the public service does not bother to fund its pension obligations. The Minister for Finance, Michael Noonan, looked a bit uncomfortable while explaining this measure on television on Tuesday evening. His justifications included an argument to the effect that much pension fund saving is invested abroad, and that his plan will see these funds ‘brought home to invest in jobs.’ Sadly some pension funds were foolish enough to invest in Ireland, in safe Irish banks and even safer Irish government bonds for example, and are nursing the biggest losses for their pains. But they will have to fork out the levy regardless, since it applies to all funded pension schemes.
Money accumulated in private sector pension funds belongs to the people who have saved it up, and is capital rather than income. The funds are trapped given the trust law and this makes the assets a sitting duck for a cash-starved government. In October 2008, the government of Argentina, unable to borrow in the international markets, simply expropriated $29 billion of assets from private retirement accounts to plug a budget gap. One wonders if Mr. Noonan’s advisers have been studying any other elements of Argentinean policy, which also features an export tax on agricultural produce.
Around 520,000 people own the €80 billion in these funds, an average of about €154,000 per person. The levy will cost them about €920 per annum on average. About 330,000 employees have entitlements under public service pension arrangements. These schemes are unfunded and thus have no taxable assets, but the total liability has been estimated by the Comptroller and Auditor-General at €108 billion. It follows that the average sum standing to each member in these unfunded schemes is about €327,000, more than double the amount standing, on average, to those in funded schemes and liable for Mr. Noonan’s levy. The jobs initiative is being funded, in effect, not by those who are fortunate enough to have occupational pensions, but by those who have small occupational pensions. Those with the bigger pensions, public servants in the main, will not be contributing. Interestingly, since the new levy is a levy on assets, it will affect disproportionately the older members of the private sector workforce who have more substantial funds already saved. Younger workers can relax: they have too little in the way of retirements savings at risk.
It is of course true that tax concessions for private sector pensions were excessive for those on super-duper incomes, and there have been sensible reforms over the last few years designed to place a cap on these tax breaks. Some people were able to duck tax and accumulate multi-million pension pots while managing the banking system into spectacular insolvency. Others have retired from their labours in the vineyard of public service with enormous pensions to which they never had to contribute. But the sins of these fortunate folk are now being visited on the workers in the private and semi-state sectors prudent enough to have made funded retirement income provision. In March of last year, the government released a document on pensions policy which expressed alarm at the condition of private sector funded pension schemes, including the inadequate level of contributions and limited coverage. The new government has sent a clear signal that it is content to see these problems get worse.
The details are here.