Fiscal Causes and Consequences

A common narrative has developed that the euro zone crisis is being misdiagnosed as a crisis requiring a fiscal cure.   See, Larry Summers here, for example; or Paul Krugman here.  

I think most of us can agree that the Irish crisis was predominantly the result of an interacting property and credit bubble.   Rising property prices fuelled credit inflows, which in turn fuelled the property bubble.   What made the Irish property bubble ultimately so damaging was the fact that it was both a property price and construction bubble.   Usually a strong supply response can help deflate or at least limit a price bubble.   But the forces driving the price bubble were so strong that the supply response did little to tame it.   When it burst it led to both a massive wealth shock and a massive structural shock to the economy given the resources that had been misallocated by the bubble to construction.   This in turn led to a series of adverse feedback loops: banking, growth and fiscal.   The policy challenge has been so severe because policies to try to stabilise one element of the crisis – e.g. debt stabilisation – tends to make another worse – e.g. growth.   The interacting crises reached a second stage of severity once the banks and Government began to lose their creditworthiness.   Official support was all that stood in the way of complete meltdown. 

It now seems rather beside the point to focus on the fact that the original source of the crisis was not primarily fiscal.   (Even the idea that fiscal imbalances were not a major part of the initial vulnerabilities is exaggerated.   For Ireland, a large structural deficit was hidden by revenues directly and indirectly associated with the property bubble, as expenditure grew strongly and non property-related revenues lagged.  It is true that the design of the Stability and Growth Pact was poorly designed to identify this imbalance.   The new Excessive Imbalance Procedure should go some way to rectifying this.)  But whatever its cause, restoring debt sustainability and State creditworthiness is now an essential part of the solution to exiting the crisis.  

One thing that has become evident is how fragile creditworthiness is in the monetary union for countries with high debts and doubts about political capacity to achieve debt stabilisation.   Not having a domestic central bank available to print money as a last resort to repay debt and avoid default is a major source of vulnerability.   Euro zone countries have shown themselves to be subject to bad expectational equilibria, where concerns about default risk leads to high market yields, which can make the initial concerns self-fulfilling. 

Stronger mutual support mechanisms are needed to give vulnerable countries a reasonable chance of sustaining or regaining creditworthiness.   But stronger countries – who themselves have vulnerabilities – are understandably reluctant to take on large contingent liabilities and weaken incentives for fiscal discipline (moral hazard) without reasonable assurances of disciplined fiscal policies from their euro zone partners.   Even with beefed up mutual support mechanisms, potential bond buyers are also looking for strong fiscal frameworks to support the political capacity to work back towards debt sustainability and ultimately less vulnerable debt levels.   Of course, the solution to the crisis goes beyond the fiscal – a more growth-oriented response from the ECB, for example, would be hugely helpful.   But pointing out that the original cause was not primarily fiscal does not seem particularly enlightening or helpful in charting a way out. 

Access to EU Funding

At the EU summit of the 21st of July last the leaders’ statement said that:

“We are determined to continue to provide support to countries under programmes until they have regained market access, provided they successfully implement those programmes. We welcome Ireland and Portugal’s resolve to strictly implement their programmes and reiterate our strong commitment to the success of these programmes.”

This was reiterated as recently as the EU summit of the 30th of January when the statement of the EU leaders said that:

“We welcome the latest positive reviews of the Irish and Portuguese programmes which concluded that quantitative performance criteria and structural benchmarks have been met. We will continue to provide support to countries under a programme until they have regained market access, provided they successfully implement their programmes.”

These both seem pretty unequivocal to me and have not been contradicted in any subsequent EU statements I have seen.

Why are Irish house prices still falling?

Gerard Kennedy and Kieran McQuinn from the Central Bank give their view on where house prices should be in Ireland, and why they haven’t stopped falling in this new paper (.pdf). This paper is a kind of update to Morgan Kelly’s 2007 piece on the likely extent of house price falls (.pdf) as well as other papers.

From the abstract of Kennedy and McQuinn, then:

In this note, the continued fall in Irish house prices is examined. The increased rate of decline in 2011 resulted in Irish prices being almost 50 per cent down from peak levels of mid 2007. Accordingly, in over forty years of house price data, the fall is now one of the most significant across the OECD. We outline the current state of activity in the housing market and, using a suite of models, assess whether the fall in house prices is in line with that suggested by current fundamental factors within the Irish economy. Given that the analysis suggests prices may have overcorrected since 2010 we discuss possible reasons for this continued decline.

The Fiscal Treaty in the Sunday Papers

The Sunday papers/blogs have some good contributions to the Fiscal Treaty debate.    In the Sunday Independent, Colm McCarthy cuts through much of the confusion with his usual clarity:

This referendum has consequences and is not just an opinion poll on whether people are pleased that we have an enormous debt and an ongoing deficit.

There are two net issues. The first is whether a ‘Yes’ vote would result in additional constraints on Irish budgetary policy in the years ahead.

The second is whether a ‘No’ vote would make the financing of the Government more difficult once the EU/ IMF programme ends in December 2013.


You should read the full article for Colm’s analysis of the two issues.   But it is worthwhile to note the conclusions:

The fiscal treaty does not, in the short or long term, create new commitments to budget cuts beyond what is in store anyway. But rejection could result in a sudden drying up of access to finance — and hence an immediate requirement to balance the books — and would be highly disruptive.

This treaty will not solve Ireland’s problems, but voting it down could make a bad situation worse, for no obvious gain.

Cliff Taylor echoes these conclusions in the Sunday Business Post.   The article is behind a paywall, but a fair-use quote gives the gist:

So there is no additional austerity for Ireland which will result from voting Yes.   Austerity is inevitable – we just have to hope that some pick-up in growth will make the sums easier.   And let’s not fool ourselves that a vote here would in some way change the course of what might happen in Europe.   That will depend on the big countries.  Full stop.

If a No vote brings no obvious advantages, it does bring risks.   As the rules stand, we would not have access to the European Stability Mechanism, the new permanent bailout fund.   So, if we need more cash after this bailout runs out – or other forms of support, such as further underwriting – we will not qualify if we vote No.   Sinn Féin has argued that the EU and IMF will not see us stuck.   But why try to find this out?

Finally, Nama Wine Lake, our new national treasure, provides a useful overview of the arguments here.

Reminder: IMF loans more expensive than EU loans

The Sunday Times reports that the IMF could be an alternative source of funding in the event of a No vote.

One point to keep in mind in this debate is that the IMF charges a penalty premium of 200/300 basis points on large loans, whereas the premium has been dropped from EU loans, as decided at the July 2011 summit.

The relevant IMF funding schemes  (Extended Fund Facility, Precautionary and Liquidity Line) are described here and here.