The issue of whether the Fiscal Compact will mean additional austerity in the post-2015 period has generated some heat in the referendum debate. John has usefully provided some light to this issue in a previous post. This post adds little to the conclusions there on the “1/20th” rule but relays a similar point in a slightly different way. Based on IMF projections Ireland will satisfy the debt reduction rule in 2015.
The debt reduction benchmark is calculated as an average over a three-year period. One of two averages can be used to satisfy the rule. There is a backward-looking average covering the years t-1, t-2 and t-3 with a benchmark calculated for year t, and there is also a partially-forward-looking average for the years t-1, t and t+1 with a benchmark calculated for year t+2.
The formula for the benchmark is in the Code of Conduct for the Stability and Growth Pact and for the retrospective average it can be seen on page 8 to be:
where bb is the benchmark or target debt ratio and b is the debt-to-GDP ratio in other years. Although there is a bit to the formula all that is needed is the debt ratios for three years in order to calculate the benchmark for the next year.
If the debt ratio for the current year is expected to be below the benchmark level given by the formula then the conditions of the debt reduction rule are satisfied.
To simulate the impact of the rule on Ireland we can use the IMF’s forecasts of the general government gross debt from the recent update of the World Economic Outlook as these extend out to 2017. We will use these to gauge Ireland’s performance to the rule beginning in 2012.
The debt ratio column are actual data up to 2010 and are the IMF’s projections from 2011 to 2017. The benchmark column are the targets for each year and is calculated by putting the debt ratios for the preceding three years into the formula shown above. Compliance is true if the debt ratio for any year is less than the benchmark calculated for that year. Under current assumptions and IMF projections Ireland will satisfy the retrospective version of the debt reduction rule in 2017.
One of the assumptions the IMF makes is that we undertake the €8.6 billion of fiscal adjustment planned for 2013-15. Projections after that are based on a “no policy change” scenario. Under IMF projections we will satisfy the debt brake rule in 2017 with no additional fiscal effort above what has already been provided for up to 2015 with neutral budgets after that.
The debt reduction rule can be satisfied while running deficits and does not require any debt repayments. The IMF project that there will be an overall budget deficit of 1.9% of GDP in 2017.
The gross debt continues to rise and in the years from 2014 to 2017 (the years used in the 2017 comparison) the gross debt increases from €201.0 billion in 2014 to €213.5 billion in 2017.
If the alternative forward-looking version of the rule was applied it would actually show that we would be in compliance with the rule from 2015, as the benchmark calculation is based on the debt ratios in the same three years, 2014, 2015 and 2016 and again compared to the ratio in 2017. Using the forward looking version of the rule in 2015 will also give a benchmark of 109.6% of GDP for 2017 which is, of course, above the projected debt ratio for 2017.
Although this is only a simulation it does show that we would not need additional fiscal adjustment to satisfy the debt brake rule. In fact, using IMF projections it can be shown that we will be able to satisfy the rule before we even leave the Excessive Deficit Procedure (EDP). The debt brake rule doesn’t actually become effective until three years after a country leaves the EDP. We have until 2018 to become compliant with the debt reduction rule but we may actually be compliant by as early as 2015.
One reason for this is that the “1/20th” rule is actually relatively benign and according to Karl Whelan in section 2.1 of this paper the “rate of progress that is deemed satisfactory is still very slow.” We have plenty to be worrying about but satisfying the conditions of the debt brake is not one of them. In fact, it is likely that we will want to reduce the debt ratio at a rate faster than that required by the rule.
38 replies on “Complying with the Debt Reduction Rule”
A very useful contribution, even to readers such as myself with a very poor grasp of economic mathematical formulas.
Meanwhile, it may be worth noting that what is moving the political debate in Europe is not the referendum in Ireland or the implications of a no vote.
The issue of capital ratios for the banking sector is the real hot political potato of the moment.
http://www.ft.com/intl/cms/s/0/8e6d8dfe-953b-11e1-8faf-00144feab49a.html#axzz1tq9Q4CVn
The British Chancellor may have occasion to regret stating that he risked “looking like an idiot”.
@Seamus
What is rate of growth is assumed in the IMF’s projections out to 2017? Is it this mythical 4.5%? If so, how does the 1/20th rule look with realistic growth scenarios?
With huge household indebtedness and a very hawkish central bank, it will not be possible to achieve much more than 1% growth for a generation.
Sure we’ll be grand lads, somethin’ will turn up.
Excellent post. I had previously calculated (and commented elsewhere) that it would be around 2019 before we met the debt-reduction rule with ‘zero fiscal effort’, as automaticity of debt dynamics took over. This was based on a more pessimistic growth scenario.
In fact, if we adhere to the structural benchmark rules of the Compact, we are likely to overachieve significantly in debt reduction in the period 2020-2030, as scope for fiscal expansion is dramatically curtailed. Just as in the 1990s and early 2000s, the debt ratio tumbled rapidly – and that was in the face of expansionary fiscal policy throughout most or all of that period.
A separate question, for the most forward-looking among us, is whether the Compact is too fiscally “virtuous” to be sustainable: at the end of the Compact’s yellow-brick road is an emerald palace of negligible public debt, limited public investment, a diminished bond market, and serious constraints on the capacity the govt to increase spending.
@ Bazza
1%? are you talking about nominal or real GDP growth?
@ bazza,
It’s has been said before but it is nominal growth (inflation plus real grwoth) that matters for the fiscal targets. Between 1971 and 2010 nominal GDP growth in Ireland average 11.5% per annum. If 4.5% is not realistic, what would be?
I made clear that the exercise was just a simulation and that any of the conclusions were based on IMF projections. Of course, no one actually knows what the future holds in store but I think it is useful to dispel claims such as these:
Prof. Terence McDonagh, Irish Times, May 2, 2012
Paul Murphy, MEP, Oireachtas Committee, April 3, 2012
Thomas Pringle, TD, Dail Debate, April 18, 2012
Dr Constantin Gurdgiev, Primetime, February 2, 2012
I’m sure I could find references numbering in triple figures for similar claims. In my opinion, they are not realistic.
[EDIT: This description of the views given above is more appropriate than my initial vexed effort.]
Seamus
Many thanks. I am now competent at the backward looking formula and managed to plug it into excel to do some iterations.
As we officially exit the ‘Program’ in 2013, why and by what rules are we excused from complying until 2017?
I do note however that by putting our actual Debt/GDP figures for the year 2009, 2010 and 2011 that the results give a required Debt/GDP of 85.51% or a putative reduction of over 19%.
In some ways the pity about all this is that theses rules were not in place before the banking crisis. We then could could simply have said ‘No’. We cannot break the rules. We are not paying the banking debt particularly.
It would also have forced the country to confront the deficit gap in a more serious manner.
OK we have “Growth” & fiscal debt reduction (relative to GDP) because somebody else buys our Grot or more accurately some multinationals grot.
But if Europe buys our stuff they must get into even higher private debt to do so……
The European system is the most unstable monetary construct imaginable – I think it was designed that way to be honest.
Its the first juristiction that I can see where finance can simply stop a countries activities dead simply by withholding the medium of exchange which is not a Central banks function , it is a countries treasuries function.
Debt is a hypothetical construct – it is not a physical good – countries efforts to sustain this unsustainable system merely serves to divert our attention from solving real world Physical problems that need to work withen a completly different monetary envoirment so as to be achievable.
The hollowing out of domestic demand as the medium of exchange evaporates is a strange but persistent characteristic of the Euro.
Economists need to ask why the Euro is confusing money with debt and what the function of money in a economy is.
Is it to facilitate the most effiecent commerce between domestic agents or to pay off a stock of debt ?
This will not end well………..30+ years of malinvestment never do I imagine.
And yet we must continue and continue and continue to misallocate physical resourses to service a hypothetical construct.
Very Strange Days.
It can be shown by induction that if we just keep to the rule we will NEVER get our ratio down to 0.6.
I think we should dispel immediatley any pretence that this referendum is about the economic math of the treaty. It is a vote of confidence in our political institutions both domestic and European. A vote against is simply nihilistic.
@Seamus
The historical growth that you speak of was not growth , it was depletion.
It was a manic effort to hyper inflate credit so as to pay the interest on a stock of “sovergin” debt.
We are now in a manic effort to increase exports to pay the interest on sov debt.
This is not rational capital creation – the debt seems to have superioty over all things.
This will not end well.
@BW2: “It can be shown by induction that if we just keep to the rule we will NEVER get our ratio down to 0.6.”
Presumably we can get to b(t)-0.6 < ε for any ε, so we can get within less than half a cent of the target?
@ Joseph,
It is not the ‘Program’ that matters in this case. It is the Excessive Deficit Procedure. This is the procedure under which a country is supposed to bring its overall deficit below the 3% of GDP reference value. We are due to leave the EDP in 2015 according to the current schedule.
The debt reduction rule comes from Council Regulation 1077/2011from the ‘Six Pack’ which is referred to Article 4 of the Treaty. This says that:
and further says:
We entered the EDP in February 2009 so the three year transition period applies to us. This is confirmed by the final column and final row of the table in this press release.
We will be subject to the debt reduction criterion from 2018, but by applying the IMF projections it can be shown that will actually be in compliance with the rule from 2015.
We could not have used the rules to prevent the bank bailout. The 3% deficit and 60% debt rules have been in place since 1992, yet we had a deficit of 32% of GDP in 2010 and our debt exceeded 100% of GDP last year. These broke the Maastricht criteria but we could not have used the rules to ‘protect’ us as allowance is made for “one-off and temporary measures”.
Egad, HTML works! (Well, it works in my browser anyway.) That’s any ε > 0 in case anyone wants to be (even more) insufferably pedantic.
@ KOD
We peak at an excess ratio of .57. Approximate formula for when this will reduce to .005 is log(.005/.57)/log(.95) which is 93 years!
@Seamus
Thanks for that explanation.
I should say that I intend to vote yes in the referendum despite many issues, not least of which is the wording.
My simple reason is that Ireland (like the US in Iraq) does not have an exit strategy to a rejection of the compact.
‘Somebody’ will give us the money is pie in the sky stuff.
[I have some sympathy with the idea that a no vote would force emergency measures to deal with the crisis but that is not certain either given past performance of supine governments and greed of self interest groups].
A no vote would be a throwing down of the gauntlet to Germany in particular and the empress’ champion, the ECB, would be obliged to defend her honour and based on recent evidence would do so with relish.
Ireland would be putting itself in the front line in a confrontation with Europe and on an issue that is not critical to the future of Ireland right now.
We need to pick our fights more carefully and on an issue that critically affects us. I would suggest that if additional ‘capital’ were ‘required’ for the banks for instance that the time had come to say No and NO.
But not on this issue. We would be putting ourselves immediately in the front line and generally people in the front line are the first casualties and are considered quite expendable viewed from the ‘situation’ room.
@Eoin B, Seamus
I did mean nominal GDP, but 1% for a generation is an exaggeration on my part. More like 1% for the next 2-3 years followed by 2% for the following 10 years. After all, this has been the experience of Japan and they have their own currency.
Seamus, the period between 1971 and 2010 is simply not comparable. For most of this time we had our own central bank and our own currency. We had periods of high inflation, devaluation and a massive boom/bubble. That experience simply won’t be repeated.
How exactly are growth rates of 4.5% or 5% going to be possible in the next few years? Any nascent recovery in Ireland will almost certainly be accompanied by a recovery in the wider Eurozone and resolution of the crisis. What then will happen to interest rates? How do we think deeply indebted households on trackers and variable rate mortgages are going to manage on interest rates of 4 or 5%? With inflation in the core unlikely to be much above 2% we are likely to experience very low inflation here for a long, long time. That means that the domestic economy will be a huge drag on any growth in exports.
I know you were only providing a simulation, but these figures are often quoted by politicians and journalists as near facts. It largely goes unnoticed that relatively small changes in the growth assumption will lead to catastrophic changes in the required adjustment. Without a radical change of policy, the figures of Gurdgiev et al look more realistic that they are given credit for and policy should take account of these possibilities (which is clearly not the case at the moment).
@Brian Woods II
Very subversive Brian, welcome to the revolutionary cadre.
@ Shay
Hi….is this chair free? 😉
Friday Rant Warning
While our politicos are busy blowing up their chests against church child abuse, collecting pre referendum moral brownie points, “ex” Goldman Sachs Draghi speaks of GROWTH and of course, Noonan and other politicos throughout Europe pick up this mantra.
Mantra?
Yeah well, is it not the same old Banksta and e-CON-omits, I meant economist’s, mantra to fool the public with and satisfy exporters with programs that are really designed to lower wages and dismantle workers rights? Implementation of wage enslavement German style is on the agenda, combined with new impoverishment of the former middle class and much more state control A. Huxley style.
The rest of world prepares the next war. Soon to come to a theater near you in 3D of course, embedded 3D journalism, nothing nicer for breakfast than on Channel 4311 a swarm of cruise missiles in AOA, mhhh…or perhaps zzzap on Channel 2351, LIVE view from our drones over Teheran, mhhh naw, zzzzap Channel 1278 Cooking with Aunt Maggie, zzzap Channel 12-999 Pray fucking harder sucker, zzzap Channel 24 Eamon O’Cuiv juggling with seven burning Hamsters in front of Tubridy in tears laughing, zzzap Channel 1 …oh what’s that?… FLIPPER!…
@Seamus
Since bazza hasn’t come back… I think a realistic growth projection in a more normal environment would be average real growth 1971-2010+expected inflation…
Oops, missed bazza’s post above.
+1 bazza!
@ hoganmahew,
Between 1971 and 2010 the average real growth in GDP was 4.2%. It we put expected inflation at 2% that would mean a nominal growth rate in excess of 6%.
The IMF project 4.5% nominal growth post 2015 and elsewhere I have assumed a 3.5% nominal growth to show the impact of the debt reduction and structural deficit rules.
As for growth… might be worth remember this lecture by Prof. Bartlett
http://www.albartlett.org/presentations/arithmetic_population_energy_video1.html
@ Seamus
I think we can safely assume we will have inflation far below the average of 2%.
Can you please reconcile your use of predicted growth of 3.5% or 4.5% with the points I’ve raised above?
It doesn’t make sense to simply average over historical data, especially when that data pertains to a completely different economic regime.
And I forgot to even mention the deflationary impact that austerity will have on growth rates.
Look, I’m not trying to be a smart ass, but adhering to the terms of this fiscal treaty will never happen. Sooner or later, the government will have to hit its core constituency by cutting pensions, medical cards etc. And there will be a massive revolt. The TINA argument will be dead and we will default or leave the Euro or both. Pretending that such massive adjustments are possible only compounds the problem because it allows governments to bury their head in the sand and not do proper strategic planning for the future.
Interesting comments from Wolfgang today….
“Among other highlights, Schäuble has apparently declared that the results of this weekend’s Greek and French elections “will not have, in essence, any impact on German financial policies”.
Schäuble also rebuffed the idea that the winner(s) of the Greek general election could seek to change the terms of its financial aid package. Greece must respect the commitments made, he said, or else “it will have to bear the
That’s a clear message to the Greek people (who may not necessarily want the advice).
Schäuble’s concludes by saying that being a member of the EU is entirely voluntary.”
And it looks like Nicky is kaput with two polls showing him behind by 7% and another poll by a bit less.
@DOCM
About the banks capital…I see a report that the IMF are sending in a crack commando team to Italy next week with emphasis on the banks and what they have done with the LTRO.
@bazza
+1
You are on fire, I think that Seamus Coffey has to be close to admitting that the economic logic of the Fiscal Compact does not mix well with the actuality, at least from the point of view of the future viability of the Irish state.
It seems to me that the favourable outcomes forecast as a result of adopting the fiscal compact depend either on developments that the compact was designed to prevent (inflation, monetization of debts), the things that the compact ensures (austerity and unemployment) or on the power of the bloc that pushed the Fiscal Compact being reduced somehow by Ireland ratifying the treaty.
There are political arguments to be made for the compact (do we want to annoy our betters) but really, can we not all agree that the FC is basically a political stroke (almost a coup d’etat) by the right/financial sector in Europe and try and calculate whether we can afford to defy them?
As a depressing aside: The current EU really is a neo-liberal laboratory run by mad monetarist market fundamentalists. Who would ever thought that George Osborne (an entitled fool of the right) would be less in thrall to the financial sector than our current crop of Eurocrats? A world gone mad.
@ bazza,
It’s hard to reconcile anything with the points you make. You think inflation will be low both in the ‘core’ and in Ireland, yet you immediately follow that by wanting to incorporate the impact of high interest rates on household demand. Why would interest rates be high if inflation is as low as you suggest?
You also say “the domestic economy will be a huge drag on any growth in exports”. So we won’t be able to grow our exports to external markets because demand will be muted here. Again, I can’t follow the inconsistency. How can domestic demand act as a “drag” on external demand?
In this post I used IMF projections for the government debt ratio. Do you think they have ignored the factors you have raised? I think they know about inflation, interest rates, exports, debt, fiscal adjustments and much more besides. Based on all this they make a forecast. And it is just that, a forecast. Nobody expects it to be 100% right, merely a best guess based on the available information.
You seem to disagree with them. That is fine. Forecasts don’t need to be the same but you can’t dismiss them because they didn’t incorporate your low inflation/high interest rates scenario or the your belief that stagnant demand in Ireland will impact our export performance. If you know an organisation that has incorporated these into a set of forecasts provide a link and we can repeat the analysis from the original post on those figures.
It has been shown in a number of posts that the impact of the fiscal rules is relatively benign in a situation where post-2015 nominal growth rate is around 3.5% per annum. In my opinion this is a conservative number. The IMF are actually forecasting the nominal growth will be 4.5% in this period. I don’t know whether they will be right or wrong but that’s not the point. The point was simply to illustrate the impact of the fiscal rules in what is one likely scenario.
@Ceteris
re Schauble remarks on Greece:
“”If Greek voters were to vote for a majority that does not honour those agreements, then Greece will have to bear the consequences of that,” he said.
“EU membership is voluntary,” he added, without elaborating.”
So the person who is tipped to head of the new euro group believes that he has the authority and right to eject countries not only from the Euro but from the EU itself!
It is beyond time that a number of countries reminded Schauble that indeed “EU membership is voluntary”.
Ireland is getting itself in a sweat over a compact whose ink will hardly be dry before it is gone, probably with the euro itself, and an EU itself that will not survive if people like Schauble remain in position.
@ JR So it isn’t just MN, EG et al using the threat tactic……
@Seamus
“Why would interest rates be high if inflation is as low as you suggest?”
Are you trying to imply that there is a one-to-one relationship between inflation and interest rates? That an average EZ inflation rate of 2% is only compatible with a narrow range of interest rates, not that different to today’s rates? Are you familiar with IS-LM and multiple equilibria?
I am sying the following:
– The ECB is very hawkish about inflation and claim they will keep inflation close to 2% where it is now. That’s what I mean by low inflation. I, for one, believe them. That means that if countries like France, Spain, the Netherlands and Italy recover and start to grow and if doubts about the future of the Euro go away, the ECB will raise rates in line with growth in order to stop inflation going much above 2%.
– If average inflation in the EZ is around 2% and Germany and the core are booming as they are now and we are struggling, then I think its fair to say that German inflation will continue to be slightly above 2% and our inflation will be around 1% or slightly more.
Is the above story really that far fetched? Is it really impossible to imagine interest rates of 4-5% and inflation in Ireland below 1.5%. By the way, interest rates of 4-5% are not high by historical standards. How do you think highly indebted households will cope with interest rates of 4-5%?
All I am saying is:
recovery in EZ => increase in ECB rates => slump in domestic Irish consumption and renewed banking crisis => continured low inflation in Ireland => nominal growth of 2% if we are very, very lucky.
Do you really think that we can cope with a continued depression in the domestic economy, low inflation, interest rates of 4-5% and rely on a massive boom in exports to deliver nominal growth of 4.5% within 3 years?
Is all that really so inconsistent?
Concerning
“In this post I used IMF projections for the government debt ratio. Do you think they have ignored the factors you have raised?”
To be frank, yes, I do think they have ignored the interation of all these factors. If they were to do otherwise, it would be a tacit admission that the plan devised by themselves and the ECB/EU is or will be a failure. Its not like economic projections have never before been tailored to meet a pre-defined hoped-for outcome.
@Shay
Thanks and…
+1
People tend to forget the mess that is the Landesbanken system and how it was Germany that watered-down Basel III in 2010.
2 further quick thoughts
@Shay
I’m not sure the EC and Germany are neo-liberal, but they certainly know how to tailor the rules to suit themselves. They are fairly dogmatic when it comes to central bank policy though.
@Seamus
I don’t mean to personally take your projections to task – everyone takes the IMF figures as the starting point when they are plainly far, far too optimistic.
@ bazza 7.50pm
+1 Clear, concise and overall right. Academic conventional economics (Seamus on this occasion) misses the diversity of reality here (very often).
….which is why they don’t actually rule the world…..!
@ bazza,
Your views certainly are diverse. They keep changing.
I would also point out when it comes to GDP it is the GDP deflator that counts and not necessarily consumer price inflation in Ireland. Consumption is equivalent to around 50% of GDP, Imports are the equivalent of 75% of GDP and Exports are the equivalent of 105% of GDP.
@Seamus
How are my views “diverse” and “changing”? I have been harping on about exactly the same thing on this whole post.
So do you admit that Irish inflation of 1-1.5% and ECB interest rates are a reasonable medium term assumptions? Or does 2% EZ inflation only correspond to ECB rates of around 1%?
Relying on a huge boom in exports to counter a lasting depression in the domestic economy is wishful thinking. Even if there is a boom in exports in the next few years, with a depressed domestic economy, we will be highly susceptible to the slightest of shocks to global demand. With a likely continued depressed domestic economy, the fact that the best estimate of medium term growth is 4.5% is risible.
@bazza
I think if one were judging policies on their effects on civil society and the distribution of power between popular democratic control, private financial interests and individuals there is not enough room between German ordoliberalism, the EU’s convoluted market liberalism and modern neoliberalism for a twenty Deutsche Mark note.
Ordoliberals are obviously more conflicted(see the collected wisdom of W Schauble) than modern neoliberals but there is really not much of significance that separates them, a neoliberal would agree that neoliberal policies have a substantial philosophical component, an element of belief, while ordoliberals more frequently clutch at necessity to explain their policies. A neoliberal believes life naturally to be nasty, brutish and short (for the hoipolloi at any rate), an ordoliberal thinks that this is a best case scenario.
It is a mistake to get too wound up analyzing the theological differences between these churches of Mammon, the key thing for me is that both groups use the phrase “market discipline” unironically at a point in history where no genuinely thoughtful person could.
@ Seamus, bazza Clearly, however, GDP is only one indicator of the condition of the economy. It reflects spending and is somewhat distorted in Ireland by the MNC effect.
bazza “With huge household indebtedness and a very hawkish central bank, it will not be possible to achieve much more than 1% growth for a generation. ”
The more important point is the continuing reduction in household wealth and disposable income, and the increasing debt service levels for Ireland….