Year: 2012

Given that we are in Fiscal Compact mode here on the site, I thought I’d make a point about industrial production in Ireland. Today’s monthly release of the Census of Industrial Production (.pdf) shows up a few interesting features of the Irish economy. The CSO report that the seasonally adjusted volume of industrial production for Manufacturing Industries for the first quarter of 2012 was 5.2% lower than the preceding quarter, but the seasonally adjusted industrial turnover index for Manufacturing Industries increased by 3.2% in March 2012 when compared with February 2012 and actually increased on an annual basis.

I thought I might dig into this a little. The chart below shows monthly data from 2007 on industrial production for the ‘modern’ sectors of chemicals, pharmaceuticals, recording media, and medical devices, and individually the key exporting pharmaceutical and chemical sectors. Seasonally adjusted and indexed to 2005, then, we have the following:

Which shows that, for these key sectors on a seasonally adjusted basis there has been a marked drop since the end of last year. Before we all go shorting Ireland just yet though, to put these figures in a bit more context, here’s the same series averaged annually, with the last period averaged quarterly for 2012.

There’s still a decline, but it’s not quite the patent cliff Frank Barry has been highlighting recently. Definitely a series to watch however. Here’s the turnover statistics for the two chemical sectors, they don’t produce one for the modern sector:

We can clearly see more of a drop , but it’s a bit too soon to tell where this series is headed. Again, one to watch.

Many thanks to Seamus for providing an excellent analysis of the debt rule.   At the risk of overkill, I think it is useful to offer one further angle.  

One aspect of the debt (i.e. 1/20^th) rule that may not be fully appreciated it that it is – like the 3 percent deficit rule – a trigger for the Excessive Deficit Procedure (EDP).   In the past, the trigger for the EDP was a deficit greater than 3 percent of GDP.   With the revised Stability and Growth Pact, the EDP can be triggered either by an excessive deficit or an insufficient rate of reduction in the debt to GDP ratio.   This fact is important for reasons that link to the discussion about the uncertainty surrounding growth prospects across recent threads.  

To see this, it is useful to recast both the deficit and debt-reduction rules in a way that makes them more easily comparable.   (I will make some approximations to make the maths a bit more digestible, but they don’t change the basic message.)

The equation for the change in the debt to GDP ratio can be approximated by,

Δd = (i – g)d_-1 – ps,

where d is the debt to GDP ratio (in percent of GDP), i is the average nominal interest rate on outstanding debt, g is the nominal growth rate, d_-1 is last year’s debt to GDP ratio (in percent of GDP), ps is the primary surplus (in percent of GDP), and Δ represents the change in a variable (measured in percentage points of GDP). 

Noting that the overall deficit as a percent of GDP (denoted def) can be written as id_-1 – ps, we can rewrite the equation as

Δd = def – gd_-1.

The 3 percent deficit rule says that the deficit must be below 3 percent of GDP.   Using the last equation, we can rewrite the deficit rule as a debt reduction rule,

Δd < 3 – gd_-1.

Ignoring the averaging procedure that Seamus details in his post below to keep things simple, we can write the debt reduction rule as,

Δd < (1/20)(60 – d_-1) = 3 – 0.05d_-1.

Both rules take a surprisingly similar form.   Given the existence of deficit rule, the debt-reduction rule only binds on fiscal policy (in the sense of triggering an EDP) if the nominal growth rate is less the 5 percent per year.   (Note this is consistent with Seamus’s calculations given that the deficit is projected to fall below 3 pecent of GDP in 2015.)

(As an aside, some commentators have noted the superiority of debt-reduction rules over deficit rules.   I agree with this as a general principle.   But it is not necessarily the case when it comes to comparing the particular rules we have above.  The deficit rule has the advantage of being “growth contingent”: the implied required rate of debt reduction falls as the growth rate falls.   The debt-reduction rule is insensitive to the rate of economic growth.   I see the growth contingency as an attractive feature of the deficit rule.) 

While noting yet again that the debt rule is already in place under the revised SGP and so not new to the fiscal compact, critics of the rule have a point when they draw attention to possible drastic implications of the rule in a very low-growth scenario.  (In our previous posts, both Seamus and I took existing projections from the IMF and Government (SPU).  These projections are based on a return to reasonable growth rates.   But there is downside risk to these relatively benign growth scenarios.) 

This is where the fact that the debt-reduction rule is a trigger for the EDP becomes so important.   If the rule actually forced debt reductions according to the third equation above, the results could be catastrophic.    To take an extreme case, if nominal growth was zero percent and the debt to GDP ratio was 120 percent, then the rule would require that the debt to GDP ratio is lowered at the rate of 3 percentage points per year.  

This would be crazy in the context of zero growth; it would require a overall surplus of 3 percent of GDP and a primary surplus of about 9 percent of GDP.   But it is not what would happen.   If the rule is not met the country would enter the EDP.   Under the EDP, a deficit reduction path would be worked out that would balance the need to move towards compliance with the need to phase the adjustment over time.    The fact that what the debt-reduction rule does is trigger the EDP is a critical fact in understanding the implications of the rules.

Note: The post has been corrected for an error in the original version. 

Gavin Barrett tries to clarify some issues in this IT op-ed.

I would usually include this as a comment on my previous post.  Philip has urged us to put more substantive comments as new posts on the grounds that many readers do not read the comments – I hope that is not true.  

Commenters have rightly pointed to the substantial uncertainty surrounding the growth projections in the SPU.   Kevin’s post also puts a question mark over near-term projections.   This uncertainty is a major theme of the IFAC’s recent Fiscal Assessment Report (available here).    Although it is benchmarked on the projections in Budget 2012 rather than recently released SPU, one of the things we do in the report is examine the budgetary implications out to 2015 of alternative nominal growth assumptions.    The Figures on page 34 provide a sensitivity analysis based on a relatively simple simulation model that allows for two-way causality between the deficit and the state of the economy.   Figure 3.3.c shows the implied additional discretionary adjustments that would be required to meet the EDP target of a deficit below 3 percent of GDP in 2015 based on alternative nominal growth assumptions. 

On the question of the need for a less contractionary fiscal stance for the euro zone as a whole that Kevin emphasises, Simon Wren-Lewis had a typically thoughtful piece a couple of weeks back on the constraints on fiscal policy within the monetary union (see here).   Unfortunately, I am sceptical that much will be forthcoming in this direction.   While I am under no illusions about the massive – some might say impossible – political challenge, I think the best route to ease the contractionary forces within the euro zone still remain with the ECB.   A credible commitment to a higher euro zone inflation target (say 4 percent) – or, even better, and price-level target based on underlying 4 percent inflation – offers a real opportunity.  

While there are downsides, this revised target could accomplish a number of things: (i) with a clear mandate to achieve this single target, it is compatible with a reasonable definition of price stability; (ii) it would allow for lower real interest rates, thereby boosting interest-sensitive spending; (iii) given inevitable nominal rigidities, it would allow for a more feasible route to real exchange rate depreciations in the periphery relative to the core; (iv) it should lead to a nominal depreciation of the euro, allowing further  trade-weighted real depreciation for the periphery; (v) it would help ease real debt burdens; and (vi) it would help ease the overall euro zone budget constraint through higher seigniorage revenues.  

I am probably more sympathetic than many readers to the concerns of stronger euro zone countries over the large contingent liabilities and moral hazard problems that come with substantially beefed up mutual fiscal support mechanisms.   But, while recognising the value that countries place on price stability, the extent of the euro-zone crisis means that a higher inflation target appears to score well on any reasonable cost-benefit analysis.   Some (sensible) radicalism is badly needed.