Economic Assessment of the Euro Area

On behalf of the EUROFRAME group of research institutes, the ESRI today published a report entitled “Economic Assessment of the Euro Area”.

Among the findings contained in the report are the following:

·         As a result of relatively weak external demand, continuing financial uncertainty and the contractionary stance of fiscal policy, output fell in the Euro Area in 2012 (-0.5 per cent). Over the course of 2012 there was a slowdown in some key economies, which were previously contributing much of the growth. This slowdown has carryover effects into 2013.

·         Even though we anticipate a recovery in confidence in some major economies over the course of this year, the outcome for the Euro Area as a whole is still likely to be a further limited fall in GDP in 2013 of 0.3 per cent. Weak external demand will not be enough to compensate for the fall in domestic demand.

·         For 2014, a recovery in domestic demand should see a return to significant growth in GDP of around 1.3 per cent. However, this forecast must be considered in the light of the continuing vulnerability to financial shocks of a number of the Euro Area member states.

·         This vulnerability of countries in financial distress is being addressed through a continuing major fiscal adjustment. However, the fiscal adjustment under way across other members of the Area is also having a substantial negative effect on growth, particularly in the crisis countries. Without this fiscal adjustment the Euro Area would be looking to growth this year at around 1½ per cent and next year at approximately 2 per cent.

The Macro-economic Impact of Changing the Rate of Corporation Tax

Today the ESRI has published a research bulletin summarising a paper entitled: The Macro-economic Impact of Changing the Rate of Corporation Tax by Thomas Conefrey (Central Bank of Ireland) and John FitzGerald (ESRI).

This paper considers the impact of changes in the rate of corporation tax in Ireland affecting the business and financial services sector. A model is estimated that relates services exports and output to world activity, competitiveness and the rate of corporation tax. This model indicates that a reduction in the rate of corporation tax in the 1990s stimulated exports and, even allowing for profit repatriations by foreign firms and replacement of lost tax revenue, it resulted in an increase in domestic output. The increase in profitability suggests that some of the increased output involved relocation of profits to Ireland by multinational firms.

The Research Bulletin is available here.

The Banking Sector and Recovery in the EU Economy

Today the ESRI has published a research bulletin summarising a paper entitled: THE BANKING SECTOR AND RECOVERY IN THE EU ECONOMY By Ray Barrell (NIESR), Tatiana Fic (NIESR), John Fitz Gerald (ESRI), Ali Orazgani (NIESR) and Rachel Whitworth (NIESR)

This paper considers how banks within Europe have become larger and more international as Europe has moved towards a unified financial services market, but this trend has been reversed since the crisis. In order to establish the effect of these structural changes on output in Europe, we use a micro data set to investigate the impact of size (as measured by asset size) on banks’ net interest margins. We show that larger banks offer lower borrowing costs for firms, which raises sustainable output. We then use NiGEM to look at the impact of banks becoming smaller and moving back into their home territory. We investigate the impacts on output according to country size, showing that the effects are generally larger in small countries, and also larger in economies that are more dependent on bank finance for their business investment decisions.

The Research Bulletin is available here.

The full version of the article is available at a fee here.

The ESRI’s Quarterly Economic Commentary

The ESRI’s Quarterly Economic Commentary (QEC) by Alan Barrett, Ide Kearney, Jean Goggin and Thomas Conefrey, published in December, is now available to download free of charge from the ESRI’s web site here. This QEC contained a number of pieces of research which may be of general interest.

1. Measuring Fiscal Stance

In box 1, entitled “Measuring Fiscal Stance”, the stance of fiscal policy in every year since 1976 is analysed within a consistent modelling framework. This research shows that the 2010 budget, while definitely contractionary, was actually not one of the toughest budgets of the last half century. That “accolade” goes to the 1976 budget, with fiscal policy in 1983 and 1984 and in 1988 and 1989 coming in next in line. After that comes the series of budgets implemented for 2009 and 2010. However as is noted in the box, a futher contractionary budget is planned for 2011 so the cumulative contraction in these years may well ultimately exceed the cumulative contraction in the late 1980s.

This measure is obtained by running the HERMES model with taxation and welfare rates indexed and certain rules on public expenditure. This “budget” is taken to be neutral – generally under this rule the relative size of the public sector in the economy would change little in the long term. This result is compared with the actual outturn with the difference being attributable to discretionary fiscal policy.

This measure of fiscal stance tells us whether a particular budget is deflationary or inflationary. It does not tell us whether it is appropriate. However, as discussed in the box, more often than not the stance has been inappropriate – i.e. procyclical.

While not discussed in the QEC, I think that it is interesting that the day of the budget the Department of Finance published an alternative measure for 2010 using the EU standard methodology. This actually suggested that the budget for this year was stimulatory. This strange outcome arises from the inappropriate nature of the EU methodology. The Department of Finance understandably did not draw attention to this result as they clearly saw that it was not a sensible approach. This problem with the EU methodology is not unique to Ireland but affects its application to other EU member economies under current circumstances. I think that the EU approach was not designed to deal with a crisis of the kind experienced in Europe over the last two years. This issue merits further research to find a more robust approach which can be applied in a consistent way to different Euro area economies.

2. The Balance of Payments and the Flow of Funds

In box 4, entitled “Balance of  Payments”, the implications of the economic forecasts for the capital side of the balance of payments is considered. With the government sector likely to borrow over 11% of GDP this year and with a prospective small balance of payments surplus, in 2010 the private sector will have a major net acquisition of financial assets abroad (more properly a repayment of net liabilities). Some of this repayment will not flow through the banking system. However, a significant part of it will affect the domestic banking system as households and companies increase savings or reduce borrowings from domestic banks. In turn, the banks are likely to reduce the size of their balance sheets and, hence, their net foreign liabilities. As shown in the box, there was a substantial reduction in these liabilities (largely to the ECB) in the second half of 2009. If this trend were to continue, with the prospective continuing large net repayment of foreign liabilities implied by the 2010 forecast, there should be a continuing substantial reduction in the banking system’s foreign exposure, especially in its exposure to the ECB. This will be important as the ECB begins to wind down its support for the Euro area financial system. Obviously this must be seen against the background of the government sector’s increasing foreign liabilities, a significant part of which will be needed to recapitalise the banking system this year.

3. Distributional Effects of Budgets

In Box 2 the distributional impact of tax and welfare policy changes in 2009 and 2010 was considered by Tim Callan, Claire Keane and John Walsh. They found that while Budget 2010 was clearly regressive, the combination of Budgets 2009 and 2010 placed most of the burden of fiscal adjustment on higher earners. 

Investing in Electricity Infrastructure and Renewables in Ireland

With three colleagues Seán Diffney, Seán Lyons and Laura Malaguzzi Valeri, we have recently published a series of papers on the economics of the electricity industry in Ireland. The conclusions are summarised in a Research Bulletin published today. There is also an article in today’s Irish Times.

The original papers are:

DIFFNEY, S., J. FITZ GERALD, S. LYONS and L. MALAGUZZI VALERI, 2009. “Investment in Electricity Infrastructure in a Small Isolated Market: the Case of Ireland,” Oxford Review of Economic Policy, Vol. 25, No. 3, pp. 469-487. Available here. We will release a working paper with additional results on this topic in the next few days.

MALAGUZZI VALERI, L., 2009. “Welfare and Competition Effects of Electricity Interconnection Between Great Britain and Ireland”, Energy Policy, Vol. 37, pp. 4679-4688. available here. An earlier version is available as a working paper.

Managing Housing Bubbles in Regional Economies under EMU: Ireland and Spain

 

Today Thomas Conefrey and myself publish a working paper entitled “Managing Housing Bubbles in Regional Economies under EMU: Ireland and Spain”. It is available here .

With the advent of EMU, monetary policy can no longer be used to prevent housing market bubbles in regional economies such as Ireland or Spain. However, fiscal policy can and should be used to achieve the same effect. This paper shows that the advent of EMU relaxed existing financial constraints in Ireland and Spain, allowing a more rapid expansion of the housing stock in those countries to meet their specific demographic circumstances. However, the failure to prevent these booms turning into bubbles did lasting damage to the two economies, damage that could have been avoided by more appropriate fiscal policy action.

The failure to tighten fiscal policy in Spain and Ireland in the early years of this decade laid the ground for the housing market bubbles in the two economies. The Stability and Growth Pact proved a distraction: government budgetary balance was not an appropriate fiscal target for those two economies. By contrast, Finland, having learned from its mistakes twenty years ago, ran substantial government surpluses to prevent domestic overheating. Specifically in relation to overheating in the housing market, we consider that a temporary tax on mortgage interest payments (first suggested in 2001) should have been used to target overinvestment in housing, investment which seriously crowded out the traded sector of both economies. This tax would have mimicked an increase in interest rates. Obviously it will be a very long time before such a tax might be needed in either Spain or Ireland to limit overinvestment in housing.

The paper shows that demographic circumstances in both Spain and Ireland meant that it was appropriate that investment in housing in those two economies should have been somewhat higher than in their neighbours. Even after the housing bubbles have burst, the relatively low endowment of housing infrastructure in the two economies (relative to adult population) means that there will be a need for additional investment in the next decade, when the current excess supply has been worked off.

In the paper we also include a graph taken from our paper “Recovery Scenarios for Ireland” published in May  which, inter alia, considered likely housing demand over the coming decade. Our model included estimated 2009 population numbers which were quite close to the latest estimates published by the CSO. We assume that between 2009 and 2015 there will be cumulative net emigration of up to 120,000. Our analysis would suggest that the underlying population increase would lead to somewhat higher demand for housing than Brendan Walsh has estimated in a recent post for the period to 2015. In addition to the pure “demographic” effect we also factor in some increase in headship on the basis of the recent rise in the number of households, which possibly reflects falling rents.


 

Tilting at windmills

In considering how to value land under current economic circumstances answers may turn up in unexpected places. One of the most important state regulatory authorities, the Commission for Energy (CER), has taken the plunge and revised down their assumed value of land. In this case it is the site procurement cost for windmills. My colleague Laura Malaguzzi Valeri pointed me to page 41 of their document on Fixed Cost of a Best New Entrant Peaking Plant & Capacity Requirement for the Calendar Year 2010 where they say:

 “Due to the significant movements in the economy over the last year, the value of land has reduced. An independent assessment was carried out on current land values, and the RAs are satisfied that the estimate for 2010 is an reasonable reflection of the current costs.”

As a result, they have revised downward the value which they assume by 63%.

Because wind producers are price takers on the competitive wholesale market this will not affect current electricity prices. Nonetheless, the fall in land prices should reduce the long-term cost of producing wind energy, with beneficial effects for consumers.

If NAMA want to read up on the details of this valuation it can be found at:

http://www.allislandproject.org/en/capacity-payments-consultation.aspx?article=f6ff1ea8-5f01-416d-a863-cb945a3d71d9

Irish Economic Association Conference

TWENTY-THIRD ANNUAL CONFERENCE OF THE IRISH ECONOMIC ASSOCIATION:  BLARNEY GOLF RESORT HOTEL, BLARNEY, CO CORK: 24-26 APRIL 2009

This year’s conference has a record number of submitted papers covering a wide variety of topics.

The conference Programme is now available http://www.iea.ie/conferences/iea2009programme.pdf: the booking form may be downloaded http://www.iea.ie/conferences/iea2009booking.doc.  There is now very limited accommodation at the conference hotel: further information from the local organisation: ieaconference@ucc.ie

There will be two plenary guest lectures:

The Edgeworth Lecture (sponsored by the Central Bank of Ireland and Financial Services Authority of Ireland): Professor Paul Collier (University of Oxford): The Political Economy of State Failure.

The DEW/ESR Lecture: Professor James Heckman (University of Chicago and UCD Geary Institute. The Economics and Psychology of Personality .

As can be seen from the programme, there are eight sessions on macroeconomics, money and finance. As usual the conference is strong on labour economics with three sessions on the topic. In all there will be 27 sessions with 80 papers. In most cases four sessions will run in parallel.

 

The Structural Deficit

Together with my colleagues Adele Bergin, Thomas Conefrey and Ide Kearney we have prepared a note that summarises the preliminary results of research under way at the ESRI examining the current macro-economic problems facing the Irish economy and the possible policy responses. The full analysis and results of this research will be published in the next ESRI Quarterly Economic Commentary to be published at the end of April. The note is available at http://www.esri.ie/research/research_areas/macroeconomics/ireland_in_recession/Maceconomic_Rec.pdf

We estimate that the potential growth rate of the economy over the period 2005-2020 will average around 3 per cent a year. This estimate is derived from research undertaken using the HERMES macro-economic model. This estimate of the potential growth rate is substantially lower than the 3.6 per cent that was estimated as recently as last year in the Medium-Term Review, reflecting the damage done by the current crisis.

Over the period 2008-2010 the cumulative fall in output could exceed 10 per cent. Even with a potential output growth rate of only 3 per cent a year, this would result in a large output gap – the gap between the potential output of the Irish economy and the actual output. (Account is taken of the fact that there was a large positive output gap in Ireland before the recession began – i.e. output was above potential.) This means that when the world economy recovers the Irish economy would be expected to grow well above its potential for several years.

We estimate that the government structural deficit is in the range 6 to 8 per cent of GDP. It is important that the government in its April budget moves to substantially reduce this deficit. If such action is followed up with a further significant reduction in the budget deficit for next year, it could move to halve the deficit by the end of 2010. This would leave a quite manageable task of eliminating the remaining structural deficit by 2015. It would also provide room for manoeuvre if the world recovery occurred later than current forecasts would suggest.

While fiscal policy action this year and next year must substantially reduce the structural deficit, the total deficit could nevertheless be 10 per cent or more of GDP this year and next year because of the exceptional nature of the world recession and the resulting cyclical increase in the deficit. However, with rapid growth in the recovery period (2011-15) the cyclical element of the deficit would be eliminated by natural buoyancy in revenue and the reduction in unemployment consequent on a restoration of employment growth.

The Public Finances – How Big a Mountain?

With a deficit for 2009 heading above 10% of GNP things indeed look bleak. However, some of the comment on the situation exaggerates the task that future Irish governments face. To the extent that the deficit is the result of an extreme cyclical downturn it could come right in the recovery phase of the world cycle. It all depends on when that recovery occurs and how “normal” it is. However, we also know that there was a major public finance problem even before the world recession took over and that problem will still have to be addressed by future Irish governments.

The budget for 2009 was designed to be broadly neutral. The fact that the deficit will be much worse than expected (and worse than last year) will be substantially due to automatic stabilisers reflecting the fact that the expected fall in output for 2009 is much worse than was expected by the Department of Finance when they framed the budget.

The concerns which I raised in an earlier post related to the possibility that the price level in 2009 will be substantially lower than anticipated in the budget. With expenditure fixed in nominal terms this could result in the budget being much more stimulatory than intended. While John McHale is right in suggesting that the depth of the current recession means that it is not the time to cure the public finance problem by deflationary fiscal policy, the gravity of the problem also means that there is no scope for the government to provide a fiscal stimulus. For this reason it is important that the government looks again at its budgetary profile for 2009. It will need to be adjusted as soon as possible to take account of any likely undershooting on the expected price level (including the price of labour).

While this approach to a fall in the price level is, I believe, correct for Ireland, it need not necessarily be the right approach for the Euro area or the US. The difference is that in Ireland the price level is anchored (with a long chain) to the Euro area price level. There is thus no danger that action by the Irish government could set off a deflationary spiral.

If the world economy were to begin its recovery in late 2009 or the beginning of 2010 then a “normal” recovery would see the world economy grow more rapidly than trend for a period. Because the Irish economy is much more highly geared to the world economy (especially to the US) than the rest of the Euro area, the recovery would also trigger a period of above average growth in Ireland. In turn, with a neutral fiscal policy in Ireland, this would be sufficient to produce a major reduction in the deficit. This could ultimately greatly reduce the size of the deficit without discretionary government action.

If the Irish labour market proves sufficiently flexible to price Irish labour back into full employment over a five year period, the resulting rise in output (and reduced unemployment) would eventually further reduce the deficit. (In the short run an across the board cut in wage rates would marginally increase the deficit. The significant positive effects on the deficit would follow with the resulting rise in output in future years.)

Taken together these two changes could eventually halve the deficit. This would still leave a lot to be done by discretionary fiscal policy in the recovery phase. While pretty painful it would, nonetheless, be possible to do it over a four or five year period without jeopardising the economic recovery.

In Karl Whelan’s post he quotes the government’s updated stability programme projections for the decline in the deficit in future years. He comments that the update provides no details on how these adjustments are to be made. However, if half of the adjustment were to be achieved in the way I outlined this would not involve any government measures. It is the rest of the adjustment which will involve significant changes in the public finances. Other posts have dealt with the need to broaden the tax base – something which would be desirable in any event.

The picture I have portrayed above, where a substantial part of the “heavy lifting” is done for the government by market forces – a world recovery and a flexible labour market – is conditional on a “normal” world economic recovery beginning within the next year. However, there is a lot of pessimism about among economists in the US. At the AEA a number of key protagonists (e.g. Rogoff) expressed doubts about the prospects of a “normal” recovery setting in in the near future. If such pessimism were to prove valid it would see the government’s fiscal problems continue to deteriorate in 2010. Under these circumstances the underlying long-term public finance problem would continue to deteriorate leaving a bigger hill to be climbed whenever a recovery set in.

In the EUROFRAME report on the Euro area economy which the ESRI co-published at the end of November, using the NiGEM world model we considered what might be the long-term effects of a permanently higher risk premium on the capital stock, and hence output in the US, the Euro area and the UK. The conclusion was that the permanent damage to these economies’ productive potential would be limited, though significant. However, the current crisis may affect the world economy through other channels than we considered and there remains the possibility that even more long-term damage will be done. In such an eventuality Ireland’s problems will be part of a broader crisis, the solution to which has still to be thought through.

A Path to Recovery

So far the bulk of the population have been insulated from the recession and, on present forecasts, this could continue through 2009. The latest ESRI QEC suggests that over the two years 2008 and 2009 output per head will fall by around 9% while real wage rates will actually increase. The insulation being provided for the bulk of the population comes from two sources: government borrowing, which will exceed 10% of GNP in 2009, and a dramatic collapse in the profitability of the company sector. A consequence of the loss of profitability, arising from the cumulative loss of competitiveness, will be that the rate of unemployment will exceed 10% before the end of next year. It is clearly unsustainable that the only people who will suffer a dramatic drop in their living standard will be those losing their jobs while those who continue in employment actually see an improvement in their living standards.

 Up to the summer the developing recession was a home-grown affair due to the mismanagement of domestic fiscal policy. The housing bubble was inflated by public policy and it crowded out the tradable sector of the economy by promoting a major slide in competitiveness. However, over the course of the Autumn the world financial crisis, and the particularly noxious form that it has taken in Ireland, has more than doubled the prospective fall in output.

 To get out of this mess a number of things need to happen. Firstly, the world economy needs to recover, including a restoration of order to the world financial system. Secondly, competitiveness needs to be restored. Thirdly, the imbalance in the public finances needs to be tackled. Fourthly the banking mess needs to be sorted out – properly.

Clearly the restoration of order to the world economy is outside the control of the Irish authorities. It remains unclear when the world economy will return to growth. Current hopes/expectations are for a turnaround by the end of 2009. The longer it is delayed the bigger the mountain that will have to be climbed in restoring the Irish economy to sustainable growth. However, when it does take place there is likely to be somewhat more rapid growth than normal in the world economy during a prolonged recovery phase.

If the world economy were to turn the corner before the end of 2009 it would have a very significant impact on the Irish economy because of its “gearing” through trade. It could be enough to undertake a significant part of the heavy lifting. It would probably eventually bring the rate of unemployment below 10% and the deficit in the public finances could fall substantially from its 2009 level. Nonetheless, the legacy effects of past policy mean that there is still likely to be a government deficit of well over 5 percentage points of GNP to be eliminated. It could well be larger than this if the world recovery is much delayed. Also, it would not address the competitiveness crisis so that unemployment would remain very high and it would not return the public finances to a sustainable path.

In the private sector wage rates are generally set on the market rather than by the “partnership process”. In the past they have shown themselves to be flexible in an upward direction. At the time of the bursting of the dotcom bubble wage rates actually fell in a few exposed sectors that were particularly badly affected, as employers and employees worked to stay in business and protect jobs. With a likely very low rate of inflation in the Euro zone next year, and a consequential moderate increases in wage rates among our competitors, tackling the competitiveness problem will be difficult. If, for example, Ireland needed to improve its competitiveness by 5% relative to its partners this could be done in two ways. A pay freeze in Ireland with wage inflation in our partners of 1% to 2% a year would mean that the process could take 3 or 4 years. Alternatively, a 5% fall in nominal wages in 2009 would achieve it all in one year with major beneficial effects on unemployment and growth in the medium term. We don’t know yet how much ground we have to make up, only that the competitiveness hurdle is high. It does seem likely that the market will deliver at least a wage freeze in the private sector and, very possibly, a small fall in nominal wage rates. This would still leave a lot of work for future years, with a high cost in terms of prolonged unemployment.

Given the problems with the public finances and the prospect of at least a standstill in private sector wage rates, if not a much-needed fall, it will be essential that the public sector at the very least follows suit. Given that public sector workers are generally better remunerated than comparable workers in the private sector it would make sense for there to be a significant cut in nominal wage rates in the public sector in 2009.

Even with a world recovery and a major gain in competitiveness this will still not be enough to sort out the public finances. Over four or five budgets from 2010 governments will have to either raise taxes or cut expenditure to restore order to the accounts. Initially, by improving efficiency in public services, some savings on expenditure are possible. However, if the public continue to want at least the current level of public services then increases in taxation will be the order of the day. As Ireland today has one of the lowest tax burdens in the OECD a significant increase in tax rates over the years of economic recovery would be feasible. However, it will mean that government will have to pre-empt an unusually large share of the fruits of the recovery in its early years in the form of additional taxes, such as a carbon tax, a property tax, and higher excise taxes.

The area where the government faces the possibility of another important “surprise” in the forecast is with regard to the price level. If sterling were to remain where it is today it could result in a much more dramatic fall in the CPI than currently forecast. If, in turn, employees in the private sector bargained in terms of real after tax wage rates (as they have in the past), this could greatly help the process of cutting nominal wage rates to improve competitiveness. A fall in nominal wage rates of 5% would, in turn, cut the CPI by a further percentage point. Such a “surprise” fall in the price level could thus be very good for competitiveness. It could also be achieved without a major drop in real incomes for employees (due to the implied terms of trade gain). However, unless the government acts rapidly, it could also dramatically worsen the public finance problem.

To deal with a fall in the CPI of much more that 2% in 2009 the government would have to ensure that wage rates fell by a similar amount in the public sector. However, that would not be enough. With welfare rates scheduled to rise in nominal terms by 3% in 2009, real welfare rates could end up rising by the largest amount experienced since 1982. Such a dramatic increase, coming on top of an already very high replacement rate could have a major impact on the long-term unemployment rate well out into the next decade.