Author: John McHale

It can be hard to get an intuitive sense of potential evolution of Ireland’s budgetary situation post-2015.   With this in mind, readers might be interested in seeing a hypothetical scenario for the period 2016-2020.   I hasten to add that this is neither a forecast nor a recommendation.  

The scenario begins with the Government’s projections out to 2015 as recently published in the Stability Programme Update.    To limit the number of assumptions, I focus on the actual budget balance rather than the structural budget balance.   The post-2015 scenario assumes: (1) an annual nominal GDP growth rate of 3.5 percent (which, for reference, compares to a forecast in the SPU of 4.5 percent nominal growth in 2015); (2) an average interest rate on outstanding debt of 4.9 percent for 2015-2020 (equal the projected interest rate for 2015 in the SPU); (3) total General Government  Revenue grows at the same rate as nominal GDP;  and (4) non-interest (or primary) General Government Expenditure grows at half the rate of nominal GDP.   Of course, a faster rate of primary expenditure growth would be possible for the same evolution of the budget balance with the tax system not fully indexed to nominal GDP. 

The evolution of the key aggregates (measured in millions of euro) are shown here; these aggregates as a share of GDP are shown here.   The debt to GDP ratio is shown here. 

Under this scenario, the actual deficit as a share of GDP would fall from the projected 2.8 percent of GDP in 2015 to -0.4 percent of GDP in 2020, a change of 3.2 percent points of GDP.   (The improvement in the underlying structural deficit should be broadly similar, starting from a projected 3.5 percent of GDP in 2015.   The rate of improvement is above the minimum required rate of improvement in the structural deficit of 0.5 percentage points of GDP per year along the adjustment path to structural balance.)   The debt to GDP ratio would be falling at a rate of 3.5 percentage points of GDP in 2019 and 4 percentage points in 2020, within the requirements of the one-twentieth rule, which comes into force after 2018.   

In Saturday’s Irish Times, Alan Ahearne does a good job laying out the dangers of unfolding events in Greece (see here).    Political support for the adjustment programme has been lost, with the Greek population understandably perhaps blaming much of their disastrous economic performance on the conditions of the programme.   While the austerity measures have certainly played a role in the growth performance, they are just one component, with the confidence-sapping effect of the fear of a melt-down situation itself playing a major role.   The correlation between austerity and weak growth is now deeply established in the minds of many Greek voters – whatever the actual contribution of the austerity measures.   A rejection of the programme in the elections is a real possibility.   So too is a tough response from official creditors to an unwillingness to meet the programme conditions.

A Greek exit from the euro zone could be containable with sufficient will.   However, there is a likelihood that moral hazard concerns could lead the response might be too halting, leading the crisis to easily spin out of control.    As Alan argues, even with a successful containment, the precedent of a country leaving the euro would fundamentally change the stability of the monetary union, making it more prone to the runs that plague fixed-exchange rate regimes.  (See also Martin Wolf here.)

Is there room to give Greece more time, providing at least some political counterweight to the massive anger at the programme?   The stronger euro zone countries are understandably concerned about the moral hazard problems of any backtracking on the conditionality being applied to Greece.  

This is where the weaker countries could play an important role.   They could do so by making it clear that they see no interest in seeking relief through default or in a relaxation of formal/informal commitments, regardless of any additional accommodations for Greece.  This need not include measures currently under discussion for strengthening the overall crisis management, including the lengthening of the maturity of the promissory notes, direct injections from the ESM into undercapitalised banking systems, or relaxing the aggregate stance of the Excessive Deficit procedure (especially for countries with fiscal space).    I think this goes with the grain with the approach of governments in Ireland, Italy, Portugal and Spain.   (Indeed, in the case of Spain, their unwillingness to accept a one-year extension for reaching the 3 percent target under their Excessive Deficit Procedure (EDP) may show excessive unwillingness to accept the easing of conditions, given that it can be viewed as part of broader easing of the aggregate stance of the EDP on the basis of the aggregate euro zone considerations.) 

I don’t want to exaggerate the impact of leadership of the weaker countries on this issue, but it could help tilt the steering wheel from what looks now like a very dangerous course.   Greece has got itself into a mess, much of it of its own making.   Greece has no choice but to make tough adjustments, but giving more time may be the only way to prevent political rejection.   Solidarity – but most of all self interest – should lead all euro zone countries to work hard at finding a workable way out. 

Simon Wren-Lewis widens the debate about self-defeating fiscal adjustment here, considering in particualr the cases of Spain and Greece.  I take a (very initial) stab at some of the analytics in this brief note.

The Zero Impact Treaty?

Some Observations About the Debt and Deficit Rules in the Fiscal Treaty

Some readers will have come across an article I wrote which was published in the Irish Times on Friday 4^th May. If not they will locate it here. This is just a short expansion on some of the ideas about the law expressed in that article. In essence, the point being made here is that the impact of this Treaty seems to be in the enhanced guarantee of adherence to its debt and deficit rules provided by (a) their ‘elevation’ to Treaty status (b) their domestication into national legal systems and (c) the Treaty’s extra enforcement provisions. Very far from costing us billions of extra euro or ushering in twenty years of austerity, the rules themselves however do not appear to involve any change at all from the standards we are already complying with – a point which is frequently missed by expert analyses. It is proposed to turn to each rule in question

1)      Debt Brake 

As I note in my Irish Times article, whatever the economic impact of such a debt brake – and this is something which has (quite reasonably) formed the subject of discussions on IrishEconomy.ie – this rule involves nothing new, since precisely such a debt brake is already found in Article 2(1a) of Council Regulation (EC) No. 1467/97   as amended by Article 1 of ‘Six Pack’ Council Regulation (EU) No. 1177/2011.   Readers will find that here (see p. 3 thereof). 

Its impact will not therefore be felt by anyone in the form of increased austerity. 

2)      Deficit Target 

Here unfortunately, in order to understand the legal position, it is necessary to quote the deficit target rule at length. Under Article 3 of the Fiscal Treaty,

 “(a) the budgetary position of the general government shall be balanced or in surplus.

   (b) the rule under point (a) shall be deemed to be respected if the annual structural balance of the general government is at its country-specific medium-term objective as defined in the revised Stability and Growth Pact with a lower limit of a structural deficit of 0.5 % of the gross domestic product at market prices. The Contracting Parties shall ensure rapid convergence towards their respective medium-term objective. The time frame for such convergence will be proposed by the Commission taking into consideration country-specific sustainability risks. Progress towards and respect of the medium-term objective shall be evaluated on the basis of an overall assessment with the structural balance as a reference, including an analysis of expenditure net of discretionary revenue measures, in line with the provisions of the revised Stability and Growth Pact.  

   (c) The Contracting Parties may temporarily deviate from their medium-term objective or the adjustment path towards it only in exceptional circumstances as defined in paragraph 3.”   

Article 3(3) provides some definitions which are necessary for the purposes of understanding the foregoing rule:  

“…”annual structural balance of the general government” refers to the annual cyclically-adjusted balance net of one-off and temporary measures. “Exceptional circumstances” refer to the case of an unusual event outside the control of the Contracting Party concerned which has a major impact on the financial position of the general government or to periods of severe economic downturn as defined in the revised Stability and Growth Pact, provided that the temporary deviation of the Contracting Party concerned does not endanger fiscal sustainability in the medium term.”  

What can be said about this new deficit rule?  The first observation is that there is already a rule in place – Article 2a of Council Regulation (EC) No. 1467/97   as inserted by Article 1(5) of Regulation 1175/2011 –  which stipulates that  

 “the country-specific medium-term budgetary objectives shall be specified within a defined range between -1 % of GDP and balance or surplus, in cyclically adjusted terms, net of one-off and temporary measures.”

Readers will find that here (see p. 5 thereof). So even if the Fiscal Treaty involved a straightforward obligation to hit a 0.5% structural deficit target, the most we could ever have been talking about would have been a shift in targets from a -1% cyclically adjusted deficit, to a -0.5% cyclically adjusted deficit.

The Fiscal Treaty does not however involve a straightforward obligation to hit a 0.5% structural deficit target.  Instead, the Article 3 Fiscal Treaty requirement involves an obligation to hit a tailor-made target for each country – and even that is shot through with exceptions and ‘wiggle room’ for those charged with enforcing it either at Irish or European levels: 

(i)                  the real requirement is merely that  the annual structural balance of the general government be at its country-specific medium-term objective as defined in the revised Stability and Growth Pact (with a lower limit of a structural deficit of 0.5 % of the gross domestic product at market prices); 

(ii)                even that is putting things too strongly, since Article 3(1) immediately stipulates that “the Contracting Parties shall ensure rapid convergence towards their respective medium-term objective.” – implying in reality that they do not actually have to hit their medium term objective, merely converge rapidly with it;  

(iii)               even ‘rapidly’ is a relative term:  according to Article 3(1), the “time frame for such convergence will be proposed by the Commission taking into consideration country-specific sustainability risks”; 

(iv)              moreover “progress towards and respect of the medium-term objective shall be evaluated on the basis of an overall assessment with the structural balance as a reference, including an analysis of expenditure net of discretionary revenue measures, in line with the provisions of the revised Stability and Growth Pact”; 

(v)                it should not be forgotten also that under Article 3(1)(c), the Contracting Parties may temporarily deviate from their medium-term objective or the adjustment path towards it in the exceptional circumstances as defined in paragraph 3 – which are broadly enough defined to include, within certain limits, ‘an unusual event outside the control of the Contracting Party concerned which has a major impact on the financial position of the general government’ and ‘periods of severe economic downturn’; 

That is not all. All of the foregoing are merely the general rules: more specific ‘soft law’ rules apply to Ireland. According to Ireland – Stability Programme Update (April 2012) at p. 31

“… Ireland’s ‘medium-term budgetary objective’ (MTO) currently stands at -0.5% of GDP. This objective was set well in advance of the Inter-Governmental Treaty on Stability, Coordination and Governance in the Economic and Monetary Union (the ‘Stability Treaty’)…”

In other words, as with the debt brake, the Fiscal Treaty involves the introduction of a structural deficit target which we are already aiming for. As with the Treaty’s debt rule therefore, regardless of the economic impact of aiming for such a target – and again, this has formed a very legitimate source of discussion on IrishEconomy.ie, the fact that the target is the same before and after the coming into force of the Fiscal Treaty should mean that the economic impact of the introduction of the Fiscal Treaty’s new deficit target should be precisely zero.

A few final rather random but still significant observations may be made on the debt and deficit rules

As regards the debt rule: 

·         even the veritable non-event of the new rule’s coming into force is postponed for several years –  Article 2(1a) plus Clause 13 of the Preamble to the 2011 Regulation provides for a transitional period before the debt reduction rule applies with full force, a rule which does not appear to be interfered with by the Fiscal Treaty (see Clause 20 of its Preamble)); 

·         some degree of confusion has arisen because of the somewhat ambiguous wording of Article 4 as to whether the ‘one twentieth per year’ benchmark reduction it refers to relates to one twentieth of the entire debt-to-GDP ration or merely to (a less onerous) one twentieth of the excess over 60% reference value. The words ‘as provided for in Article 2 of Council Regulation (EC) No. 1467/97 of 7 July 1997’, however indicate that what was intended was the lesser amount i.e., one twentieth of the excess over 60% reference value. There appears to be no change there from the existing legal position.

As regards the deficit rule:

·         despite the misleading wording of Article 3(1)(a)of the Fiscal Treaty, the Treaty does not really oblige the budgetary position of a Contracting State’s general government to be ‘balanced or in surplus’ (since moments later Article 3(1)(b) refers to a lower limit of a structural deficit of 0.5 % of the gross domestic product at market prices) – a lower limit which could not exist were there really an obligation to have a budgetary position balanced; 

·         structural deficits are easier targets to be aiming at for an economy in a downturn than ordinary deficits; 

·         as regards the meaning of ‘rapid convergence’, in Ireland’s case, the Commission has already set us an ‘excessive deficit procedure’ general government balance target of 2.9% by 2013. It seems unlikely to adopt a different approach in the context of structural deficits. (see p. 45 of  Ireland – Stability Programme Update (April 2012)). 

There is of course far more to be said about the law and the Fiscal Treaty, but not in a blog of this size. The IIEA were kind enough to invite me to contribute a few thoughts to their website on e.g., the implications of putting this material in the Constitution. Interested readers may want to visit that site which they will find linked here.

Paul Krugman has an interesting column in Sunday’s New York Times; it is also appears in the Business section of today’s Irish Times.   There is much that I agree with in the article regarding the boarder European crisis resolution response.   But I think his comments on Ireland’s adjustment policies are off the mark.   Paul complains about Ireland being used as a misleading data point in the international debate.   I think Paul is himself guilty on this score. 

Here’s what he says about Ireland:

What’s wrong with the prescription of spending cuts as the remedy for Europe’s ills?

One answer is that the confidence fairy doesn’t exist – that is, claims that slashing government spending would somehow encourage consumers and businesses to spend more have been overwhelmingly refuted by the experience of the past two years. So spending cuts in a depressed economy just make the depression deeper. Moreover, there seems to be little if any gain in return for the pain.

Consider the case of Ireland, which has been a good soldier in this crisis, imposing ever-harsher austerity in an attempt to win back the favour of the bond markets. According to the prevailing orthodoxy, this should work. In fact, the will to believe is so strong that members of Europe’s policy elite keep proclaiming that Irish austerity has indeed worked; that the Irish economy has begun to recover.

But it hasn’t. And although you’d never know it from much of the press coverage, Irish borrowing costs remain much higher than those of Spain or Italy, let alone Germany.

A number of responses:

1.   As far as I can see, those involved in the design of Ireland’s adjustment programme do not believe in the “confidence fairy”.   It has been explicitly recognised that fiscal adjustment slows the economy.   The programme has been designed in order to balance the need put Ireland on a fiscal path consistent with debt sustainability and regaining the country’s creditworthiness, while securing needed official lender support, and minimising the adverse effects on the real economy through a official-lender supported phased adjustment approach.

2.  Ireland’s growth performance has been disappointing.   But the causes of the poor performance go well beyond the effects of fiscal austerity.   The weight of impaired balance sheets in a post-bubble and a weak international environment are also major drags on growth.   Of course, Paul is far too good an economist not to realise this.  

3.  It would be true that Ireland’s adjustment effort is failing if the fiscal measures were directly self defeating in terms of improving the underlying fiscal situation.   There are a number of relevant measures: Are the fiscal adjustments leading to an improvement in the underlying primary deficit?   Are these adjustments improving the underlying path of the debt to GDP ratio and putting Ireland on a path to debt to GDP ratio stabilisation?   And are these adjustments helping to restore Ireland’s creditworthiness? 

On the underlying primary deficit, the number has come down from 9.7 percent in 2009 to 6.0 percent in 2011, with a projected further fall to 4.2 percent in 2012. 

On the debt to GDP ratio, the calculation is more complex because we have to see how adjustments affect the path of the ratio.   For plausible multipliers, it is certainly possible that the debt to GDP ratio rises in the year of adjustment due to a strong adverse effect on the denominator.    For example, using an automatic stabiliser coefficient 0.4 – a key parameter in determining the possibility of self-defeating adjustment – simulations show the debt to GDP ratio would rise this year as a result of a (permanent) additional €1 billion of adjustment with a deficit multiplier of 1.  However, this ignores the positive effect on the future debt ratio of lowering the nominal primary deficit this year, which will lower the nominal debt and thus interest payments in the future.   Simulations show that the multiplier would have to be as large as 3.8 – completely implausible for a small open economy – for the debt to GDP ratio to be actually higher in 2015, all else equal. 

On creditworthiness, the impressive recent work of Delong and Summers introduces the possibly adverse effect of “hysteresis” on creditworthiness.   (The effect here refers to the fiscal shadow cast by lower output today due to persistent effects on output.)    This is harder to get an empirical handle on due to the difficultly in observing these effects.   However, notwithstanding the fact that Ireland’s bond yields are above those in the Germany or even Spain, the improvement in Ireland’s market creditworthiness has been dramatic since last summer as Ireland’s adjustment programme has gained credibility.   (The evolution of Ireland’s 2-year bond is shown here; the 9-year yield here.)  This has occurred despite increasing evidence of the damage done to the economy by the bubble, despite the euro zone crisis remaining in flux and despite the clamour to abandon the adjustment programme and default. 

The success of Ireland’s adjustment programme is too important for it to be used as misleading fodder in a debate over appropriate fiscal policies for creditworthy countries.