Author: John McHale

The voting public must be getting frustrated with the wildly conflicting claims of politicians and economists on consequences of accepting/rejecting the Fiscal Treaty. As some of the consequences are genuinely uncertain – notably access to funding if the Treaty is rejected – conflicting assessments of consequences are not really surprising. But the public are also being subjected to some wild claims relating to the budgetary arithmetic of meeting the fiscal rules – rules already in place under the revised Stability and Growth Pact. It might be worthwhile to take a closer look at the numbers.

To get a sense of the likely additional fiscal effort required to meet the 1/20^th and structural balance rules, a useful starting point is the most recent Government projections for the period to 2015 just published in the Stability Programme Update (SPU). Of course, as these are just projections; the actual situation in 2015 may be quite different. But examining what extra discretionary adjustment effort would be needed helps identify a rough order of magnitude, and hopefully weed out some wilder assertions. For reference, details of the implementation of the Stability and Growth Pact rules are available here.

The 1/20^th Rule

The actual application of the rule uses both backward and forward looking averaging. To keep things as simple as possible, I will just look at the rate of debt reduction in the current year.

The change in the debt/GDP ratio is given by a simple formula:

Δd = [(i – g)/(1 + g)]d_-1 – ps,

where d is the debt/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 the previous year’s debt/GDP ratio, and ps is the primary surplus (in percent of GDP).

We can use the projections in the just published SPU to get a sense of the projected underlying rate of debt ratio reduction in 2015. The lagged debt/GDP ratio (2014) is 119.5 percent of GDP, the nominal interest rate is 0.049, the nominal growth rate is 0.045, and the primary surplus is 2.8 percent of GDP. This yields a projected underlying fall in the debt/GDP ratio of 2.3 percentage points of GDP in 2015. (The actual fall projected in the SPU is 2.1 percentage points due to a stock-flow adjustment.) This suggests a further total improvement in the primary surplus equal to 0.7 percentage points of GDP would be sufficient to achieve the required 3 percentage-point reduction rate [(1/20)(119.5 – 60)]. Moreover, all else equal, the primary surplus as a share of GDP required to meet the rule declines as the debt/GDP ratio declines.

The Structural Balance Rule

The structural balance rule requires the structural deficit to be brought down to 0.5 percent of GDP. The Stability Programme Update projects a structural deficit of 3.5 percent of GDP in 2015. The implied nominal structural deficit is €6.3 billion. The nominal structural deficit consistent with the 0.5 limit (Ireland’s Medium-Term Budgetary Objective, which is the operational definition of structural balance) is €0.9 billion. The difference – €5.4 billion – might seem to suggest a large additional adjustment is required. But this ignores the impact of growth in nominal potential/actual GDP in subsequent years in bringing down the structural deficit in the absence of any discretionary adjustments.

Growth affects both the denominator and the numerator of the structural deficit as a share of GDP. (For simplicity I assume that actual and potential GDP grow at equal rates post 2015.) The denominator effect is straightforward. For the numerator, we could use the standard coefficient used by the European Commission for Ireland that assumes that the reduction in the deficit is 0.4 times the change in nominal GDP. (This coefficient is usually used for doing cyclical adjustments, but it should also be applicable for measuring the impact of changes in nominal potential GDP on structural balance in the absence of discretionary adjustments to tax and expenditure parameters.) However, to err on the conservative side, I assume a coefficient of just 0.2 for the calculations. The SPU projections imply a nominal growth rate for potential GDP of 3.16 percent in 2015. Assuming this growth rate remained constant for subsequent years (which again seems conservative), even with no further post-2015 discretionary adjustments the structural deficit as a share of GDP is projected to fall to 0.8 percent of GDP in 2019 and to 0.2 percent in 2020.

There’s many a slip twixt cup and lip – but hopefully these benchmark calculations can help identify some of the wilder budgetary arithmetic.

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. 

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.

The complete IMF World Economic Outlook April 2012 is now available (overview here).   See, in particular, the Foreward by Olivier Blanchard for a very useful stock taking.

Update: The IMF’s Fiscal Monitor was also released today (see here).   It has lots of useful comparative data and analysis.   Box 5 (page 27) has a useful overview of the Fiscal Compact.

Thanks to Eoin Bond for the link to the text of Jörg Asmussen’s talk to the Institute for International and European affairs (see here).    While it will undoubtedly be controversial, I think it is a balanced take on Ireland’s crisis and crisis-resolution efforts, and in particular the support that has been received from the eurosystem.

However, I do wish to take issue with the account of the recent efforts to restructure the repayment schedule on the promissory notes, something that has been receiving a great deal of attention here in recent weeks. 

Mr. Asmussen says:

I understand the strong desire of the authorities to minimise the costs associated with the banking sector rescue, including costs incurred to date, and those still to come. Let me make some comments in this area. When the programme for Ireland was designed, the costs of the banking sector measures already in place, including the promissory notes, were fully factored in. The annual cash repayments of promissory notes is thus financed by programme resources. That programme is on track. Any deviation from that programme should be considered very carefully indeed. The perceptions that have built-up around Ireland’s successes in the programme should not be jeopardised. It has been hard-won and it is worth fighting for. Therefore, the ECB remains of the opinion that Ireland should honour its commitments stemming from the promissory notes, as foreseen. This in our view is the best way to regain sustainable market access.

I don’t disagree that Ireland’s best interests are served by honouring its commitments to both market and official funders.   But there is a significant difference between reneging on a commitment and a renegotiation with official creditors aimed at the shared goal of resolving Ireland’s funding crisis through re-entry into market funding.    While there has been a sustained improvement in Irish bond yields, the extent of near-term funding needs will be a barrier to market re-entry.    The originally agreed repayment schedule on the promissory notes envisaged reasonably rapid repayment of the principal and interest – with payments of €3.1 billion beginning in 2011.   It is true that the resulting funding needs were recognised at the time of the design of the programme.   What was not known at the time was the how broader euro zone tensions would escalate, making it more difficult, despite significant progress in demonstrating the capacity to honour commitments, in bringing bond yields down to levels consistent with robust debt sustainability.   It is hard to see how a negotiated rescheduling of the repayment schedule based on the common interest in Ireland’s success would have any adverse reputational spillovers.   Indeed, the improved maturity profile on the outstanding obligations of the State should have a significantly beneficial effect on creditworthiness.  

Interestingly, Mr Asmussen appears supportive of a restructuring of the promissory notes that would involve paying them off through a long-maturity loan from the EFSF, and paying off the Emergency Liquidity Assistance (ELA) ahead of schedule.   This would improve the maturity profile.   But it would come at the cost of a higher interest rate given the very low ultimate interest rate on the ELA.   It is possible that the ECB thinks Ireland is asking for too much – a low interest and a long maturity.   (And we must recognise the ECB’s general discomfort with the ELA arrangement to begin with.)   But an overly purist position can be self defeating in terms of the broader goal of finding a route through the euro zone crisis.   The Irish authorities have worked steadily to make the necessary and hugely difficult adjustments and avoid a default that would be both damaging domestically and damaging to the euro zone.   Given the quite particular remaining challenge that Ireland faces in regaining market access, I do not think it is unreasonable to expect this particular targeted change in the negotiated supports in the common interest of euro zone stability.