Author: John McHale

Martin Wolf has another excellent piece in today’s FT, which also appears without the need for a subscription in the Irish Times.    A major theme of Martin’s recent analysis has been the asymmetries in the current account positions across the euro zone, and as a result the need for a more balanced crisis-resolution strategy that involves expansion in the core.   While his analysis has been incredibly useful in many ways, I have always felt that he underemphasises the “capital account” nature of the crisis.  It seems partly under the influence of the recent excellent Breugel paper on “sudden stops” in net capital flows, this latest article provides what I think is a more balanced perspective.   For our own debate, the piece provides a useful opportunity to reflect on the relative roles of current and capital account aspects of the euro zone crisis. 

Much of the discussion of the crisis has cast it as a crisis of the current account of the balance of payments.   There is much to this; it is undoubtedly true that improvements in the relative competitiveness of the periphery and the relative demand growth of the core are critical elements of the solution.   However, the crisis is even more immediately a crisis of the capital account, with – as documented in the Bruegel paper – a “sudden stop” in net private capital flows to the periphery.  (Everybody interested in the crisis should read the Bruegel paper.) 

It is useful to consider what would have happened if large-scale official funding — including the funding of periphery banks through the eurosystem — had not taken place.  (The Breugel paper documents how massive the official funding has been.)  Current account deficits in the periphery would have declined massively, and (absent default) would have swung to large current account surpluses as existing credit lines were not rolled over.    This would have resulted in even deeper depressions and widespread defaults.   Care must be taken in interpreting the current account balance – or turnarounds in that balance – as a sign of economic health.

Without in anyway playing down the importance of the need for more balanced adjustment across the euro zone (which requires more expansionary policies in the stronger countries of the core), the “sudden stop” in private capital flows highlights the critical need to re-establish creditworthiness.   This is critical to facilitating more phased adjustment without putting an intolerable strain on the willingness of the core to fund the current account imbalances of the periphery.  

The re-escalation of the crisis in late 2011 – which may be raising its ugly head yet again with the renewed pressures on Spain and Italy – shows how fragile creditworthiness is to bad expectational equilibria within a monetary union.    This has led to efforts to shore up the lender of last resort function within the euro zone.   But a reliable lender of last resort means that the stronger countries face potentially huge liabilities for their weaker partners.   It should not be surprising that assurance is needed that adjustments will take place without default on official lenders in return for providing the financing to allow those adjustments to take place in a more phased way.  

The fiscal compact must be seen in this light.   Focusing on the unbalanced-current-accounts aspect of crisis, there is substance to the criticism that the compact forces excessively restrictive fiscal policies on the core.   But the capital account – i.e. creditworthiness – aspect cannot be ignored.   A commitment to shared discipline appears necessary to allow both the massive official funding to continue and to make it sufficiently reliable to make the market creditworthiness of the periphery less fragile. 

The international debate on the wisdom of fiscal austerity has being heating up.    Since the onset of the crisis, the consensus seems to have gone through different stages: initially there was widespread support for fiscal stimulus, followed by concerns that fiscal policy needed to tighten as debt to GDP ratios rose in many countries to worrying levels, followed more recently by concern that fiscal policies may tighten too much given the persistence of the crisis-induced recessions.  

A useful aspect of the recent debate is greater differentiation between countries facing serious sovereign creditworthiness challenges and those that do not.   Countries facing immediate creditworthiness problems face a dilemma: fiscal tightening tends to further weaken the real economy; but allowing deficits and debt to stay on a higher path further weakens creditworthiness.  The fiscal council has been grappling with this dilemma in its first two reports (see here and here).  

Drawing on recent work with a number of co-authors, Giancarlo Corsetti provides a useful framework in this VOX piece for thinking about the dilemma.  He makes the important point that the appropriate fiscal stance can be quite different for countries facing a large market risk premium (e.g. Ireland) and those that don’t (e.g. the UK).   Countries facing a large risk premium face a dilemma in setting the fiscal stance between supporting demand and supporting creditworthiness – a trade off that is absent or at least much less pronounced in countries with low long-term bond yields.   Corsetti’s framework has the additional element that increases in the sovereign risk premium can feed through to the risk premium facing the private sector though the entwining of bank and sovereign balance sheets.   While he does not believe that this additional element makes fiscal contractions expansionary, it does tend to reduce fiscal multipliers.   On the other hand, for countries not facing an elevated risk premium, multipliers are likely to be large for countries in deep recessions with policy interest rates constrained by the zero lower bound, suggesting the appropriateness of a more stimulative fiscal stance. 

A group of Irish economists have an interesting joint article in today’s Irish Times.   It is available here.   It usefully goes beyond the rather sterile austerity/no austerity debate to focus mainly on the mix of adjustments.  

Drawing on the available evidence, the article notes that fiscal consolidation measures lead to slower growth and job losses.

The evidence is clear: contractionary fiscal policy does indeed restrict economic activity and employment.

The austerity-focused policies being pursued in Europe and in Ireland will continue to drive down employment and living standards, while embedding high levels of long-term unemployment in the economy.

However, the article does not claim that consolidation is unnecessary (though it does not offer a preferred time path for bringing the deficit down), but rather focuses on the mix of consolidation and financing measures.   The authors argue for a mix that involves higher capital spending and higher taxation aimed primarily at higher income individuals.   (For the medium term, they also argue for higher social expenditures financed partly by increased PRSI contributions.)

Such an investment programme must be accompanied by “smart” fiscal consolidation, focusing on the least contractionary forms of fiscal adjustment. This requires progressive and equality-proofed taxation targeting high-income groups, property assets, unproductive activity and passive income, as well as environmental measures.

In the medium term, we should explore the potential of social insurance and local taxation to broaden the tax base while providing real benefits in return. PRSI can be expanded and combined with general taxation to provide free universal healthcare and earnings-related pensions. Stronger local taxation has the potential to be more accountable while providing investment in services responsive to local needs.

The mix of adjustments is also receiving recent attention in the international debate.   For differing perspectives on the most effective mix from a macroeconomic perspective see Alberto Alesina and Francesco Giavazzi here and Simon Wren-Lewis here. 

Minister Noonan’s comments today, as reported by the Irish Times, are worth noting:

Mr Noonan has indicated he may ultimately seek to use the euro zone’s bailout fund to refinance the cost of bailing out Anglo.

“The ECB would favour that because it would improve their collateral significantly,” Mr Noonan said. “But that would be of little use to Ireland unless we got the commitment to ongoing medium term low-cost funding from the ECB.”

I think this is very important (although I would say eurosystem rather than ECB in the last sentence).   Whatever you think of the Anglo/INBS bailout’s, as a financing mechanism the promissory notes/ELA are an excellent deal (with an ultimate interest rate to the State estimated at 1 percent after factoring in CBI profits that go to the Exchequer).   The problem is that we have to pay them down relatively quickly (creating large near-term funding needs as well as giving up a low interest rate), so we want to restructure to lengthen the term.   The ECB sees the arrangement as too close to monetary financing for comfort to begin with. 

There is a danager that restucturing — of whatever kind is on offer — becomes a political imperative.   One wrinkle is that the commitment to keep the ELA in place in a way that is consistent with even the current promissory note repayment schedule might be a bit shaky.  There might be a role for the EFSF/ESM to shore things up.   But any such restructuring must not lose sight of the extremely low interest rate we currently have.

I am surprised the release of the wording of the proposed amendment to the Constitution has not received more attention today.   Stephen Collins reports on the wording in a piece on the inside pages of the Irish Times.   From the article:

The amendment will involve the insertion of the following subsection after subsection 9° of article 29.4 of the Constitution.

The new subsection 10° will state: “The State may ratify the Treaty on Stability, Co-ordination and Governance in the Economic and Monetary Union done at Brussels on the 2nd day of March 2012. No provision of this Constitution invalidates laws enacted, acts done or measures adopted by the State that are necessitated by the obligations of the State under that Treaty or prevents laws enacted, acts done or measures adopted by bodies competent under that Treaty from having the force of law in the State.”

I just heard the normally excellent Stephen Donnelly say on RTE’s Drivetime programme that the amendment will put detailed fiscal rules in the Constitution.   My reading is that the purpose of the amendment is to ensure that the proposed Fiscal Responsibility Act that will establish the rules is not in violation of the Constitution.   The amendment does not put fiscal rules in the Constitution. 

The draft of the Treaty is available here.  The next piece of crucial information will come with the publication of the proposed Fiscal Responsibility Bill.   The referendum to ratify the amendment will take place on Thursday, May 31.