Brian Lucey writes on the bondholder bailout and other matters in today’s Irish Times: article here.
Author: John McHale
Pat Kenny’s Frontline made for depressing watching last night. The first segment focused on the level and composition of the fiscal adjustment for the next four years with an emphasis on next year. Credit to Dan O’Brien and the others on the panel for being brave enough to be specific about where they would cut.
But given the size of the needed adjustment, I worry that this formula of focusing on specific adjustments one-by-one is just not going to work. For each proposed adjustment – means testing child benefit, cutting public–service pensions, introducing a property tax – the affected group will focus on the negative effect on them and will inevitably try to shift the burden.
Recognising the size of the overall adjustment, I think it is better to start with a plan for the overall distribution of the burden across the income/wealth distribution. The pain will need to be spread broadly but progressively. After recent budgets, the ESRI has provided an excellent analysis of the distributional implications of tax and benefit adjustments using its SWITCH model. This tool could be available prior to the budget to evaluate alternative four-year plans. The key is to make people think about the overall effect on them in the context of how the overall burden is being shared. My sense is that there is recognition a large adjustment must take place and most are willing to play their part — but only if assured that others are bearing their fair share. The alternative of arguing about specific cuts in isolation of the overall distribution of the pain is probably doomed to failure.
The Irish Times carries an important op-ed by Michael Walsh of Mercer on the crisis in the defined-benefit pension system. Compared to the fiscal, banking and employment crises, the DB pensions crisis is largely below the radar — but still hugely important.
The focus of the article is on the need for policies to ease pressures on sponsoring businesses, and to prevent the more radical response of winding up existing schemes. Of course, the proposals have potentially huge implications for a key component of the wealth of many Irish workers. Unfortunately – but perhaps inevitably in an 850 word article – the actual reforms being proposed are less than clear. I hope the diverse readership of this blog can provide some clarifications and perspective.
There are two proposals:
First:
The Society of Actuaries and the Irish Association of Pension Funds have put a proposal to government to address this issue. It would involve insurers being allowed to sell, and pension schemes being allowed to buy, a new kind of annuity. These so-called sovereign annuities would be directly linked to Irish government bonds. They would therefore be much cheaper than conventional annuities. This would increase the chances that pension schemes can continue to operate and make good current funding deficits over time.
How exactly would these sovereign annuities work? That they lead to cheaper annuities immediately suggests a reduction in the present discounted value of the expected benefit stream – that is, a loss in wealth.
And second:
Our proposal at Mercer is that pension schemes that wind up be permitted to pay lump sums to pensioners instead of buying annuities. The lump sum would be the capital value of the person’s pension calculated on a prescribed basis. The calculation would allow for current life expectancy and expected future mortality improvements together with a specified long-term rate of interest or a rate linked to average euro-zone bond yields. Pensioners could then put the money in an Approved Retirement Fund from which income could be drawn down. Alternatively, they could use the money to buy an annuity, although if this is done at the current time it would likely be for a lower amount than their previous income from the pension scheme.
The proposal as written comes across as relatively painless. But as Michael says, the devil is in the details. What exactly is the “prescribed basis”? Again, there is a presumption that any reduction is the contingent liability of the sponsor is also a reduction in the contingent asset of the member.
Michael Walsh may well be right that, all things considered, such reforms are warranted. But the stakes for many individuals are such that a public debate is crucial, notwithstanding the complexity of the issues involved.
A number of media commentators have drawn a comparison between the present debt crisis and the ERM crisis of 1992/93. Then, the authorities assured markets there would be no devaluation; but the high interest rates needed to defend the peg against sceptical currency traders proved too painful and the government eventually succumbed. Today, sceptical markets are demanding a high risk premium to hold Irish bonds. There is concern that the pain of high interest rates and their impact on debt dynamics will, once again, make market expectations self fulfilling.
I believe it is a mistake to take this comparison too far. The combination of long average maturity, liquid reserves, and the back-ups of the NPRF/EFSF make a forced default in the short to medium run unlikely. Moreover, a cost-benefit calculation for sovereign default for a country that clearly has the capacity to repay suggests a voluntary default is also unlikely.
Patrick Honohan’s address to the SUERF conference (Dublin), “Banks and the Budget: Lessons from Europe”, is available here.
While the address contained important observations on the interaction between the budgetary and banking crises, I expect it is his comments on the fiscal adjustment programme that will make most news:
I have recently been looking more closely though at the multi-year prospects for the budget. Of course it can be said, if the economy stays close to the track originally envisaged, the deficit would come close to 3 per cent by 2014. But as the IMF and others have noted, the real economy, the price level and also interest rates on Government borrowing, have evolved in a less favorable way. Servicing of the additional debt related to bank restructuring is also a negative factor.
Some explicit reprogramming of the budgetary profile for the coming years is clearly necessary soon if debt dynamics are to be convincingly convergent. Recent movements in the yield spread on Government debt – both for Ireland and for some other countries – readily demonstrate the costs that can result unless international lenders remain convinced that the budget is going to be kept on a convergent path, as indeed the Government is committed to ensuring.
During the 1980s Ireland paid a high price in terms of borrowing costs because the markets feared much steeper exchange rate depreciation than actually occurred. An equilibrium of pessimism, with the economy struggling, and investors requiring a risk premium that imposed additional costs on the taxpayer, displaced what could have been an equilibrium of self-fulfilling optimism. It is important now to re-set the fiscal path to ensure a virtuous cycle of lower borrowing rates contributing to even faster fiscal adjustment and a lower overall cost of the adjustment to society at large.
While there has been an international debate on this matter for larger countries, there seems to me to be no question, for Ireland and for other small financially-stressed sovereigns, but that national growth is best served by ensuring that the public finances are convincingly on a convergent path: the impact on funding costs and confidence surely more than offsets any short-term adverse impact on domestic demand from lower net public spending.