Author: John McHale

Obama’s Tax Proposals

Even after a string of bad economic forecasts, the news on Obama administration proposals to reform the taxation of overseas’ profits stands out as particularly worrisome news for the Irish economy. 

The White House website provides a good overview of the proposed reforms: fact sheet here. 

Let’s hope the powers that be take note of findings summarised in this recent HBS Working Paper by Harvard’s Mihir Desai (via Greg Mankiw’s blog).   The best hope is that the U.S. Senate waters down the proposals (see here from some initial reaction).  But the politics look unfavourable.

A Policy Offense

Over the past months, the challenges of stabilising the public finances and sustaining the banking system have dominated the macro policy debate.   Unavoidably, the depth of the crisis has put policy making in a defensive—indeed survival—mode.   The first-order issues have been maintaining the ability to borrow and ensuring a working credit system. 

In the months before the next budget, I hope the debate will broaden to focus more on a policy offense to counter the recession.   Even though it is getting harder to be shocked by ever-worsening economic forecasts, this week’s outlooks from the ESRI on growth and unemployment were truly depressing—all the more so since the burden will fall especially hard on young workers, as Liam Delaney has reminded us.   One message that comes through in the slides from Thursday’s ESRI conference is the importance of minimising inflows into unemployment.   It is worth noting that in his presentation at the conference Jaakko Kiander said Finnish fiscal policy was too restrictive in the midst of their “Great Depression;” it took years for employment to return to pre-recession levels.    We should be careful we do not look back later with the same regret. 

On fiscal policy, the government was under obvious time pressure in putting together its emergency budget.   There is no excuse for October’s budget.   A fully formulated—and preferably legislated—medium-term fiscal framework should provide room for shorter-term countercyclical measures.   We should take advantage of the time to have a vigorous debate about how to use whatever fiscal room there might be.     

(I do not mean to suggest that promising policies are not being debated every day on this blog.   A few that come immediately to mind: Paul Hunt’s eloquent arguments on tackling inefficiencies in the non-traded sector and for targeted infrastructural investments in growth sectors; Sean O’Riain’s proposals for development-oriented financing; and Liam Delaney’s emphasis on youth-oriented investments and opportunities.)

On credit policy, Karl Whelan has been the catalyst for an impressive debate on how to sustain the banking system in the face of apparent insolvency.   But I find it surprising that relatively little attention has been given to the customer side of the credit market—both in terms of the demand for credit and the impact of business/household balance sheets on the willingness to supply credit.  

In the international debate, there is a growing attention to the idea of a “balance sheet” recession.   The outstanding feature of such a recession is potential borrowers try desperately to repair balance sheets by curbing their spending.    In addition, the poor state of balance sheets harms the creditworthiness of many of the remaining willing borrowers.   This again suggests there is much to debate on the policy front, from the role of coordination failure in the credit collapse to the potential for targeted tax relief in sustaining investment and employment.   

The Fed’s Exit Strategy

The Fed is using an impressive range of firepower to counter the greatest deflationary threat since the Great Depression.   With such massive injections of liquidity, however, it is not surprising that leading figures are already debating exit strategies and the extent of the longer-term inflationary threat.   It is a fascinating debate to watch. 

John Taylor worried in the FT last month that “extraordinary measures have the potential to change permanently the role of the Fed in harmful ways.”   He said, “The success of monetary policy during the great moderation period of long expansions and mild recessions was not due to discretionary interventions, but to following predictable policies and guidelines that worked.” 

Writing this week in the FT, Martin Feldstein is also anxiously looking ahead:  “[W]hen the economy begins to recover, the Fed will have to reduce the excessive stock of money and, more critically, prevent the large volume of excess reserves in the banks from causing an inflationary explosion of money and credit.  This will not be an easy task since the commercial banks may not want to exchange their reserves for the mountain of private debt that the Fed is holding and the Fed lacks enough Treasury bonds with which to conduct ordinary open market operations. It is surprising that the long-term interest rates do not yet reflect the resulting risk of future inflation.”

Robert Hall and Susan Woodward strike a more optimistic note in a piece on the VOX site:  “[T]he Fed can control inflation by varying the interest rate it pays (or charges) banks on their reserve holding. Consequently, the Fed’s exit strategy need not be constrained by concerns about inflation – reserve interest-rate policy can take care of inflation, but the Fed should publically announce this policy.”

On Nationalisation

The debate on bank nationalisation on this site and elsewhere has been taking place at an impressively high level.    Owing to the efforts of Karl and others, we stand a much better chance of having a rational banking policy.   Yet I can’t help being puzzled at the depth and breadth of the support for nationalisation from so many leading economists.    I have no doubt that this support for the state ownership of such a critical sector of the economy is not a position easily come to.   What has led so many liberal-leaning economists to support nationalisation? 

As best I can read it, there is a huge fear of government failure at one level, and a relatively relaxed attitude to failure at another.   The driving fear – indeed prediction – is NAMA will significantly overpay for bank assets, imposing a potentially huge cost on taxpayers.    On the other hand, while advocates of nationalisation are well aware of the dangers of politicised credit allocation, I think it is fair to say they believe we can devise institutions that would allow arms-length control and speedy re-privatisation. 

I weigh the risks of these two forms of potential government failure differently.    On the overpayment risk, a critical achievement of the debate so far is to shine a searchlight on the danger.   With this danger firmly in mind, it should be possible to devise effective and transparent mechanisms for determining and paying expected value.   Innovative mechanisms – such as Patrick Honohan’s idea to combine lower direct payments with shares in NAMA – can help attenuate overpayment bias and reduce risk to the taxpayer.   Bottom line: I think this risk is manageable with due attention. 

I am more worried about the danger of a politicised credit system – even with politicians having the best of intentions going into their new roles.   On my reading, the international evidence on bank ownership and performance raises a huge cautionary flag.   (A good survey is:  William Megginson (2005), “The Economics of Bank Privatization,” Journal of Banking and Finance, 29, 1931-80; working paper version here).   While recognising that selective quotations do not prove a point, I think the following from another paper by Andrei Shleifer and co-authors gives a good sense of the danger:

A government can participate in the financing of firms in a variety of ways: it can provide subsidies directly, it can encourage private banks through regulation and suasion to lend to politically desirable projects, or it can own financial institutions, completely or partially, itself.   The advantage of owning banks–as opposed to regulating or owning all projects outright–is that ownership allows the government extensive control over the choice of projects bieng financed while leaving the implementation of these projects to the private sector. Ownership of banks thus promotes the government’s goals in both the “development” and “political” theories.

. . .

We find that higher government ownership of banks is associated with slower subsequent development of the finanical system, lower economic growth, and, in particular, lower growth of productivity.   These results, and particularly the finding of low productivity growth in countries with high government ownership of banks, are broadly supportive of the political view of the effects of government interference in markets (LaPorta, Rafael, Florencio Lopez-de-Silanes, and Andrei Shleifer (2002), “Government Ownership of Banks,” Journal of Finance, 57(1), 265-301).   

Perhaps paradoxically, the danger of politically directed lending is increased by the compelling rationale for a co-ordinated expansion in credit that nationalisation could facilitate.  Lucien Bebchuck and Itay Goldstein do a good job outlining the basic co-ordination failure and rationale for intervention.  The basic idea is that the creditworthiness of firms increases with a broad expansion in credit given interdependencies in the profitability of investment projects.   A coordinated credit expansion can then shift the economy from a bad (low creditworthiness, low credit) equilibrium to a good (high creditworthiness, high credit) equilibrium.   Nationalised banks would certainly be in a good position to solve the coordination problem.  But such directed lending is likely to be the thin end of the wedge to a more pervasive politician-directed credit allocation system.   I think the long-run costs would be lower with a coordinated expansion achieved through transparent fiscal instruments.  

The ease with which the government has come to direct the investment strategy of the National Pension Reserve Fund provides a useful warning.   As reported recently by the National Treasury Management Agency, investments “under the direction of the Minister for Finance” now account for 23.4 percent of the total fund (and that only includes investments in the preference shares of Bank of Ireland).  Here again there is a rationale for the government’s direction (though I believe it is a weak one given that international bond markets are still very much open for Irish debt).   But any semblance of arms-length governance is thoroughly shot – with as far as I can tell barely a whimper from economists. 

Two final brief points relating to majority government ownership (the most likely alternative to full nationalisation): 

First, in their Irish Times piece the proponents of nationalisation worry that the government would leave the banks undercapitalised under majority government ownership.    Under nationalisation, they see the government having a strong incentive to recapitalise the bank to maximise divestiture value.   However, given the government will eventually want to divest itself under both majority share ownership and nationalisation, I do not see why the incentive to recapitalise is weaker under the majority ownership option.  

Finally, it is reasonable to question whether the risk of politicisation is any less under majority government ownership than under full nationalisation.   However, a key focus of work on politicisation has been on cost to politicians in exercising control.    The transparency and governance institutions of a publicly traded company should make it more costly for politicians to direct the banks’ credit allocation for political ends.  

Thoughts on the budget

With so much being said and written about the budget this week, forgive me for putting in my two cents worth.   From a macro perspective, the key trade-off going into the budget was always going to be between gaining credit worthiness and losing economic growth.   Oversimplifying a bit, the former called for a larger adjustment; the latter a smaller one.   However, it would be possible to improve this trade-off with a judicious composition of tax and expenditure changes.    How did Minister Lenihan do?

On size, I think the adjustment was at the upper end of the reasonable range.   Karl Whelan – and indeed the Minister himself in slightly different terms – has noted the budget restores the original 9.5 percent of GDP target if in place for a full year.   Another way to look at it is in terms of the much-maligned structural deficit.   (As an aside, it is hard to recall the star of an economic concept fading so fast as the structural deficit, with George Lee even amusingly referring to it as “voodoo economics.”)  But if you look at the macroeconomic framework document made available by the Department of Finance, it seems the structural deficit target played an essential role behind the scenes in determining the size of the adjustment.   In the update to the Stability Programme, the actual deficit was projected at 9.5 percent of GDP and the structural deficit was projected at 8.1 percent of GDP.   These projections then slipped on evidence from the most recent exchequer returns to 12.75 percent and 10.25 percent respectively.  The framework document projects that the budget brings the structural deficit back down to 8.2 percent – effectively the original target.   It is important to note that this is the projection for the structural deficit for 2009, and not what it would be if it were in place for a full year.   For this reason, the Minister has got a start – something in the order of one percent of GDP – in lowering the structural deficit from 8.2 percent in 2010.  

By the Department’s own estimate, the budget will knock a percentage point of GDP growth for 2009.  This is quite a hit given the measures will only be in place for seven months and only reflect a very short-term multiplier effect.  Even so, given the precarious state of national creditworthiness, and the credibility advantage of adhering to the stability programme’s target for the structural deficit, I see the size of the adjustment as appropriate. 

I am less impressed by the composition of the adjustment.   As has been pointed out by many commentators, the weight of empirical evidence shows that fiscal adjustments based on tax rises and capital expenditure cuts tend to be more contractionary and less durable than adjustments based on cuts to the government wage bill and transfer payments.  There is particular reason to worry about the supply-side effects of this budget.  The increase in marginal tax rates over a significant portion of the income distribution is large relative to the revenue raised.   Workers earning 52,000 euro, for example, saw their marginal tax rate rise from 44 [41 higher rate + 1 income levy + 2 health levy + 0 PRSI] percent to 51 percent [41+2+4+4].   Given that the deadweight loss of the income tax rises with the square of the marginal tax rate – which means the added burden of a given rate increase is greater that higher the tax rate is to begin with – we must worry about the large welfare cost of this rate increase.   Added to this, higher taxes are likely to impact wage setting and job search, with resulting adverse effects on competiveness and unemployment. 

Another way the trade-off could have been improved was with well-specified multi-year plan.   Without minimising the difficulty of projecting the revenues from new revenue sources such as carbon and property taxes, I think more should have been done to reduce the lingering uncertainty about how severe the ultimate adjustment is going to be. 

Finally, the Minister missed the opportunity for innovative temporary stimulus measures that a more thoroughgoing focus on the structural deficit would have allowed.   My candidates for such measures were a temporary reduction in VAT rates and a temporary reduction in employer PRSI.   I believe each would have an offsetting stimulus effect without undermining the path to a 3 percent structural deficit by 2013.  

Overall, a mixed bag.