Committing the NPRF

Should the NPRF be used for bank recapitalisation? 

I have always thought the fund a good idea.   It helped increase national saving by reducing measured budget surpluses.   (These surpluses would have been difficult to sustain politically.)  And I believed it would make pension benefits more secure in the face of a rising tax cost as the population ages.  Along with many others, I thought the fund only a good idea if investment decisions were not politicized.   That seems almost quaint. 

I now think it serves another purpose that I simply did not appreciate.   Others were more prescient.   It provides a valuable bulwark against the tail risk of a real “run-on-the-country” kind of crisis (that includes both bank and government debt).   The risk is nicely captured by Larry Summers in his 2000 Richard Ely lecture on international crises.   As he says, in this kind crisis the mode of investment analysis shifts from “economics to hydraulics.”  Fundamentals become irrelevant as everyone tries to get their money out before everybody else.  

The existence of a large and relatively liquid NPRF makes falling into such a bad equilibrium less likely.   I therefore think the Government should be slow to commit a large chunk of the fund to bank recapitalization.  My sense is that it would be better to borrow the funds, notwithstanding the recently increased spread.   Having a substantial liquid sum on the asset side of the government’s balance is valuable insurance in perilous times. 

Ireland on PBS

There were two segments with an Irish interest on yesterday’s Newshour with Jim Lerher.   (The Newshour is the probably the most influential news programme in the US.)

The first is an interesting, if not particularly deep, look at the relative fortunes of Ireland and Poland.  You can view the segment or read the transcript here.

The second has a spirited criticism by John Bruton of the “Buy American” bill in the US Congress. 

Back to the banks

The policy pendulum looks set to swing back to dealing with credit flow in the banking system.  With so many policy proposals floating around internationally, I would be very interested to hear current views on the best policy course for the government. 

 Taking it as given that there has been a severe contraction of new credit, how much is due to: (i) a collapse in the demand for credit as firms and households repair balance sheets; or (ii) a collapse in the supply of credit?  

 Under (ii), is the main reason for the decline in supply: (a) the declining creditworthiness of potential borrowers; or (b) the risk aversion of bankers as they teeter on the edge of insolvency?

 It seems to me that if the contraction is mainly driven by some combination of (i) and (ii a), the government would be wise to limit the additional fiscal commitment.   A large package would further tighten the fiscal solvency constraint and force a more rapid fiscal correction. 

 The case for a large package seems more compelling if the credit contraction is being driven by the caution of the bankers.   Whatever the size of the package, what is the proper balance between re-capitalisation, insurance for new credit flows, troubled asset purchases, etc? 

A not-so-modest proposal

With the massive hole in the public finances, it seems unavoidable that the tax take will rise sharply.   On the positive side, Ireland at least has more tax room than other countries.   On the negative side, near-term, large-scale increases in taxes will further harm demand leading to a further turn in the vicious cycle.   Indeed, the expectation of lower after-tax income must already be curbing household spending.    Moreover, higher taxes will undermine the incentives-based model that has underpinned Irish growth. 

What to do?  

I have previously thought Ireland was fortunate to have avoided an unfunded earnings-related state pension system.   But it is time for some new thinking in what is now a full-blown economic emergency.   Weighing the benefits against the costs, I think a “notional defined contribution” unfunded system would be a large net positive.   Under this system, benefits are rigidly linked to earlier contributions.   For a given contribution rate, contributions receive a “notional” rate of return equal to the growth rate of the wage bill.   But the system is unfunded, so that the revenues are made available to the government today.   There is effectively a “free” period where the government receives revenues but does not have to pay out benefits. 

Why is this a good idea?

First, and most immediately, it would allow for a sizable inflow of funds to the exchequer.   With a contribution rate of 6 percent and a base equal to the entire wage bill, the government would raise roughly 4 percent of GNP (assuming a labor income share of GNP of two thirds—hopefully someone can fill in the correct labor share).    This would largely meet the massive correction penciled in for 2010 and 2011 (though it might make sense to phase it in more gradually).  

Second, the disincentive effects of higher marginal tax rates would be greatly diminished by the strong link from contributions to benefits.   Indeed, it is reasonable not to refer to the contribution rate as a tax rate at all.   The alternative of dramatically higher income tax rates is likely to be a huge drag investment and enterprise going forward. 

Third, the adverse effect of the fiscal correction on expected lifetime income would be minimized as today’s contributions lead to higher future benefits   This is critical in an environment where household confidence in their future after-tax income has collapsed. 

Fourth, the decimation of many private-sector defined-benefit schemes has left many workers dangerously exposed.   At least for those earlier in their careers, this scheme could help build pension “wealth.”

One way to view the policy is as a form of long-term borrowing from current workers.   It is a response to the fact that traditional borrowing through the debt markets is, many believe, reaching its limits.   In return for their contributions, workers under this policy receive a special form of asset–a promise of future benefits that is tightly linked to their contributions.   While there is a risk that the government will renege on its benefit promise.  The recent experience with losses on financial wealth should be borne in mind in assessing the extent of risk in this system.    

A word of caution:  I think it would be critical to avoid turning this into a redistributive scheme.   Lifetime redistribution should continue to take place through the flat rate pension/proportionate PRSI contribution system.   Blurring the link between contributions and pensions would greatly undermine both the incentive and relatively benign income expectation effects of the policy.  

I think it would also be a mistake to demand employer contributions.   Unlike the employee contributions, employer contributions would be a pure labour tax, the last thing that is needed right now.   It would probably also make the policy a political non-starter in the current climate. 

I don’t pretend this is a free lunch—future generations would be stuck with it.   But it may be the closest thing to a free lunch we have.   As a general rule, it is not wise to make long-term policy such as pensions policy to deal with a crisis.   However, it is worth remembering the US Social Security system was introduced during the Great Depression.  

It is far from perfect.  But what are the alternatives?

Baseline Scenario on Nationalisation

This post by Simon Johnson on the Baseline Scenario blog provides an interesting international perspective on bank nationalisation.   You can read it here:

http://baselinescenario.com/2009/01/20/nationalization-is-not-inevitable/#more-2085