The Irish Economy

Simon Wren-Lewis has a nice post here. The whole situation makes you wonder whether, despite all the ECB’s talk of independence, there is a major Western central bank more subject to political constraints anywhere in the world.

I would add a couple of points.

First, the ECB and the rest of us are fixated on what will fly politically in Germany; but there are 16 other member states in the Eurozone, and not all of them are as pliable as little, eager-to-please Ireland. In particular, I have always thought that there were two reasons to avoid having Italy enter a bailout programme: not just the fact that EFSF/ESM won’t have enough money, but the fact that if this happens, Italy may decide to leave EMU. The reason why economists like Paul de Grauwe have been asking for ECB intervention is so that an Italian bailout becomes unnecessary; now it seems that Italy will only get ECB intervention if it enters a bailout programme. The whole thing seems upside down, and people are playing with fire here. Despite its large debts, Italy wouldn’t be having these difficulties on the market if it wasn’t in EMU: to ask a big, important country with a sense of its own dignity to give up sovereignty — and potentially enter the same death spiral as Greece, and now apparently Spain — simply so that it can remain in a single currency that isn’t working seems like a bit of a stretch to me.

Second, I agree with Simon that the ECB’s worrying about the moral hazard facing states like Italy in a situation like this is pretty stupid. (I would add that it is also wrong because it mixes up fiscal and monetary policy. Let the ECB stick to monetary policy, and let governments, individually and collectively, stick to fiscal policy.) But in our dysfunctional, destructive monetary union it may indeed be politically necessary for the ECB to insist on fiscal policy conditionality before doing the job of a central bank. Forcing Italy into a bailout programme seems like a particularly dangerous way of doing this, however.

There is a better way I think. The IMF is signaling that Spain and Italy are doing all that could be reasonably asked of them right now. Surely if the IMF is willing to certify that a country is running a sensible fiscal policy, this should be enough to allow the ECB to do what needs to be done?

UPDATE: Francesco Giavazzi is quoted here as making an obvious and very important point: for an unelected technocrat like Monti to steer Italy into a bailout programme, with the consequent loss of sovereignty that would be involved, prior to elections, would be unacceptable.

Landon Thomas outlines some of the reform ideas doing the rounds in policy circles and profiles some of the key participants in this NYT article.  He includes the ESBies idea proposed by our euro-nomics group and a member of our group Markus Brunnermeier, as well as Daniel Gros and Graham Bishop.

I am not entirely sure if it belongs in a post with this title heading but Hans-Werner Sinn makes his own proposal in this FT op-ed.

I spent a few hours today revising and updating this paper, and was both astonished, and not surprised at all, to see the extent to which trust in the EU and its institutions collapsed in 2011. The figures below show the percentage of respondents in Eurobarometer surveys saying they trusted the institution in question, minus the percentage who said they didn’t trust it. The decline in 2011 is really quite dramatic. I am sure that the usual suspects will tell us that what Europe obviously needs is a better communications strategy. Personally, I think that less destructive economic policies would have a bigger impact.

(Source: Eurobarometer)

Since Brendan and Philip have both posted on competitiveness in the past couple of days, I thought I’d follow up with a link to the following piece by Gaulier, Taglioni and Vicard.

Eurointelligence points us to a piece by Alan Beattie on the political difficulties which the IMF faces in dealing with the Eurozone crisis. As we know in Ireland all too well, while the IMF has generally been on the side of the angels, it is the ECB and EC that have called the shots, with the result that the IMF’s reputation suffers by association with Troika policies that are a complete and utter disaster. The dilemma for the IMF is that a complete withdrawal from the Eurozone crisis, while the single currency collapses, won’t do its reputation much good either.

Charles Goodhart and Sony Kapoor have it right, I think: it is the Eurozone that is dysfunctional, and in the future IMF conditionality has to be directed at the ECB and other Eurozone-level bodies as much as (if not more than) it is directed at individual member states. It’s time for the IMF to decide whether it wants to prove Peter Doyle right, or prove him wrong.

The orthodox view is that enhanced competitiveness should play a significant part in Ireland’s (and other euro area countries’) recovery from recession.

In the March 2012 “Review Under the Extended Arrangement” the IMF team states that:

“Ireland’s economy has shown a capacity for export-led growth, aided by significant progress in unwinding past competitiveness losses.” (my italics)

The evidence does indeed point to a significant improvement in Ireland’s competitiveness between 2008 and the present.  The following two graphs show the ECB’s ‘Harmonized  Competitiveness Indicator’ (HCI) based on (a) Consumer Prices and (b) Unit Labour Costs.  (A rising index implies a loss of competitiveness.) Both graphs show a competitive gain since 2008, with second  showing the more dramatic improvement. However, this measure is affected by the changing composition of the labour force, which became smaller but more high-tech as a result of the collapse of many low-productivity sectors during the recession.

Concentrating on the HCI based on the CPI, the Irish competitive gain has still been impressive – our HCI fell 17% between mid-2008 and mid-2012, giving us the largest competitive gain recorded in any of the 17 euro-area countries over these years.  Greece, at the other extreme, recorded no change in its HCI, Portugal fell only 4.5%, Spain 6.6%, Italy 6.8%.  So by this measure Ireland is some PIIG(S)!

However, we need to dig deeper and understand why Ireland’s HCI has fallen so steeply.

Part of the story - the part on which some commentators dwell - is that early in the recession the Irish price level and Irish nominal wages fell. From a peak of 108 in 2008 the Irish Consumer Price Index fell to 100 in January 2010. But it has started to rise again – by mid-2012 it was back up to 105. The fall in the Harmonized Index of Consumer Prices has been even less impressive – from a peak of 110 to a low of 105 and now rising back to its previous peak.

Wages are more important than prices as an index of competitiveness because price indices are influenced by indirect taxes and include many non-traded services and administered prices. But Irish nominal wages tell much the same story as the price indices. The index of hourly earnings in manufacturing peaked around 106 at the end of 2009 (2008 = 100) and then fell to a low of 102 in 2011, where it appears to have stabilized.  Even in the construction sector, where employment collapsed in the wake of the building bust, wage rates declined only 6 per cent between 2008 and 2011.

Falling wages and prices are in line with what many commentators thought would happen after the surge in unemployment in 2008.  Widely-publicized wage cuts in the private and public sectors were seen as part of the ‘internal devaluation’ needed to rescue the Irish economy from the recession.  It was argued that this was the only way we could engineer a reduction in our real exchange rate given our commitment to the euro. (Paul Krugman likes to refer pejoratively to an ‘internal devaluation’ as simply ‘wage cuts’.)

However,  the Irish wage and price deflation has not been very dramatic and seems to have stalled in 2011, even though the unemployment rate continues to climb.

So why has Ireland’s competitiveness improved so sharply since 2008 if the ‘internal devaluation’ has been so modest?  The answer, of course, lies in the behaviour of the euro on world currency markets and the fact that non-euro area trade is much more important for  Ireland than for any other member of the EMU.

This can be seen by looking at the HCI for the euro area as a whole.  The euro area HCI fell from 100 in mid-2008 to 84.7 in mid-2012 – almost as big a fall as was recorded for Ireland and far higher than that recorded in any other euro area country.

The paradox that the euro area HCI has fallen much further than the average (however weighted) of the constituent EMU countries is explained by the fact that for each individual country the HCI is compiled using weights that reflect the structure of that country’s total international trade, but for the euro area as a whole the weights reflect the only the area’s trade with the non-euro world.

In its notes on the series the ECB draws attention to this:

“The purpose of harmonized competitiveness indicators (HCIs) is to provide consistent and comparable measures of euro area countries’ price and cost competitiveness that are also consistent with the real effective exchange rates (EERs) of the euro. The HCIs are constructed using the same methodology and data sources that are used for the euro EERs. While the HCI of a specific country takes into account both intra and extra-euro area trade, however, the euro EERs  are based on extra-euro area trade only.” (my italics)

It is understandable that Ireland should show a large competitive gain by euro area standards as the euro declined on world markets after 2008 because non-euro area trade is far more important to Ireland than to any of the other 16 members of the EMU. A fall in the dollar value of the euro does nothing to make France more competitive relative to Germany, or Greece relative to either of them, but it does a lot for Ireland relative to its two most important trading partners - the UK and the US.

As a consequence, the decline in the value of the euro on world currency markets, and especially relative to sterling and the dollar, has had a much larger effect on our competitiveness than on that of any other euro area country.

The following graph shows the USD / EUR exchange rate and Ireland’s HCI since 2008.  It does not take any econometrics to convince me that the main driving force behind Ireland’s competitive gain has been the weakness of the euro.  Undoubtedly a more sophisticated treatment, including the euro-sterling and other exchange rates of importance to Ireland – duly weighted – would show an even closer co-movement.

This should alert us to the point that Ireland’s much-praised recent competitive gain has been due more to the weakening of the euro on the world currency markets than to domestic wage and price discipline.

No doubt it could also be shown that a significant amount of the loss of competitiveness in the years before 2008 was due to the strength of the euro.

The fault - and the blame - lay not with us but with the far-from-optimal currency arrangement under which we labour.

Continuing gains in  competitiveness would therefore seem to depend more on further euro weakness than on the process of ‘internal devaluation’.  Should this have been a condition of our Agreement with the Troika?

I am part of an INET-sponsored group that has been considering whether and how a collapse of the Euro can be prevented. Details of our discussions to date are available here.

The WSJ has a really good piece by Gabriele Steinhauser and Matina Stevis on the core story of the Eurogroup meeting, which seems to have slipped past the domestic media somewhat. Yes, yes, they’ll get to Ireland’s debt in September/October. Grand. The key issue of just who pays for any losses within the ESM is not settled, nor is it likely to be any time soon. From the piece:

Germany’s finance minister said that even once the euro zone’s bailout fund has been authorized to directly recapitalize struggling banks, the lenders’ host government should retain final liability for any losses.

Wolfgang Schäuble’s statement early Tuesday indicated disagreements on how far the currency union needs to go to protect countries from expensive bank failures. His declaration, which followed more than nine hours of talks between euro-zone finance ministers here, clashed with those of other officials, who insisted that banks’ host states wouldn’t have to guarantee any support from the bailout fund.

The issue is hugely important for Spain, which risks being locked out of financial markets amid concerns over how a European bailout for its banks will affect Madrid’s ability to repay investors.

Fun times ahead.

Like many people, I suspect, I usually check in on Sunday night to see what Wolfgang Münchau has said this week. This week’s article was a cracker, and it’s hard to see where he’s wrong. Either governments decide to make the radical reforms that are needed, or monetary union collapses: the news from Brussels this morning suggests that they are not going to do the necessary any time soon. The Government and Central Bank have had a long time now to get contingency plans in place, and it would be nice to think that they had actually done so.

Update: for similar views, see Sony Kapoor here, and Karl Whelan here.

Well, it seems obvious to me at any rate: here. If the EFSF/ESM still doesn’t have enough money to deal with Italy and Spain, then we are still in multiple equilibrium territory: if the markets don’t panic, they will be right, and if they do panic, they will also be right.

Don’t get me wrong: this was a good summit that made some important intellectual breakthroughs. But there are only so many things that one summit can do, and we have had so many bad summits that it isn’t clear to me that the system can now deliver the many needed reforms in time.

Call for Papers

Bank Resolution Mechanisms

A joint academic-practitioner conference with the theme Bank Resolution Mechanisms wil be held in Dublin, Ireland on Thursday May 23rd, 2013, organized by the Financial Mathematics and Computation Cluster (FMCC) at University College, Dublin and the Department of Economics, Finance & Accounting at National University of Ireland Maynooth. (more…)

You can find it here. They usefully distinguish between short run and long run responses to the crisis, and correctly stress the need to maintain aggregate demand in the short run.

As for the long run reforms: if the euro survives, there will have to be “a broad-based dialogue about what a fuller fiscal union would imply for the sovereignty of member states and the accountability of the center,” and we may as well start thinking about these issues in Ireland now.

I notice that Philip’s last post has attracted very few comments, which is a shame, since the paper he linked to is a very important contribution to the debate, both here and in Europe, and deserves to be read widely. It is especially useful for people overseas seeking to draw lessons from the Irish experience, since it highlights the extent to which the Irish “good news story” is in fact a story about pharmaceuticals. Hence I hope Philip will forgive me if I make these comments “on the front page”, as it were.

Among the key findings are:

1. Wages declined only very slightly after the onset of the crisis here, and have since recovered. More generally, the European evidence is that wages are sticky downward.

2. The decline in unit labour costs in Ireland has been very modest once you take compositional effects into account (Figure 3, middle panel): they have been rising since 2010 and are now less than five percent lower than at the start of 2008. Indeed, for the economy as a whole they are back where they started (the previous statement was based on excluding agriculture, construction, real estate and the public service).

3. Despite 2, there has been a 14 percent depreciation of the Irish real exchange rate even taking compositional effects into account (once again, the index excludes agriculture, construction, real estate and the public service; including these the real depreciation is about half as big — Figure 3, right hand panel).

4. The Irish real exchange rate has been appreciating since 2010.

5. Peripheral adjustment has involved massive employment losses.

Here are some questions I have:

1. What happens when you calculate a composition-adjusted real exchange rate index for Ireland vis à vis other eurozone members only?

2. What happens if you include agriculture in the index? This is an important traded sector in the Irish context.

3. What happens if you do both 1 and 2?

4. One of the most striking graphs in the paper is Figure 2 on p. 6, which shows that while while manufacturing value added has risen by 30 percent since the start of 2008 (thanks to what happened in the pharmaceutical sector), gross production has only risen by 5 percent. Can we make further progress in understanding this discrepancy (there are some helpful suggestions in the paper), and what might this tell us about the movement in Irish unit labour costs and real exchange rates since the crisis began?

Update: Zsolt has kindly responded to my questions here.

Niamh Hardiman has a post here which echoes one of the most important points George Soros made in his Trento speech: current EU policies are amplifying anti-EU sentiment, which in turn makes it more difficult politically to move towards the tighter Eurozone integration that is economically required to save the Euro project; which in turn exacerbates the economic situation, and so on.

I have two brief comments.

The first is that this sort of negative feedback loop suggests the need for a “big bang” approach to policy reform in Europe: not some temporary liquidity fix that will give the system a little more rope to hang itself with, but a fundamental shift in the policy stance, which could change both the economic and the political dynamics.

The second is that we have got to stop referring to parties which are willing to go along with the current policy mix as “pro-European”, as if a party like Syriza is anti-European or anti-EU (it is clearly not). When Mrs Thatcher set about dismantling the social contract that had defined Britain for thirty years, this did not make her anti-British, and nor was Arthur Scargill anti-British when he tried to oppose her. People disagree, often fundamentally, about policies: that is what democracy is all about, and the moment that “Europe” is defined with any one set of policies, rather than with a framework for deciding policies collectively, it is (or ought to be) finished as a political project.

I conclude that what the EU needs right now is a loyal opposition, willing to provoke an almightily row in order to promote change. Step forward Mr Fabius?

In early 2009, the Irish domestic banks had three critical problems: insolvency, distress, and a liquidity crisis.  Only one of these problems, the liquidity crisis, was solved successfully at an acceptable cost, via ECB liquidity provision.  This massive liquidity provision was one key motivation for the Financial Measures Programme (FMP), which lays out a plan the banks must follow to become liquidity self-financing.  Now, through no fault of the Irish banks but because of the continuing financial crisis, the liquidity target plan in the FMP is looking much too optimistic and needs some adjustment. 

• 1. The loan-to-deposits target date should be changed from 2013 to (end-of) 2015.
• 2. The ECB should make clear that their liquidity assistance to Irish banks is for a longer period than originally envisioned.

Without these adjustments, the Irish domestic banks will be incentivised to continue to starve the domestic economy of credit over the next few years.

(more…)

Wolfgang Munchau writes in the FT that Chancellor Merkel has rejected any proposal that might actually resolve the eurozone crisis. He notes the incentives for Spain, Greece and Italy to default and exit.

Everyone agrees on the need for big changes to bank resolution mechanisms both in Europe and in the USA. The problems with bank resolution differ in Europe and the USA, and the appropriate solutions differ too. Coco bonds make great sense for the Eurozone but are less appropriate for the USA. European regulators need to think for themselves on cocos, not just ape the muted response of US regulators. Contingent convertible (coco) bank bonds have a trigger point (such as a minimum equity/asset ratio) which when reached immediately forces a conversion of the liability from a debt to an equity claim. So when the bank gets into trouble, junior-grade debt liabilities immediately disappear and are replaced by diluted equity. Coco bank bonds are a very partial solution (at best) to the TBTF bank resolution problem in the USA. For all but the very biggest banks, the harsh and effective resolution system in the USA can close and re-open troubled banks very quickly. This type of super-fast bank resolution will never happen in the fragmented multi-national banking system of the Eurozone. Also, the technical competence of bank oversight in the USA will never be matched across all seventeen countries of the Eurozone, some of whom have long histories of weak and ineffective bank regulation. Cocos can partly substitute for weak regulatory oversight by encouraging greater market discipline emanating from bank bondholders.  Cocos would fit well into the design of a politically-feasible banking union for the Eurozone. 

If the euro survives, some type of contingent convertibility for bank debts in the Eurozone is likely to be part of the new banking system.  Ireland as a small economy in the Eurozone would particularly benefit from a coco feature imposed on bank bonds, and should encourage this regulatory policy innovation.

The third picture in this post is really quite something.

Brad DeLong and Barry Eichengreen have a really nice piece on the lessons today’s policy makers might usefully draw from the work of the great Charles Kindleberger.

It prompted the following two thoughts on my part, neither of which is perhaps relevant to Kindleberger.

Spain’s banks are getting a series of loans. Hooray. The rather vague Eurogroup statement on Spain is here. It’s being reported that Spain will require up to 100 billion euro for its banks, which will be added to its national debt. The money will come in tranches, first from the EFSF, and then later from the ESM. There aren’t specific austerity measures attached to this series of loans. People in Ireland are sure to lose their minds over the fact that there won’t be specific conditionality attached to these loans, and the IMF will be ‘observers’ rather than actually part of a Troika of funders. The talk generally is likely to be something like ‘why couldn’t we get such a deal’, and apparently Minister Noonan will be bringing this up with his colleagues at a later date.

It should be noted however that Spain is already enduring a fair bit of austerity, has already signed up to the Fiscal Treaty, and so will have to produce a `programme’ of sorts under its own steam. Spain’s economy is also in pretty rough shape. I made the chart below from FRED to show household debt as a percentage of GDP (left hand axis) and unemployment in Spain (right hand axis), two variables we should be interested in. Clearly with an unemployment rate heading for 25%, a very indebted household sector, and a set of bunched bank balance sheets, the Spaniards have their work cut out for them even without a further programme of adjustment.

A few things to consider:

1. Will treating Spanish banks separately (in some sense) to the sovereign prevent its bond yields from spiking?

2. What will the effect on the EFSF and ESM balance sheets from a large scale Spanish ‘withdrawal’?

3. Will everyone now immediately target Italy (or Belgium) as the next domino to fall?

Jeremy Paxman may have been disappointed by the extent to which Krugman and Rogoff agreed in tonight’s Newsnight programme, despite his having helpfully set up their conversation by asking Rogoff if the big problem was demand or debt. But the pro-austerity (or was that small government? and did they understand the difference?) pair at the end were straight out of central casting. Well worth watching, also for a reminder of just how utterly parochial and blinkered Irish debate on the eurozone crisis, and plausible solutions to that crisis, has been.

I wrote the following background piece in response to a request last week.  It’s similar to John’s Compact Logic.  My respondent wrote back:  “So a Yes will facilitate EU growth policies, the exact opposite of the No position?”. I was also asked about the consequences of a Greek exit:

Adopting the euro as our currency was supposed to give us much greater stability than the fixed exchange rate regimes that preceded it.  But if Greece leaves the euro, financial markets will no longer accept at face value a statement by a struggling country such as Ireland that it intends to remain within the single currency.  We are likely to see a repeat of the Irish currency crisis of the early 1990s when markets lost their faith in the fixed exchange rate arrangement of the time and Irish short-term interest rates quadrupled over the space of a few months.

Ironically, the currency turmoil of that time was triggered by the outcome of a European treaty referendum but, for once, not one of ours.  Everything had been proceeding smoothly towards the eventual introduction of the euro.  Financial markets believed that Central Banks would intervene to any extent necessary to defend existing exchange rates and a speculative attack on a currency could not possibly be successful.  All changed when Denmark voted no to the euro in June 1992.  It was possible that France would do likewise in September. Suddenly the single currency was no longer inevitable.  Sterling succumbed to  speculative attack and devalued, and attention shifted to Ireland.  Over a billion pounds flowed out of Irish financial markets over the course of a few days and short term interest rates soared to almost 60 percent.

The Irish government tried to hold off the speculators.  Currency control were reintroduced.  The Central Bank raised its lending to the money markets more than twenty-fold to prevent mortgage and commercial interest rates rising by more than 4 to 5 percent.  But this could not be sustained over the longer term as all the country’s foreign exchange reserves would be lost.  Ireland succumbed to devaluation in January 1993.

The same turmoil, with a run on the banks and a massive risk premium on foreign lending to Ireland, would undoubtedly follow a Greek departure from the euro.  The difference in the present case is that where then we had only our own Central Bank, we now have the European Central Bank with its vastly greater firepower.

The fact that numerous other countries would be calling on the firepower of the ECB at the same time, and possibly indefinitely into the future, is why the eurozone powers seem lately to have drawn back from the precipice of countenancing a Greek exit.

The ECB has recently shown itself ready to provide enough liquidity to stave off catastrophe.   At the behest of the Americans, the IMF and now the French, the German government now seems to agree that austerity alone on the fiscal side will fail, just as it did in the Great Depression of the 1930s. But can the Germans be expected to run deficits to stimulate the European economy, or countenance eurobonds – which would put their own credit rating at risk –  before the rest of the eurozone has promised to limit its borrowing?  As a German politician said this week, “you don’t lend your credit card to someone who doesn’t know how to control their spending”.

Kevin and Philip have been keeping readers of this site up-to-date with economic analysis of Grexit, problems with EMU and other big picture items over the last few days.

If I may, I’d like to bring things back down to the level of Ireland and the upcoming referendum on the Fiscal Compact. To my mind, a few important concepts have gone out the window as the debate in Ireland about the referendum on the Fiscal Compact has descended into political games. Perhaps the first victim was cause-and-effect, with the mere correlation of banking debts and government deficits being translated by many into iron-cast causation.

A close second in the casualty list was the concept of opportunity cost: in other words, there’s not really much point focusing on how bad or economically illiterate the Fiscal Compact is in and of itself. We need to ask how attractive it is relative to the other options. As of now, the most important attribute of the Fiscal Compact is its ability to get Ireland the funding that it otherwise would not be able to get, to allow the country to gradually close the deficit. By 2020, that may be completely unimportant and we may want to ditch the Compact. But we are voting in 2012, not 2020.

With that in mind, I’ve developed “Austerity Games”, as a basic guide to voters on deficits, debt, fiscal policy and the EU’s Fiscal Compact (below, click to enlarge). Hopefully it’s useful to some readers.

Austerity Games: choices for Irish voters

For a fuller exposition on why the IMF will not be a panacea, Karl Whelan has an excellent blog post here.

Lorenzo Bini Smaghi is fond of the word “irrational”. It appears several times in the article that Philip linked to yesterday. In particular, it seems that LBS thinks that Greek voters are irrational. Given that Greece is the birthplace not only of democracy, but of Euclid and the rest of them, it seems worthwhile querying the notion that Greek voters are irrational.

One evidence of their irrationality that is sometimes advanced is that while they have overwhelmingly rejected the current austerity measures in a democratic election, polls also show that they would like to remain in the euro.

What is irrational about this?

I guess the first best solution for Greeks is for Greece to stay in the euro, but for the current programme, based on multilateral austerity and internal devaluation, which has failed and indeed has no chance of succeeding, to be replaced with a programme which involves more debt forgiveness and more fiscal transfers from the centre. What is irrational from a Greek perspective about wanting this? That it probably isn’t going to happen is of course an important fact, but there is nothing irrational about wanting what is best for you.

Then there is the question of whether it is irrational to vote for Syriza. Let us assume that if Syriza forms a government with like-minded parties, and refuses to implement the current austerity programme, Greece is somehow ejected from the Eurozone. Knowing that this is a likely outcome, is it irrational for Greeks to vote for Syriza?

I’m not so sure.

If they vote for the two parties that have brought Greece to this sorry state of affairs — and why on earth would they? — then what is the likely outcome? The programme continues, and what Greece has lived through for the past few years continues for the next few years. This would offer zero hope for ordinary Greeks; no prospect of anything changing in the foreseeable future which might improve their lives. And in the end the strategy will probably fail, anyway.

If they vote for Syriza, perhaps Greece will leave the Eurozone. In that case, what happens? There is the certainty of a major economic crisis in the short run, but then what? Some commentators argue that the result will be hyperinflation. Given that the Greek primary deficit is very small, I am puzzled by the certainty with which this prediction is sometimes made. I suppose there is a certain probability of a very bad outcome like this occurring, but the probability is surely much less than one. On the other hand, there is also the possibility of default and devaluation leading to a recovery in two or three years. Again, the probability of this scenario occurring is less than one, but it is surely rather greater than zero.

And then there is the possibility that the Europeans will blink, and that the Greeks will get something like their preferred solution. I think this probability is vanishingly small myself, but perhaps I am wrong.

So, Greek voters can do what Europe’s elites are now urging them to do, and vote for the two establishment parties. In this case, they know with certainty that nothing will get better, and indeed that things will continue to get worse. Or, they can roll the dice. I don’t think it’s irrational for them to roll the dice. And thankfully, they seem to be gambling on Syriza, not Golden Dawn.

Of course, with a certain probability, which may be less than one, but is certainly much bigger than zero, a Greek Eurozone exit will lead to financial chaos elsewhere, and possibly even the collapse of the single currency. But that will primarily be our problem, not a problem for Greek voters.

So I am unconvinced by the argument that Greek voters are irrational, even if one only considers the economics of the situation they find themselves in. And this argument is strengthened when you consider non-economic factors. Everywhere in Europe you hear ordinary people saying that they feel powerless, that voting changes nothing, that they feel disenfranchised. In Greece, voters may be about to really change things, regaining some control over an agenda which has up till now been dictated by people like Lorenzo Bini Smaghi. I guess that many voters will derive utility from this.

Knowing all of this, leaders in other European countries should surely be trying to offer Greek voters something that the status quo excludes: hope. Instead, they are offering warnings about dire consequences, and statements to the effect that the rest of us can handle a Greek exit. You do have to ask: who is it that is being irrational here?

Charles Goodhart and Sony Kapoor have a really good article here.

If true this is madness. It can’t be true, surely: can it?

Dublin is lobbying Paris against pushing for changes to the core treaty text or anything that could be considered “constitutional” in character and require a second Irish referendum for ratification.

Source: here.

The issue of whether the Fiscal Compact will mean additional austerity in the post-2015 period has generated some heat in the referendum debate.  John has usefully provided some light to this issue in a previous post.  This post adds little to the conclusions there on the “1/20th” rule but relays a similar point in a slightly different way.  Based on IMF projections Ireland will satisfy the debt reduction rule in 2015.

The debt reduction benchmark is calculated as an average over a three-year period.  One of two averages can be used to satisfy the rule.  There is a backward-looking average covering the years t-1, t-2 and t-3 with a benchmark calculated for year t, and there is also a partially-forward-looking average for the years t-1, t and t+1 with a benchmark calculated for year t+2.

The formula for the benchmark is in the Code of Conduct for the Stability and Growth Pact and for the retrospective average it can be seen on page 8 to be:

where bb is the benchmark or target debt ratio and b is the debt-to-GDP ratio in other years.  Although there is a bit to the formula all that is needed is the debt ratios for three years in order to calculate the benchmark for the next year. 

If the debt ratio for the current year is expected to be below the benchmark level given by the formula then the conditions of the debt reduction rule are satisfied.

To simulate the impact of the rule on Ireland we can use the IMF’s forecasts of the general government gross debt from the recent update of the World Economic Outlook as these extend out to 2017.  We will use these to gauge Ireland’s performance to the rule beginning in 2012.

The debt ratio column are actual data up to 2010 and are the IMF’s projections from 2011 to 2017.  The benchmark column are the targets for each year and is calculated by putting the debt ratios for the preceding three years into the formula shown above.   Compliance is true if the debt ratio for any year is less than the benchmark calculated for that year.  Under current assumptions and IMF projections Ireland will satisfy the retrospective version of the debt reduction rule in 2017.

One of the assumptions the IMF makes is that we undertake the €8.6 billion of fiscal adjustment planned for 2013-15.  Projections after that are based on a “no policy change” scenario.  Under IMF projections we will satisfy the debt brake rule in 2017 with no additional fiscal effort above what has already been provided for up to 2015 with neutral budgets after that.

The debt reduction rule can be satisfied while running deficits and does not require any debt repayments.  The IMF project that there will be an overall budget deficit of 1.9% of GDP in 2017. 

The gross debt continues to rise and in the years from 2014 to 2017 (the years used in the 2017 comparison) the gross debt increases from €201.0 billion in 2014 to €213.5 billion in 2017. 

If the alternative forward-looking version of the rule was applied it would actually show that we would be in compliance with the rule from 2015, as the benchmark calculation is based on the debt ratios in the same three years, 2014, 2015 and 2016 and again compared to the ratio in 2017.  Using the forward looking version of the rule in 2015 will also give a benchmark of 109.6% of GDP for 2017 which is, of course, above the projected debt ratio for 2017.

Although this is only a simulation it does show that we would not need additional fiscal adjustment to satisfy the debt brake rule.  In fact, using IMF projections it can be shown that we will be able to satisfy the rule before we even leave the Excessive Deficit Procedure (EDP).  The debt brake rule doesn’t actually become effective until three years after a country leaves the EDP.  We have until 2018 to become compliant with the debt reduction rule but we may actually be compliant by as early as 2015.

One reason for this is that the “1/20th” rule is actually relatively benign and according to Karl Whelan in section 2.1 of this paper the “rate of progress that is deemed satisfactory is still very slow.”  We have plenty to be worrying about but satisfying the conditions of the debt brake is not one of them.  In fact, it is likely that we will want to reduce the debt ratio at a rate faster than that required by the rule.

In the Irish Times, Michael Noonan is quoted as saying:

“On next year’s profiles we’re looking at 2.2 per cent of growth in GDP. The uncertainty caused by a No vote will cause that to come down and consequently that would make my job more difficult in planning the next budget. I don’t want to be put in a position where we have to increase the pace of the correction and, simply, the electorate are entitled to that information.”

I am curious. Am I the only one who thinks that plus 2.2 per cent is wildly over-optimistic, unless there is a radical change of direction in Eurozone macroeconomic policy?

When teaching economic history a question that frequently arises in the classroom is: do governments make policy based on interests, or do ideas also matter? Is it the case, as George Stigler once wrote about the UK’s move towards free trade in 1846, that

Economists exert a minor and scarcely detectable influence on the societies in which they live. . . . If Cobden had spoken only Yiddish, and with a stammer, and Peel had been a narrow, stupid man, England would have moved toward free trade in grain as its agricultural classes declined and its manufacturing and commercial classes grew

Or is Keynes’ famous line about ideas, written in the 1930s, and which is now such a cliché that I can’t bring myself to reproduce it here, more accurate?

This distinction between interests and ideas seems to me to be potentially quite important now, in the context of the EMU crisis.

You sometimes hear the argument made that in the final analysis, the Germans will give in on Eurobonds and the like, since the costs to them of allowing EMU to break down would be so enormous. This is an interest-based, rational choice prediction. But what if the Germans are advocating generalized austerity and internal devaluation in the periphery, not just because they don’t want to bail out other countries, or accept a higher rate of inflation in Germany, but because they genuinely believe that this is what is required in order to solve the crisis? What if they genuinely believe that there are no macroeconomic problems, only microeconomic problems? I think that there is plenty of evidence in favour of this view, and the German chapter in this book helps place it in its historical context. In this case, I don’t see any reason to be optimistic about where this crisis is heading: we can expect to see plenty more headlines about collapsing output, rising unemployment, and political radicalization in the months and years ahead, and eventually something will give.

Just because something is a cliché doesn’t mean it isn’t true.

In this interview, Mrs Merkel gives the forthcoming Irish referendum as a reason why the treaty should not be renegotiated.

Almost no-one in Ireland thinks this treaty is a good one, and that includes the people who believe that we have no realistic option but to ratify it. Indeed, almost no-one outside Germany seems to want it, including the governments who signed it. It follows that if M Hollande were to lead a push to have it renegotiated, we should support that effort. If our May referendum is an obstacle in the way of achieving that goal, we should postpone it.