Category: Fiscal Policy

EFSF Borrowing Rate

Calculated Risk is one of the best economics and finance blogs out there. It’s a fantastic free resource for analysis of the US macroeconomy, financial markets, housing markets and other issues. Ireland has hit CR’s radar in the past week or so and in a number of posts he has written that the likely borrowing rate from the EFSF will be 8%.

I believe the source for this figure is an article by Wolfgang Munchau (who in turn perhaps based it on a Barclay’s Capital research note that was subsequently corrected). I discussed this issue here: I believe the correct rate will be lower than 6%. This is still very high but it is worth clarifying that the 8% figure just seems to be based on flawed calculations.

CR must get a million emails and comments a day, so I thought I’d use the blogosphere to hopefully clarify this issue.

Default Inevitability?

With the 10-year yields heading towards 8 percent and the 5-year CDS cost surpassing Argentina’s, Ireland has very definitely lost the confidence of potential lenders.   Morgan Kelly’s Irish Times article offers an explanation: the combination of the cost of bailing out the banking system and the dismal underlying rate of nominal GDP growth makes it impossible to avoid a default. 

While the situation is clearly critical, I do not agree with Morgan’s starkly pessimistic conclusion of default inevitability.   Given how influential his analysis is, however, I think it is useful to recap the argument using the IMF’s fiscal-space model as an organising framework (see here).   The model shows that default results when a country’s debt to GDP ratio passes a critical point.   This critical point depends on gap between the nominal interest rate and the nominal growth rate and also the economic and political capacity for generating a primary surplus (a country’s fiscal space is then the gap between the debt to GDP ratio and the critical point).   It is easy to see how continued creditworthiness might be beyond a country’s capacity when facing the combination of a very high bank bailout cost and a very low underlying nominal growth rate.

Morgan argues that this is the case for Ireland.   But I do not see things as being as dire as he makes out.   Even taking his high €70 billion estimated cost of the bank bailout, a large gap between the nominal interest rate and the nominal growth rate of 4 percentage points means that the bailout cost would add €2.8 billion to the required primary balance (just under 2 percent of GDP).   This could well push a country over the edge, but it hardly seems decisive.   Moreover, Morgan argues that Ireland cannot afford a nominal interest rate greater than 2 percent.   To get an interest-growth gap of 4 percent, this means that the nominal growth rate would be just negative 2 percent.   While I share his concerns about the effects of Ireland’s balance sheet recession on growth, I think a medium-run nominal growth rate of positive 2 percent is actually still quite conservative.   But this means the nominal interest rate could be as high as 6 percent and still yield the 4 percent interest-growth gap assumed above.   Of course, this is all just illustrative, but the bottom line is that there is a clear enough path out of this crisis provided the political will is there. 

But do we have the political will?   This is where I have become more pessimistic watching an apparent failure to prioritise the national interest by our political leadership – government, backbenchers, opposition, independents, social partners.    Unlike Morgan I think default is avoidable.   That would make it even more of a shame if it happens.   I remain hopeful that we will all get the message. 

Alpha Politics

That squelching we hear is the sound of political heels digging in.  It is hard to know whether the effort to shift the burden of the fiscal adjustment to others is better symbolised by Mary O’Rourke’s staking out a no-go area on behalf of pensioners, or Jackie Healy–Rae’s latest demands for Kerry pork.   Pat Leahy captures this depressing scene well today in the SBP (article here):

There are many other aspects of the way we run our affairs that outsiders such as Commissioner Rehn might wonder about.

What, for instance, will Rehn and his friends in the square glasses from Frankfurt make of the fact that the government can pass this budget—which they consider necessary for the continued economic independence of the country—only if they agree to build the Tralee by-pass and open a new ward (or whatever) at Kenmare Hospital, in order to keep Jackie Healy-Rae happy?

The capacity of Irish politicians to always put their own local interest over the national interest is astonishing.   It is true that this is precisely what they have been instructed to do by their voters, but at this time of extreme national crisis, it is still remarkable. 

Not surprisinly, the delay of stabilisations has been a central focus in the literature on the political economy of economic reform.    A classic paper in this literature is Alberto Alesina and Allan Drazen’s, “Why are Stabilizations Delayed?” (1991).   [The paper is available from JSTOR here; a non-technical summary along with empirical evidence is given is Alesina et al. (2006), “Who Adjusts and When?  The Political Economy of Reforms” (available here).]

The essential idea is that the burden of the stabilisation will not be equally shared in a polarised political system.   How unequally depends on a parameter, alpha.   The higher is alpha the larger is the share of the burden borne by the “loser”.   Each group has the Healy-Rae like power to veto stabilisations that are not in their interests.  With uncertainty about the costs of delay for other vested interests, stabilisations tend to be delayed in a “war of attrition”—notwithstanding the collective costs of such delays.   (See pages 3-4 of Alesina et al. for an accessible non-technical description of the model.)

I have written in earlier posts about the importance of the overall adjustment being viewed as fair.   One element of this boils down to alpha being viewed as small, so that the various vested interests don’t have to dig their heels in quite so firmly to avoid being the ones ending up bearing a disproportionate share of the burden.  Broad political leadership is required to create the necessary trust. 

Pat Leahy concludes grimly on where our broader policital system seems to be:

The problem is that there is no certainty that the government is capable if of implementing a fiscal programme that would achieve such an outcome [i.e. avoid an EU bailout/IMF intervention].   The opposition remains generally resigned to the targets, but against the measures that would achieve them.   Civil society appears to be mobilising against the cuts. 

One wonders what Rehn will make of it all. 

Government Plans €6 Billion Adjustment in 2011

The government have released a ten-page document outlining its plans for the level of adjustment in the upcoming budget and also some details on growth projections and adjustments planned for future years. Here‘s the press statement.

The summary:

The Government has agreed on an adjustment of €6 billion for 2011 and this will reduce the General Government deficit to around 9¼ to 9½% of GDP next year. Taking account of the €15 billion consolidation package, my Department now expects annual average real GDP growth to be 2¾% over the 2011 to 2014 period.

The government have also released a note on the accounting treatment of the promissory notes. The key point:

the terms of the promissory notes will provide that no interest will be chargeable in 2011 and 2012.

I’m guessing these are newly-negotiated terms, though I’m happy to be shown that this is not the case.

In any case, the bottom line is that this €6 billion of adjustment will have slightly more effect on the GGD than the approach I had been recommending. I had been recommending €7 billion but that figure included €1.5 bilion for the promissory note interest, which does not apply now.

There is lots to absorb in this plan but, for now, let me say that I think the govenment have taken the right decision in relation to the size of the planned adjustment. Now we just have to see if they can get it passed.

Portrait of a market

With Irish 10-year bonds at 7.601%, a little escapism is called for: Federico Etro has a nice piece on the market for art.