Category: Fiscal Policy

All in a Day, a Guest Post by Ciaran O’Hagan

Ciaran O’Hagan is head of rates research at Société Générale in Paris

Risk aversion has picked up in Europe over the past weeks. The debate over the fiscal and banking outlooks in Ireland needs to be placed in this context. While Irish credit is under pressure, it is also against a backdrop that favours risk aversion.

The flavour of Wednesday’s press alone gives a good idea of the headwinds facing any country wanting to grow itself out quickly from public debt. 

The ECB’s chief economist, Mr Stark, is warning of a slowdown in growth,  Meanwhile the Bundesbank’s Weber is cautioning that the global financial crisis is not yet over and setbacks in financial markets cannot be ruled out.  Behind this talk is of course the cautioning of governments that they need to show long-term commitment towards fiscal consolidation, or else brave the consequences.

Unfortunately several governments are non-existent. Belgium’s mediators warn there will be no announcement in relation to a new government this week, and there is no quick progress in the Netherlands either. Italy’s finance minister affirmed that there’s no autumn emergency. In France, the unions are trying to complicate very necessary – if still modest – pension reforms.

Even what should just be simple procedure is becoming problematic. Comments from the ECB, as reported by government sources in Berlin, suggest ongoing frustration with the IMF over how to deal with the challenges posed by Greece. And Eurostat is reported as saying it is frustrated as it can’t get all the Greek documentation on debt that it wants.

Moreover in Brussels, we have the overriding impression of cacophony from the latest Ecofin and Eurogroup meetings. We had the spectacle of head of the Commission, Mr Barroso, calling on the governments to reform. That absence of reform leads to titles in the press Wednesday like “Europe is Acting as Though it Wants to be Left Behind” (the WSJ) and “Realisation has dawned that sovereign credits cannot survive unless banks are recapitalised (the FT).

Even in AAA land, we read titles like “German banks are in reality the Achilles’ heel of the European banking system” (FT). The Bundesbank’s Weber affirmed that higher capital requirements for banks won’t curb economic growth. However even Mr Weber would probably agree that without strong banks, there will be no robust recovery. Unfortunately Europe won’t allow banks fail, and yet at the same time, many governments treat them as taxable cash cows and excuses for a lame recovery.

Last but not least, Mr Lenihan, the Irish finance minister, extended the guarantee for deposits at domestic banks and laid out plans for the dénouement of Anglo. These were necessary actions. However they unfortunately raise the contingent liability for the Irish state still further.

All this is just in a day’s news. It provides an unfortunate backdrop for any country wanting to grow itself out of public debt quickly. Ireland’s growth rate is probably more elastic than most with respect to global prospects. Unfortunately fiscal consolidation elsewhere in Europe over 2011 and beyond faces strong headwinds. That is helping make investors ever more averse to taking on risk, even among sovereigns, traditionally regarded as among the strongest of all credits.

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The Costs of Default

Panizza, Sturzenegger, and Zettelmeyer’s influential 2009 Journal of Economic Literature survey on the economics of debt and default has been referenced on different threads over the last few days.   The message has been that the costs of sovereign default in terms debt market access and borrowing costs are relatively low.   While I know that those referencing the paper know these findings provide only part of the picture, I am concerned that some blog readers will come away with too strong a conclusion. 

The puzzle of sovereign debt markets is that they should only be possible if there are costs to default – and especially to voluntary default.   In contrast to corporate borrowers, legal sanctions do not provide much of a deterrent for sovereign governments.   The traditional explanation has instead focused on the value of reputation and thus on future access.   But the finding of low direct capital market punishments for defaulters has put that explanation in doubt. 

Yet sovereign debt markets are alive and well.   From this we can infer that there must be costs of some sort.   Recent attention has focused on domestic costs, such as the costs of severe output losses that have accompanied a number of recent debt crises. 

Here is what Panizza et al. (cautiously) conclude:

If anything, defaults appear to be deterred by the domestic “collateral damage” that tends to accompany debt crises, rather than punishments from outside.   While it is very difficult to empirically disentangle the causes and effects of defaults, there is at least some evidence supporting the idea that defaults may magnify the output drops observed during debt crises.   Once output costs in line with this evidence are assumed in parameterized models of sovereign borrowing, the level of sovereign debt that can be sustained in equilibrium rise to more reasonable levels compared to models in capital market penalties are the only punishment. 

One interesting possibility is that in a world with uncertainty about government/country type, revealing yourself as “non-honest” can have implications for broader dealings both domestically and internationally. 

Even if we take a strict cost-benefit perspective, we should approach “default” cautiously – whether it is debt restructuring or the revocation of guarantees.

Your Country, Your Money

Five finalists have been announced for the Your Country, Your Call competition which, you may recall from the large advertising campaign earlier this year had the modest ambition of finding “two major proposals that, when implemented, will transform our economy – or significant elements of it – by creating jobs and opportunity.”

Competing ideas include installing solar panels on wind farm sites, creating “an Irish Content Industry Association which would then drive the development of a cultural and creative quarter. A media park would be established to attract global content industries” and, my favourite, “Building a world-beating entrepreneurial and innovation ecosystem around digital services aimed at positioning Ireland at the forefront of its associated spin-off industries.”

Two winners will be selected. They will be awarded €100,000 and then be given a development fund of, em, up to €500,000 each to implement the ideas. (Isn’t it great how these transformative ideas are so cheap?)

Obviously, it’s easy to poke fun at this competition. However, there is a serious question. The Times reports

The Department of Enterprise, Trade and Innovation said yesterday it had not provided money to fund the competition but a spokeswoman said formal arrangements were being put in place to allow a payment to be made. Earlier this year, Your Country, Your Call asked the department for €300,000 in funding for the initiative.

The question is whether public money should be used to support this idea. Just to be clear, my answer would be no.

The fiscal multiplier varies over the business cycle

Alan Auerbach and Yurij Gorodnichenko have a nice piece over at Vox which reports empirical evidence that the size of the fiscal multiplier in the US is not constant over time, but varies over the business cycle. During good times, it is small — between 0 and 0.5 — while during recessions it is high — between 1 and 1.5. (During depressions it is even higher.) This is of course exactly what we teach our undergrads in standard macro courses (at least, I think of them as standard macro courses, but I guess not everyone agrees nowadays): here is more evidence consistent with those models.

Recessions are not a good time to have to cut government expenditure. They’re an even worse time to cut expenditure if you don’t have to.

The IMF and Fears of an Irish Default

The response to Brian Lucey’s article has been quite astonishing (over 300 comments at last count!).   Although clearly we don’t all agree, the debate has been enlightening – and entertaining – thanks to Brian and the many excellent participants on this site.

But with all the excitement over default, I think we passed over too quickly the important set of IMF fiscal policy papers that Philip linked to on Wednesday.   The papers provide a useful analytical perspective on Ireland’s fiscal challenge, which could frame a more productive discussion on fiscal (and indeed banking) policy.

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