Why are Irish Government bond spreads so high?

Well this might not seem like a mystery at all, given the ballooning budget deficit and the overhang of banking problems. But I do want to ask what others think about the potential role of the overfunding/prefunding of the government deficit.

The NTMA’s recent Preliminary Results highlights the fact that there was additional borrowing of 8 per cent of GDP in 2008 over and above what was needed to cover the Government’s borrowing requirement for 2008. This extra amount has been banked (safely I am sure).

Of course this should all be transparent to an efficient market, but could it be that such a large volume of gross borrowing might have contributed to market sentiment against Irish paper and increased the spread over bunds?

After all, this additional borrowing affects the General Government Debt to GDP ratio driving this to 41 per cent. (Though it does not affect the traditional National Debt ratio which is around 31 per cent of GDP).

Why is Ireland’s tax collapse so severe?

Publication of the Exchequer Returns today provides more hard evidence on an aspect (previously mentioned by myself and others) which helps unravel this mystery.

Much of the answer lies in the systematic shift towards cyclically sensitive taxes over the past two decades.  There has been more and more dependence on corporation tax, stamp duties and capital gains tax (in that order).  These three saw their share in total tax revenues rise steadily from about 8 per cent in 1987 to 30 per cent in 2006 before falling to 27 per cent in 2007 and just 20 per cent as soon as the economy turned down in 2008.

This has been an almost automatic albeit unintended consequence of the combination of Partnership with an almost unbroken period of rapid growth.  At each pay round, Government negotiators offered concessions in those taxes that are felt by the working person — Income tax and expenditure taxes.  These concessions could be afforded because of the steadily soaring revenues in the cyclically sensitive taxes.  But each notch in this ratchet made the tax system more vulnerable to an economic downturn.

In 2008, tax revenue fell by almost 14 per cent — but the percentage fall in the cyclically sensitive taxes was much larger, at 36 per cent.

Had Ireland’s tax structure been less cyclically sensitive, the fall in revenue would have been much lower.  Indeed, if cyclically sensitive taxes had been back at their 1987 share of total revenue, the fall in revenue last year would have been much lower: 8 per cent instead of 14 per cent.

The medium-term policy implications are clear. The tax structure must be rebalanced in favour of non-cyclical taxes such as income tax, VAT and excises.  Politically painfully of course but ultimately inevitable, I would say.

The Fed’s Ballooning Balance Sheet

With a return to growth for the Irish economy heavily dependent on economic recovery in the world’s major economies, we must hope that the monetary policy actions being taken by the Fed and other leading central banks will be successful.   Unfortunately, it’s a bit hard to judge what’s going on at the moment, particularly at the Fed.  

I’m teaching a module at UCD this semester on central banking.   I last taught the course in Autumn 2007 but already I’m going to have to rip up many of my old lecture notes, so dramatic have been the changes in monetary policy procedures, most notably at the Fed. 

There have been a number of profound changes at the Fed, including a move away from targeting the Federal Funds rate and towards paying interest on reserves.  But the most notable change has been the massive expansion in the size of the Fed’s balance sheet.  The most useful summary of this development that I have found is this recent post by Jim Hamilton.  Commenting on the huge expansion in the Fed’s balance sheet, Hamilton notes “The bottom line is that Bernanke has made a gamble with something approaching 2 trillion.”

Conference Announcement: Responding to the Crisis

Below are details of a conference on the Irish economic situation. Admission is free, but spaces are limited. Places can be booked by email to stefanie.feicke@ucd.ie, telephone (01) 7168335.

The conference website is here.

Responding to the Crisis

The UCD School of Economics, in association with the Dublin Economics Workshop, has arranged a half-day conference on the current economic crisis at the Royal College of Physicians, 6, Kildare St., Dublin 2, on January 12th. 2009.

Programme

14.15 Introductory Remarks

Rodney Thom (UCD)

14.20 Session 1: Fiscal Consolidation

Chair: John Fitz Gerald (ESRI)

Philip Lane (TCD): Fiscal Policy Options in the Euro Area

Ciaran O’Hagan (SocGen Paris): How Much Can Small Sovereigns Borrow?

Colm McCarthy (UCD): Expenditure Control and Fiscal Consolidation

Discussant: Karl Whelan (UCD)

Coffee at 15.45

16.00 Session 2: The Property Bubble and the Banking Crisis

Chair: Brendan Walsh (UCD)

Patrick Honohan (TCD): Resolving the Banking Crisis

Morgan Kelly (UCD): The Irish Property Bubble and its Consequences

Robbie Kelleher (Davy): Bank Solvency, Basle II and Accounting Standards

Discussant: Alan Ahearne (NUI Galway)

Conference concludes at 17.30.

Will This Year’s Contraction Be Much Worse Than Last Year’s?

Media coverage of the current Irish recession has popularized two ideas. The first is that the recession came about very suddenly. The second is that forecasts (such as the ESRI’s prediction of GNP growth of -4.6% for 2009 compared with -2.6% for 2008) imply that economic performance this year is likely to be far worse than last year. It turns out, however, that neither of these ideas are correct. The source of the misconception, in both cases, turns out to be the lack of use of the CSO’s quarterly national accounts (QNAs) in popular discussions of the Irish economy.

Take the first idea — that the recession occurred quite suddenly. The swing from GNP growth of 4.1% in 2007 to a projected decline in GNP of 2.6% in 2008 has been widely cited to illustrate a violent switch from excellent economic performance in 2007 to a slump in 2008. However, the truth is more subtle. These figures for economic growth are the “annual” growth rate, defined as the percentage difference between the average level of output in a year and the average level of output in the previous year. However, this calculation doesn’t always give an accurate indication of economic performance during a year because it is heavily influenced by what are known as “base effects”. To give an example of what this means, consider a case in which GNP expands rapidly one year and then stays constant throughout the next year. We might intuitively view the second year as one in which there was no growth. However, the “annual” growth rate will appear to be quite positive because the average level of GNP in the second year is higher than its average level in the previous year.

A closer look at the quarterly data shows a gradual slide into the current recession. The QNAs show seasonally adjusted real GNP alternated between expansions and declines from 2007:Q1 onwards. GNP turns out to have peaked in 2007:Q3 and the graph below clearly shows the economy was essentially flat over the period from 2007:Q1 to 2008:Q1 before a more pronounced recession set in during 2008:Q2. So, far from being sudden, the quarterly data show the economy stalling for about a year before the public realized a recession was upon us. (My UCD colleague Colm McCarthy made this point in his paper with Rossa White presented at the DEW in Kenmare).

Now consider the second idea, that a swing from -2.6% growth last year to -4.6% this year implies that things will be getting much worse. Again it turns out that this swing is completely due to the dreaded base effects. The ESRI’s figure of -2.6% growth for 2008 is consistent with a 1% decline in seasonally adjusted GNP in 2008:Q4. Combined with the declines from earlier in the year, the implied level of GNP at the end of 2008 is below the average for 2008 as a whole. So suppose, for example, that GNP managed to remain flat at this level for the whole year (a highly unlikely achievement). In this case, the average-over-average calculation for GNP growth for 2009 would give -2.1%. A dramatic turnaround from sharp contraction to flattening out would not be picked up by this measure.

Against the background of a severe worsening of the global economy and serious domestic fiscal problems, perhaps a better starting point is the observation that the year after 2008:Q3 is unlikely to be better than the previous year. GNP declined 4.8% over the year ending in 2008:Q3. Projecting this average decline of -1.2% per quarter through 2009:Q4, gives a figure for annual (average over average) GNP growth for 2009 of -5.1%.

These calculations show that, rather than a severe worsening, forecasts such as the ESRI’s projection of -4.6% for 2009 actually represent a slight improvement relative to the economic performance seen in the year ending in 2008:Q3.

My point here is not to question the ESRI’s forecast, which may turn out to be a good one, but to argue that economists and media commentators should make more use of the QNA figures when discussing the performance of the Irish economy.

One small change that could be made is to switch from discussing the average-over-average figure for output growth to instead discussing Q4-over-Q4 figures, which reflect the level of output at the end of the year relative to the start of the year. From my time working at the Federal Reserve Board, I know that this is the measure of growth that the Fed staff uses when describing its forecasts to the FOMC. In the above example of flat Irish GNP this year, this Q4-over-Q4 figure would show the economy improving from -4.7% in 2008 to 0% in 2009 rather than the marginal improvement cited above of going from -2.6% to -2.1%.

A caveat to this suggestion, however, relates to the use of GDP and GNP figures for projecting tax revenues. Because Ireland’s tax year corresponds to the calendar year, the year-average level of output is the appropriate figure for budget calculations. The calculations above show how far we are now from the projections underlying October’s budget. Taking the ESRI’s figure for 2008, achieving the budget’s projection of a 1% (average over average) decline in GNP in 2009 would require GNP to actually grow at a 2% annual average rate throughout 2009.

Ten Years of the Euro

We now have a full decade of evidence concerning the impact of European monetary union on Ireland and the other member countries. While my view is that the euro has been beneficial in many ways, the next year or two will be highly revealing about the capacity of member countries to undertake economic adjustment while operating within the constraints of a common currency area.

The Economist has a nicely balanced article in its most recent edition: “Demonstrably Durable“, while John Hurley had an op-ed giving the local central bank view in the Irish Times on December 30th.

I gave my own view on the impact of the euro on Ireland in an article for the Sunday Business Post back in May: you can read it here.

I have also recently written a couple of academic survey papers on different dimensions of the euro:

EMU and Financial Integration,” IIIS Discussion Paper No. 272, December 2008. Prepared for the 5th Central Banking Conference of the European Central Bank.

The Macroeconomics of Financial Integration: A European Perspective,” IIIS Discussion Paper No. 265, October 2008. Prepared for the 5th Annual Research Conference of DG-ECFIN (European Commission).