Should Ireland Try a Fiscal Stimulus?

Responding to Labour leader Eamon Gilmore’s suggestion of a fiscal stimulus at his party’s recent conference in Kilkenny, Jim O’Leary argued in yesterday’s Irish Times that the option is unattractive. I would like to expand on some of Jim’s points and offer a few more.

The first is that the Government’s fiscal targets for 2008-2011 will in all likelihood be over-shot significantly in 2008 and 2009, and will be hard to hit in the terminal year of 2011. The targets are (as per the Budget Stability Update), GGB deficits for the years 2008 to 2011 at 5.5%, 6.5%, 4.7% and 2.9%. The gross debt grows from 36% through 43.4%, 47.5% to 47.8%, while net debt starts at 25% and grows through 31% to stabilise at 34% for both 2010 and 2011. 

To begin with, the out-turn for 2008 will be a GGB deficit of maybe 6.5%: the NPRF vauation was 10% of GDP at end-June, but can only be 9% at best now; and GDP for 2008 will probably come in under the figure assumed in this table. At end 2008, gross and net debt ratios will likely be 2 to 3 points higher for these reasons. But borrowing in 2009 could be in the 8 to 9% zone, rather than the 6.5% target, and the assumed growth in NPRF value in 2009 may not happen. There could be bank bail-out costs not included in the budgetary arithmetic. At end 2009, gross debt will likely breach 50% (of nominal GDP below the 2008 outcome), and the net debt ratio could approach 40%. These would be the numbers before the fiscal consolidation begins!

There is a casual assumption being made by some commentators, and possibly some Governments, that the sovereign debt markets will pony up whatever is required, at least for developed countries and certainly for Eurozone members. But Germany struggled with a bond issue during the week, secondary markets are illiquid, spreads have widened and the weakest Eurozone member (Greece) trades 1.65% above bunds at ten years. The second-weakest is Ireland at 1.35%, and some Eurozone countries with worse debt ratios are trading on narrower spreads than us.

Martin Wolf argued in the FT during the week that a weaker Eurozone member could, in principle, default. There cannot be a currency crisis, but there can be a credit crisis instead. Greece is the current bookie’s favourite, but Wolf described Ireland as ‘…a dramatic case’, noting the speed of the fiscal deterioration and the over-leveraged private sector. The system as a whole needs to de-leverage, and there is no point offsetting a necessary balance-sheet improvement in the private sector with a public borrowing explosion. Indeed, de-leveraging the public sector through liquidation of the NPRF at some stage, and crystalising the painful losses, will need to be addressed. If you can’t easily sell debt, you may have to sell equities, as many hedge fund managers have discovered.

Any attempt by Government to stimulate will run up against Ricardian Equivalence anyway, even more so in the UK version, where the tax reductions are accompanied by specific commitments to increase taxes later. If the private sector is determined to improve its balance sheet through cutting consumption and investment spending, fiscal easing will either fail, in which case it is pointless, or ‘succeed’ at the cost of frustrating the unavoidable private sector adjustment.

Finally, Mr. Gilmore proposed specific capital spending initiatives, such as school building. These may be better projects than some other components of the capital programme, but it is notoriously difficult to fine-tune with capital spending.   

 

 

  

How to recapitalize the Irish banks

Sheltering under the Irish Government’s guarantee, the Irish banks have survived massive falls in their share prices.

In each case the current market price is less than 10 per cent of its peak — 2 per cent in the case of Anglo Irish Bank.  Value to book ratio (using the last annual accounts) varies between one fifth and one sixteenth.

Time to recapitalize, then, I would guess.  When the regulator finally decides to require them to increase their capital (not least to reflect the large foreseen losses of the “incurred but not reported” type), the Government will have to be ready to participate.  But how?

For some ideas and a cautionary comment by an academic scribbler, see today’s Irish Times: http://www.irishtimes.com/newspaper/opinion/2008/1211/1228864660643.html

Adjusting to the End of a Housing Bubble: Lessons from Spain

Ireland is not the only country undergoing a sharp contraction in housing and it is interesting to learn about the policy debate in other countries (especially fellow members of the euro area). This new article on VoxEU gives a good overview of the current debate in Spain:

The Spanish trade-off: Bricks vs. brains

VAT Cut Won’t Halt Cross-Border Shopping

This website got a plug today in Alan Ahearne’s “Short View” column in the Sunday Independent. The article asked whether the Government should heed calls for a fiscal stimulus plan for this country. Ahearne concludes that the answer is an unambiguous no.

Cuts in VAT rates, along the lines introduced in the UK, would do little to bolster economic activity in this country. Part of the tax cut may not be passed on to consumers. Moreover, a substantial chunk of Irish households’ spending is on imported goods. Increased spending on imports provides only limited support to our economy. The bang for the buck from a VAT cut is small in an open economy like ours because much of the impulse leaks out through higher imports.

A stimulus proposal might be effective at boosting transactions if it were huge. But the country can’t afford such a plan. Claims that a VAT cut could be self-financing are baseless. The Dept. of Finance estimate that the 0.5 percentage point hike in the standard VAT rate in Budget 2009 will raise €220 million. A crude extrapolation would suggest that slashing VAT to the UK rate of 15 per cent would add another €3 billion to the State’s already enormous borrowing requirement. As argued previously on this website under the post “On Deficits and Debts” (3 December), there’s a limit as to how much the Government can comfortably borrow on international markets.

A cut in VAT would also likely do little to stem the flow of shoppers across the border with Northern Ireland. Price differentials between the Republic and the North largely reflect the weakness of sterling and differences in business costs.  A fiscal stimulus won’t solve these problems. A focus on improved competitiveness and realistic wage-setting would be much more valuable. Meanwhile, budgetary policy should aim at avoiding national bankruptcy.

Free riding

Nice article in the Irish Times today by Jim O’Leary. I particularly liked the following unusually honest section:

The case for borrowing more to fund an attempted stimulus package would be more difficult to rebut if there was a high probability of it being successful, but fiscal stimulus is notoriously difficult to effect in a very open economy like Ireland. The reason is that a high proportion of any increase in demand leaks out through imports.

From our point of view, the best sort of stimulus package are those put in place by our trading partners since these boost demand for our exports without costing us anything. And here, the good news is that most of our main trading partners have announced reflationary fiscal measures of one sort or another in recent weeks/months. What we need to do is ensure that we are well-positioned to avail of the opportunities that will flow from these and what that means, first and foremost, is reducing our production costs to competitive levels.

It is hard to disagree with the logic. If the amazingly profligate government we have had over the past decade had listened to people like JOL on issues like benchmarking, then we might have tried to pull our weight as part of a Europe-wide reflationary package, but as things stand, we are going to have try to free ride. Not very glorious (and rebalancing the books will obviously make a bad recession worse) but there you are.

But let’s hope that too many others don’t also take a similar view! The thing about free riding is that what is individually rational can be collectively disastrous. Dani Rodrik is gloomy here.