Thursday, 3 December 2009

Current government policy is misguided

Jim Stewart: The current stated policy of the Government is to reduce the fiscal deficit as a percentage of GDP to 3% or under by 2014 (formerly 2013). This target is unlikely to be achieved and the attempt to do so will delay recovery..

According to the recent OECD report on Ireland, almost every other country in the OECD has pursued a policy of a fiscal stimulus to varying degrees (OECD, p. 52 and fig.2.3). Even countries which are likely to have a higher deficit as a percentage of GDP than Ireland such as the UK are pursuing a fiscal stimulus policy. A member of the MPC in the UK is quoted in the Financial Times (17/11/09) as stating “it would be a mistake for government to rush too quickly to unwind fiscal deficits.” While recognising the deficit should be reduced, this is seen as “a long term project” that is over five years or more. Those countries that have pursued a fiscal stimulus policy such as the UK and Germany, have recorded recent increases in output.

All the larger countries in the Eurozone will have a budget deficit in 2009 greater than 3%. The forecast average for the Eurozone for 2010 is 6.9% (http/ It is likely that all will have a debt/GDP ratio greater than 60% in 2010 (Finland may be an exception). The forecast average debt/GDP for all eurozone countries for 2010 is 88.2%. The forecast debt/GDP ratio for Ireland is 78% (excluding cash balances held by the NTMA and the NPRF it is 51%)[*see note below]. It is likely that several countries in the Eurozone will have a fiscal deficit greater than 3% in 2014.

What is our Borrowing Requirement?

The Pre-Budget Outlook (See Department of Finance, November 2009, Table 6) estimates the Exchequer Balance to be €25.75 billion for 2009, but €3 billion of this relates to a payment to the NPRF in order to provide the banks with extra capital. This expenditure represents a financial transfer to a state agency (NPRF) which used the funds for a financial investment. This investment is most likely to result in a net gain (but the gain accrues to the NPRF rather than the Exchequer, and should be excluded from any analysis of the underlying or structural balance). A further €9 billion relates to capital expenditure. Assuming this capital expenditure has positive net present values it should again be excluded from the underlying or structural imbalance.

The NTMA has a policy of over funding. Free cash balances in December 2007 were €4.7 billion, €20 billion in December 2008, were almost €30 billion in October (NTMA Press Release 6/10/09) and Are likely to be higher now. There is very little economic analysis of this strategy. A policy of over-borrowing adds to the interest bill. Assuming a gross cost of 4.5%, and a 1% rate of interest earned on depositing funds with the ECB results in a net cost of 3.5%. On cash balances of €30 billion this would amount to annual cost of approx. €1 billion thus increasing the current budget deficit. It may also result in a slightly higher interest rate because of increased supply. It does however indicate no issue with raising debt. This is consistently demonstrated in bids for Irish government at a multiple of amounts on offer. The interest rate on Irish Government 10 year bonds has since the start of the banking crisis in November 2008, remained around 1% above the average Eurozone bond yield, but the differential has fallen compared with Germany (see diagram), and is lower than Greece since 13th November. Recent rises in Irish Government debt yields following the Dubai crisis, are unlikely to be lasting. Sovereign debt in the Eurozone area is unlikely to be the next subprime crisis, and will not result in the breakup of the Eurozone. Those who consider this to be the case (See Financial Times articles by Wolfgang Munchau 30/11/2009 and Gillian Tett 23/11/2009), underestimate the political and economic investment in creating the Eurozone, especially by Germany.

Expenditure Cuts Alone Will not Solve the Problem

Expenditure cuts alone cannot be the sole basis for a rational economic strategy. This is so in particular because a little more than half the projected deficit is accounted for by current spending and the rest by capital expenditure and contributions to the NPRF which in turn funded the banks. Cutting capital expenditure without assessing its role in the future economic success is neither sensible nor prudent.

There is however scope for reducing current expenditure. The Report largely produced by the Department of Finance (misleadingly called the McCarthy Report as many of the chapters are very similar to responses by the Department of Finance to proposals from individual departments, see:- Department of Finance - Evaluation Papers from Department of Finance) does have several sensible suggestions, for example, reducing the number of reports that are translated into Irish, ceasing payments into the National Pension Reserve Fund, amalgamating the Pensions Regulator with the Financial Regulator, reducing added years in public sector pension entitlements).

The case for solving the economic crisis by expenditure cuts alone has not been made. Other policies are needed.

My next post will suggest some policy options.

*Note: This excludes liabilities of semi-state companies such as Anglo-Irish Bank and loans issued to NAMA but the same conventions apply in measuring debt/GDP ratios in other Eurozone countries.


Michael Burke said...

This is a very useful post.

The State IS able to borrow currently despite repeated assertions that the markets will not support current and projected spending.

It should be noted too that this is hardly a function of the government austerity measures to date, since other EU countries which have engaged in reflation have seen just as big an appetite for their debt and their bond yields have fallen even further. This explains Ireland's compression of yields versus Germany while remaining stable versus the average; the other European states, all with big deficits, all engaged in reflation, have seen their yield differentials fall even faster than Ireland's.

With NTMA over-borrowed maybe we could get Ireland's yields to fall even further by copying the Belgians, Spanish, French, Germans etc. by using the funds to reflate?

This would establish a virtuous circle of lower debt costs, higher GDP, lower deficit ratios, leading to lower debt costs.

Paul Sweeney said...

This is most interesting. I’m not sure about the term “over-borrowing.” In fact, the total borrowing to date is actually €34.8bn per NTMA. This sum means the “over borrowing” at an interest cost by Jim’s calculations is a staggering sum of €1.2bn! Is this not close to the much disputed level of public sector spending “adjustment“ of €1.3bn which caused public sector/ social partnership talks to collapse on Friday 4th December?

But we need to borrow in advance. Are you saying, Jim, that we have borrowed far too much? One advantage I can see of advance borrowing, beside the immediate cash management issue, is that we are OK on borrowing for about 18 months, giving lie to the doom laden warnings about not being able to borrow at all etc. Indeed one part of the last loan was over subscribed by 8 times and part of the rest by 2.5 times.