Wednesday, 24 November 2010

The €400 mn solution - a plan to recover bondholders' money

Michael Burke: There are some very large numbers bandied around in the misnamed ‘National Recovery Plan’ (NRP). €6bn of fiscal tightening this year and €15bn altogether over the next 4 years represents nearly 4% of GDP in the current year. If there is no growth over the next 4 years, then the reduction in government outlays and increased taxes will be just under 10% of GDP.

Of course, the DoF forecasts 2.75% real trend growth over the medium term, which would reduce that proportion. However, the projection for GDP in December Budget of €164.6bn was approximately €5bn over-estimated, and out by 3%. Given that the year only had 3 more weeks to run, this suggests at least a severe underestimate of the conjunctural deflationary forces at work in the economy, or, in light of the relative accuracy of other main macroeconomic data, potentially a structural misunderstanding of the key components of economic growth. In any event, an approach which fails the test of a 3 week forecast is unlikely to be very reliable over 4 years.

Where Are We?

There seems little point in rehearsing the arguments over the impact of fiscal contraction once more. The government is wedded to the notion that a reduction in its own output will prompt an increase in the activity of the private sector. This is based on a thorough misinterpretation of the history of this economy from the late 1980s onwards- which we should return to in a future post.

But, in the phrase that has become familiar, we are where we are. So, let us look instead at this economy as it is now and focus on one of the smaller numbers in the NRP. That number is €400mn.

That is the difference between two much larger numbers €15bn and €14.6bn, a difference of just 2.6%. €15bn is the threatened level of spending cuts and tax increases over the next 4 years. €14.6bn is the actual cuts and tax increases made over the last 2¼ years (p.5, which many here had asserted was precisely the cumulative fiscal tightening, and been criticised for exaggeration). Clearly, the previous measures were even more ‘front-loaded’ than the planned ones. And the composition of the packages is broadly similar – a 2:1 ratio of threatened spending cuts and tax increases compared to a 5:2 ratio for the measures already enacted.

A reasonable person might assume that the effect of the measures will therefore be broadly the same. The previous measures were accompanied by a €21bn decline in nominal GDP and a €26.2bn decline in GNP from Q3 2008 to Q2 this year. The decline in output accelerated in the second year of recession, which happened in no other European country. And, from end-2008, taxation revenues are due to fall by €12bn at the end of this year, while welfare outlays have increased despite entitlements being slashed.

But this is not how the DoF sees it; stating there is ‘an implied uncorrected (sic) deficit of 20% of GDP’ in 2010. This is the argument that, while the economy and therefore government finances have gone to the dogs, the government’s actions have saved the country from a far worse fate, in fact a deficit of just over €31bn, assuming unchanged growth in H2. (Table 1.3 in the NRP seems to imply €158.4bn GDP in 2010, which relies on zero growth for the rest of this year).

This cannot be true.

When this policy was first implemented in 2008 total government revenues were €46bn and the deficit was €13bn. The government both cut expenditure and raised taxes, and we are invited to believe that the deficit would now be €18bn worse if they hadn’t, at €31bn. But this implied deterioration in government finances is almost the entirety of the actual decline in GDP in the same period (over 85%), and nearly 70% of the decline in GNP.

A Little Analysis

DoF provides little in the any of analysis, despite a late section in the NRP on sensitivity analysis. However, even this poor contribution to understanding the relationship between government spending – growth – government finances is an improvement on what precedes it. Table A.2.2 shows the cumulative effects on the deficit (the General Government Balance) arising from a 1% change in output. The cumulative average change in the GGB over 4 years from that 1% change in output arising from lower rates or higher world growth is 1.9%.

This is based on the ESRI’s HERMES model, which may have its own faults (and certainly produces some quirks). What wasn’t put through the model, or at least wasn’t published, is the same effect from a change in government spending. To make a simple point, government spending is a category of GDP, so even without any attempt to assess the multiplier effects of a change to government spending the inescapable conclusion must be that a reduction in government spending will lead to lower GDP by at least that amount. The only alternative is that it will be offset by increased private sector activity - but that is to repeat the fallacy which created this crisis, centring on Expansionary Fiscal Contraction, a notion which has been demolished by the IMF.

The DoF says the results are ‘symmetric’- applying equally to the expansion or contraction of the economy. On that basis, all multipliers aside, a €14.6bn contraction in the fiscal position would lead to deterioration in the GGB of €27.75bn, or €13.15bn on a net basis, subtracting the tightening itself. And, since we are only two years into the tightening process the deterioration in government finances is on course to be worse than the DoF/ESRI/HERMES estimate.

So, an extra €400mn tightening in a second round of slash&burn isn’t a solution after all. Meanwhile, the level of national debt may just about double overnight as the ECB/EFSF insist on full repayment for bondholders, while the economy is bound hand and foot by ‘austerity’ measures. The solution to any debt crisis cannot be to double your debt and lower your income. Bond prices slumped today as the markets see what the policymakers refuse to acknowledge - that a default is increasingly likely. In fact it is imperative.

The bondholders should be burnt. Ireland has a history as a religious country. The millions who will suffer from this ‘recovery plan’ may feel that the bondholders, along with the others who brought the country to its knees, should burn in Hell.

7 comments:

Slí Eile said...

It remains to be seen how long this current 'plan' lasts. Fine Gael has already indicated that it will come up with an alternative 'plan' for the coming four years (a smart move indeed). The simple assumptions underpinning the Plan will be tested by events and trends over the coming year. If the huge deflationary impact further erodes economic activity then the Plan is on course to achieve a perverse effect on investment, consumption, confidence and market stability. The Chart on page 6 gives the game away - it shows a gradual narrowing of the government deficit from 2010-2014 by means of a reduction in public spending as % of GDP and a very modest increase in revenues (not the same as taxes) as % of GDP. The convergent position in 2014 is around 40%. This is a good 7-8 percent points below the EU27 average (never mind higher Scandinavian levels). In other words the adjustment from here to 2014 is predicated on restoring us to low-spend and low-tax European status. No prospect of spending more and spending more wisely on social services and social infrastructure to improve well-being and reduce inequality.

Aidan R said...

Hi Michael

You stated the notion of "Expansionary Fiscal Contractionnoti has been demolished by the IMF"

Do you have a reference/link to a paper on this.

Thanks

Seamus Coffey said...

@ Michael

The issue of the changing GDP numbers you raise in paragraph two is not down to forecasting incompetence. Take from here, The Progression of Projections.

- - - -

We will begin with the December 2009 projections and work through the changes that have been made to this projection and try to get a meaningful comparison to the November 2010 DoF projections.

The first issue we have to consider is the revision carried out by the CSO on the GDP figures. The DoF in last week’s Economic and Budgetary Outlook referred to this and claimed that “the overall size of the economy is now smaller, reflecting revisions by the CSO to the level of GDP in 2009 and to previous years (a methodological change)".

I cannot find any evidence of the CSO undertaking “a methodological change”, but they did revise the GDP numbers. This is a regular occurrence. When first released by CSO the 2009 nominal GDP was stated as €163.543 billion. (See Table 2 in 2009 Q4 National Accounts Quarterly here).

When June came around the CSO issued the revised GDP numbers and nominal GDP for 2009 was stated as €159.647 billion (see the equivalent table here). This represents a drop of €3.896 billion or 2.4%. With budget deficits and borrowings measured relative to nominal GDP this is a substantial change.

@Sli Eile

More on Closing the Gap

Anonymous said...

Answer this for me. If the government has really made an "adjustment" (surely the most loathsome word in the English language) of 14.6 billion since the beginning of the crisis, why is it that total government expenditure (ex-bank bailout) is actually HIGHER
this year than in 2007?

The rounded figures for total gross current and capital expenditure, including debt service costs, are:

2007: 65 billion

2010: 68 billion!

The source for the first one is the 2008 budget (National Accounts sections) and the second comes from the Plan just published. (It's amazing how difficult it is to nail down a number for the actual total amount the government spends and how they try to hide the interest payments on the balance sheet).

Clearly, any cuts to public sector pay and the capital budget have been more than offset by rocketing social welfare costs and interest on the national debt.

So, perhaps a little more candour gentlemen! I'm inclined to agree with arguments for stimulus but it seems false to suggest that the government has been deflating the economy when they are, I repeat, spending MORE today than even in the boom years.

Michael Burke said...

Hi Aidan

Apologies, the piece should have had this link,

http://www.imf.org/external/pubs/ft/weo/2010/02/pdf/c3.pdf

which has as its main conclusion 'fiscal consolidation typically has a contractionary effect on output', and argues that only two episodes can be identified where EFC applied, Denmark and Ireland in the 1980s. I can't argue about Denmark, but the Irish example is a misunderstanding - ignoring the effects of overseas booms and domestic devaluations, and especially the huge transfers from the EU.

Anon,

th DoF concurs that €14.6bn has been withdrawn from the economy. But the effect is not the same as the action.

As many of us here have argued, withdrawing government demand will send the economy into a tailspin and so push up unemployment and poverty. These in turn push up social welfare outlays, even while entitlements are slashed. The same will occur with the 'Recovery Plan'

Anonymous said...

It has suited the government hitherto to claim that 14.6 billion has been cut from the budget. This has, they thought, bolstered their neo-liberal, austeritarian bone fides.

But the truth is, as the figures I cited previously indicate, that they are spending more money now than ever before. This is indisputable.

As per Keynesian economics, the quantity of government expenditure is ultimately more important than the composition of it; cuts in one area have been offset by increases in social welfare.

Your, ie the Irish Centre-Left's, failure has been your fixation on stimulus versus austerity, public sector pay cuts etc. over the past two years.

That is now all largely irrelevant. The huge losses, and thus insolvency of our banks, are the only thing that matters. Everything else is a sideshow.

We need a strategy for structured default. This should have been your focus from the beginning.
6 billion here, 6 billion there is meaningless set against the colossal burden of bank debt which is about to be foisted on the Irish people. We have no alternative other than to default. Let's start thinking about how to do it; spare us the bromides about cuts and taxation until this is accomplished.

Try and see the big picture for once.

Michael Burke said...

Anonymous

we are agreed on the need for a default, however it is structured.

But that alone, even combined with the necessary removal of the banking millstone by abolishing the guarantee for bondholders, would not restore a single service cut, nor pay cut nor job loss.

For that, something else is required.

The rise in the overall government spending total is no surprise here- we forecast that would happen. Unlike the government and its supporters this arose from a recognition that cutting programme and capital spending would both reduce taxation revenues and increase welfare outlays. This is precisely what happened and will occur again under the 'NRP'.

This is because cutting government spending causes the private sector to reduce its own spending, through lower demand and above all lower investment. As the insitutional sector accounts show, the private sector is hoarding cash. This in turn produces unemployment and impoverishment, which is then reflected in both sides of the government accounts- a collapse in taxation and much higher welfare payments.

Thankfully, in the words of the DoF, these processes are symmetric- an increase in government spending, especially investment, leads to much higher private sector activity, and from that increased taxes and lower welfare outlays.

All government spending is not equal. As the IMF says, government is by far the superior method of regenerating the economy and of all other possible measures 'only targeted transfers to the poor come close'.

http://www.imf.org/external/pubs/cat/longres.cfm?sk=23671.0