Tuesday, 7 February 2012

The Fiscal Compact, or: where will we be in 2018?

Tom McDonnell: The debate about the fiscal compact is likely to continue for some time. Much has been made of the 'one twentieth' rule but in practice it is adherence to the rules around the structural balance which will really matter in terms of the fiscal stance post 2015.

Ireland is currently working its way through an Excessive Deficit Procedure (EDP) which requires the general government deficit to be no worse than 3% of GDP in 2015. At that point Ireland will be expected to improve its structural budget balance by converging to a medium term objective of a deficit no larger than 0.5% of GDP. The Department of Finance estimates that the structural deficit will be 3.7% in 2015. If one generously accepts this figure as accurate then the government will be obliged to adopt a fiscal stance consistent with 'correcting' the remaining gap. This will trigger additional discretionary fiscal consolidation equivalent to circa 3.2% of GDP - about €5 billion in 2012 terms (though not necessarily all in the same year). This suggests that the programme of continuous austerity will continue out to 2017/2018. A bleak prospect.

This continuous fiscal tightening combined with the huge private debt overhang will drag on the economy's capacity to generate increases in real GDP. Debt sustainability in the absence of higher inflation (anathema to the ECB) or low interest rates on government borrowings (perhaps by extending the official programme past 2013) will be challenging. The Treaty does refer to an ability to deviate from the medium term objective under 'exceptional circumstances'. It will be interesting to see how this is interpreted in practice and it is possible there may be scope for wriggle room.

The fiscal compact is certainly no panacea for the current crisis though it might ameliorate the severity of the next one. The answers to the current crisis lie elsewhere.


Paul Hunt said...

"The answers to the current crisis lie elsewhere."

Elsewhere?! Where? Is it a place - or a set of policies?

Tom McDonnell said...


Both of the above.

Paul Hunt said...


Tom McDonnell said...

Probably a topic for another post I think.

My personal preference is to give the ESM a banking licence and use it to backstop Government borrowings. It would act as a de facto lender of last resort channelling through ECB funding. I suspect it would take too long to put in place Eurobonds and it is perhaps politically unworkable to mandate the ECB as a direct lender of last resort. There would have to be protocols and conditions associated with such a mechanism - and I dont deny the importance of fiscal rules.

But even this is just one element. I am not convinced that the monetary union can be made to work in the absence of some form of fiscal federalism and centralised banking regulation. There are also the issues of insolvency in Greece and others and a broken banking system.

Each policy target needs at least one policy instrument.

What are your own thoughts Paul?

Paul Hunt said...

You're probably right about being a topic for another post, but I think we should stay with this issue.

The unwinding of this Faustian pact between governments (of all complexions) and the banks and financial sector has turned some EU member-states' - and risks turning more memeber-states' - sovereign debt in to junk. There is a core demand by most sovereign bond market participants for bonds that are, as nera as damn-it, almost risk-free. That's where they put their 'good money' and, for pension funds, where they want it when they are close to the point of paying out to claimants.

There is simply too much sovereign debt out there at the moment that is perceived as too risky - and many funds are prevented from buying it. So the primary objective of the EU's Grand Panjandrums with this 'fiscal compact' is to reduce the supply of sovereign debt over time and to increase its quality.

And yes I know some bank and sovereign bondholders should take a hit, but many governments and their banks are locked in a deadly embrace and it will take some adroit manoeuvering over an extended period before they will be able to release the grip on each other without both falling down. In the Irish case, specifically, something has to be done with the IBRC ELA as a matter of urgency. While that huge fiscal leakage continues, it will not be possible to secure the popular consensus to support the deep-seated structural reforms required.

Despite this, it still makes sense to take steps to reduce the quantity and to increase the quality of the stock of sovereign debt. The best way of reducing the power of the bond markets - and of curtailing opportunities for the shorters, hedgies and vulture capitalists - is to shrink the supply so that they are crying out for the issue of more debt, rather than the current situation where governments are pleading, cajoling and begging market participants to buy more paper.

But reducing the stock and increasing its quality has major implications for the financing of public activities - in particular, the financing of investment in infrastructure and utilities.

Governments will simply have to get these off their books and create an asset class that has a credit rating a little higher than the cost of sovereign debt. In the Irish case, a major programme of privatisation would not only reduce the stock of sovereign debt, but it would benefit all citizens as consumers and taxpayers by removing the financing tax the current gloriously inefficient financing of investment is imposing.

Paul Hunt said...


Of course, those on the left would be vehemently opposed to this. The view is that the rights and entitlements of individuals should be independent of the circumstances of their birth or the social or economic context and taxes should be raised to provide the services to meet these rights and entitlements. This is a perfectly valid position, but it requires an enormously strong and inclusive national common bond to secure and sustain the popular support and democratic legitimacy for such a level of taxation and of economic and social provision.

The example of the Scandinavian countries is frequently advanced, but the levels of taxation and public expenditure were highest when the common bond was strongest at the time when the culture and society were extremely homogenous. As immigration has increased that bond has weakened and levels of taxation and public provision have fallen accordingly.

In Ireland, I would contend the common bond that would sustain high levels of taxation and high levels of public provision is far, far weaker. We may lament this and wish it were stronger, but wishing won't strengthen it.

Irish people have experienced a decade of falling levels of taxation and of a narrowing of the tax base. There appears to be widespread, and probably understandable, public opposition to the increases in the levels and to the widening of the tax base the Government is being compelled to pursue.

There are real limits to the extent to which the tax burden may be increased - irrespective of how equitably it might be imposed. And this sets a limit on the stock of high quality sovereign debt that may be sustained.

This, I fear, is the reality, but it appears that the penny hasn't dropped for most people - and certainly not for those on the 'progressive-left'.