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

Michael Burke24/11/2010

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.

Posted in: Fiscal policy

Tagged with: NRP



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