Wednesday, May 2, 2012

What’s on the table?

Today Irish Times carries an opinion piece from Prof. Terence McDonough of NUIG on the Treaty on Stability, Cooperation and Governance.  It is headed ‘Treaty not a safe option but a perilous experiment’.

I agree with some the article says in relation to the funding options available to Ireland in the event of a ‘No’ vote.  Towards the end of the article there is a summary of “what’s on the table” in four points.  There are a number of parts in this list that I disagree with.

1. Structural deficits for Ireland should be about half of 1 per cent of GDP, with a 3 per cent top limit on the headline deficit even in the worst years. This requirement seriously compromises government ability to end recessions.

The implementation of the 0.5 per cent structural deficit rule in the new treaty is considerably more stringent than any of the existing “six-pack” regulations, which are themselves unwise. Eventually, a shortage of government bonds will emerge, forcing conservative investors such as pension funds into less safe investments, risking the reappearance of dangerous asset bubbles.

The 0.5% of GDP target for the structural deficit is not ‘new’ and is not more stringent than the existing ‘six pack’.  The balanced-budget rule in terms of the structural deficit has been in place since June 2005 as we discussed here.  In fact the current rule is actually less stringent than that proposed in 2005. 

In the March 2005 document approved by the Commission as the template to revise the Stability and Growth Pact, the rule required high-debt countries to have  structural balances that were “in balance or surplus”.  This is slightly relaxed in the 2012 Fiscal Compact with high debt countries allowed a structural deficit of up to 0.5% of GDP.

The balanced-budget rule is restrictive and will bring government debt levels down to low levels as previously discussed but it is not so because of the Fiscal Compact.

2. Debt should be 60 per cent of GDP. If debt is greater than 60 per cent, it will be reduced by 1/20 per year over the next 20 years. This would start in 2018, when the bailout terms expire, and could require up to €5 billion a year in savings to 2038.

This is utterly wrong.  The debt brake rule, which on this occasion is part of the “six pack” and was introduced as part of Council Regulation 1177/2011 last November.  The regulation makes no reference to 20 years.  What it does specify is that if a country’s debt ratio exceeds the 60% of GDP threshold, then the country must close one-twentieth of the gap between the current level and the 60% threshold (and doing so on average over a three-year period is sufficient).

Consider a country with a debt equal to 100% of GDP.  This is 40 percentage points above the threshold.  In order to satisfy the rule one-twentieth of this gap must be reduced.  One-twentieth of 40 is 2, thus the following year the indicative target for the debt ratio is 98% of GDP.

This can be easily achieved with growth and inflation.  With 2% growth and 2% inflation this country could satisfy the conditions of the debt brake with a deficit of close to 1.9% of GDP.  In the second year GDP would be around 104 and the nominal debt 101.9 giving a debt ratio of 101.9/104 = .98.

Here are some indicative nominal debt levels at different nominal growth rates for a country that starts with a debt ratio of 120% of GDP.

Debt Levels

In the extreme case of no nominal growth for 20 years the debt must be reduced from 120 to 81.5 over the 20 years with very moderate debt reductions in the second 10 years.  With just 2% nominal growth (the ECB’s inflation target plus zero real growth) the debt stays relatively constant and is up slightly to 121.1 after 20 years.  In this scenario the debt must fall marginally for the first 10 years and then can increase gradually after that.

In a more typical scenario of 4% nominal growth (say 2% inflation and 2% real growth)  then the actual debt must never be reduced.  Deficits are around 2% of GDP are allowed right from the start and over the 20 year period shown above the nominal debt can increase from 120 to 178.6.  The level of debt increase allowed is even greater with 6% nominal growth.

Today’s article says that the debt brake rule “could require up to €5 billion a year in savings to 2038”.  I am not sure what this means.  By using the word savings I assume this is money put on deposit or, in this case, money used to pay down debt.  There is no plausible scenario in which Ireland will have to reduce the debt by €5 billion per annum. 

Even with zero nominal growth such repayments would not be required.  Any nominal growth close to 2% will mean the debt level has just to be maintained and if nominal growth is above 2% the amount of debt can actually be increased.  From 1971 to 2010 average annual nominal GDP growth in Ireland was 11.5%.

3. Even after we reach this target, Ireland will be forced to run primary surpluses, that is excluding interest payments on the national debt, for many years, taking steam out of the economy.

Ireland will have to run primary surpluses for the foreseeable future but this will probably not be the case if we can reach the target of the 60% of GDP threshold.  If we ever get the debt back to 60% of GDP then we will only be required to run primary surpluses if the interest rate exceeds the nominal growth rate.  This might not happen and small primary surpluses might be required to keep the debt ratio at 60% but there nothing to suggest that “Ireland will be forced to run primary surpluses”.

If will take decades for the debt to approach the 60% threshold and, of course, this limit does not come from the Stability Treaty.  It was first introduced as part of the Maastricht Treaty in 1992.

4. If these conditions are violated, control over fiscal policy is ceded to Europe and the European Court of Justice.

This is just plain wrong.

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