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Austerity, through tax or cuts, is the only option, according to Constantin Gurdgiev (“the interloper”)

However one interprets the core constraints of the Fiscal Compact Treaty  (officially cosily known as the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union), several facts are indisputable.

 

Firstly, the new treaty will restrict the scope for future exchequer deficits. This has prompted the ‘No’ side of the referendum campaigns to claim that the Treaty will outlaw Keynesian economics. This claim is exaggerated. Combined structural and general deficit targets to be imposed by the Treaty would have implied a maximum deficit of 2.9-3.0 percent in 2012 as opposed to the (equivalent) IMF-projected general government net borrowing of 8.5 percent of GDP. With the value of the Treaty-implied deficit running at less than one half of our current structural deficit, the restriction to be imposed by the new rules would have been severe. However, in the longer term, Treaty conditions allow for accumulation of fiscal savings to finance potential liabilities arising from future recessions. This is entirely compatible with the spirit of Keynes, even though it is at odds with the extreme and fetishised worldview of the modern Left, that sees no rational limit to debt accumulation so long as it stimulates economies out of recessions and broader crises.

 

Secondly, the Treaty will impose a severe long-term debt ceiling, but that condition is not expected to be met by Ireland any time before 2030 or even later.

 

One interesting caveat regarding the 60 percent of GDP limit is the exact language employed by the Treaty when discussing the adjustment from excess-debt levels. The Yes camp made some headway in convincing voters to support the Treaty on the grounds that debt paydowns required by the debt bond will involve annually reducing the overall debt by one twentieth of the debt level in excess of the 60% limit. However, the Treaty itself defines “the obligation for those Contracting Parties whose general government debt exceeds the 60% reference value to reduce it at an average rate of one twentieth per year as a benchmark” (page T/SCG/en5). Thus, there is a significant gap between the Treaty and reality.

 

Another debt-related aspect of the treaty that is little understood by some analysts is the relationship between the deficit break, structural deficit limits and the long-term debt levels consistent with the economy’s growth potential. Based on IMF projections, our structural deficit for 2014-2017 will average over 2.7% of GDP, which implies Treaty-consistent government deficits of around 1.6-1.7% of GDP. Assuming long-term nominal growth of 4-4.5% per annum, our ‘sustainable’ level of debt should be around 38-40% of GDP. Tough, but we were at public-debt-to-GDP ratios of below 40 percent in every year from 2000 to  2007. It is also worth noting that we have satisfied the Treaty’s  60% debt limit every year between 1998 and 2008.

 

Similarly, the Troika programme for fiscal adjustment implies a de facto satisfaction of the Treaty’s deficit limit after 2015, and consistent non-fulfilment of the structural deficit rule and the debt rule at all times between now and 2017. In other words, no matter how we spin it, in the foreseeable future, we will remain a fiscally rouge state, client of the Troika and its successor, the ESM.

 

On the negative side, however, the one-twentieth rule will be a significant additional drag on Ireland’s economic performance, compared to the current Troika programme. If taken literally, the average rate of reduction of the Government debt from 2013 through 2017, required by the Treaty would see our state debt falling to 87.6% of GDP in 2017, instead of the currently-projected 109.2%. In other words, based on IMF projections, we will require some €42 billion more in debt repayments under the Treaty over the period of 2013-2012 than under the Troika deal.

 

On balance, therefore, the Treaty is a mixture of a few positive, historically-feasible, benchmarks that are dubious for the future, and a rather strict short-term growth-negative set of targets that may, if satisfied over time, be beneficial. Confused? That’s the point of the entire undertaking: instead of providing clarity on a reform path, the Treaty provides nothing more than a set of ‘if, then’ scenarios.

 

Let me run though some hard numbers – all based on IMF latest forecasts. Even under optimistic scenarios, Ireland’s real GDP is expected to grow by an average of 2.27% in the period from 2012 to 2017. This is the highest forecast average rate of growth for the entire euro area, excluding the Accession states (the EA12 states). And yet, this growth will not be enough to lift us out of the Sovereign debt trap. Averaging just 10.3% of GDP, our total investment in the economy will be the lowest of all EA12 states, while our gross national savings are expected to average just 13.2% of GDP, the second lowest in the EA12.

 

In short, even absent the Treaty, our real economy will be bled dry by the debt overhang – a combination of the protracted deleveraging and debt-servicing costs. It is the combination of government debt and unsustainable levels of households and corporate indebtedness that is cutting deep into our growth potential, NOT the austerity-driven reduction in public spending. In this sense, Treaty-induced acceleration of debt repayments will exacerbate the negative effect of fiscal deleveraging, while delaying private debt deleveraging.

 

However, on the opposite side of the argument, the alternative to the current austerity and the argument taken up by the No camp in the Treaty campaigns, is that Ireland needs a fiscal stimulus to kick-start growth, which in turn will magically help the economy to reduce unsustainable debt levels accumulated by the Government.

 

There is absolutely no evidence to support the suggestion that increasing the national debt beyond the current levels or that  dramatically increasing the tax burden on the general population – the two measures that would allow us to slow down the rate of reductions in public expenditure planned under the Troika deal – can support any appreciable economic expansion. The reason for this is simple. According to the data, smaller advanced economies with average Government expenditure burdens of c 31-35% of GDP have expected growth rates averaging 3.5% per annum. Countries that have Government spending accounting for 40% and more of GDP have projected rates of growth closer to 1.5% per annum. Ireland neatly falls between the two groups of states both in terms of the Government burden and the economic growth rate. So, if we want to have growth above that projected under current forecasts, we need (a) to accept the argument that growth is not a matter of stimulus, but of longer-term reforms, and (b) to recognise that for a small open economy, higher levels of Government intrusion into the economy is associated with lower-growth potential.

 

Despite our already deep austerity even after the Treaty becomes operational, the Irish Exchequer will continue running excess spending throughout the adjustment period. Between 2012 and 2017, Irish government net borrowing is expected to average 4.7% of GDP per annum, the second highest in the EA12 group of countries. Between this year and 2017, our Government will spend some €47.4 billion more than it will collect in taxes, even if the current austerity continues. Of these, €39 billion of expenditure will go to finance structural deficits, implying a direct cyclical stimulus of more than €8.4 billion. The Treaty will not change this. In contrast, calling on the Government to deploy some sort of fiscal spending stimulus today is equivalent to asking a heart attack patient to run a marathon in the Olympics. Both, within the Treaty and without it, the EU as well as the IMF will not accept Irish Government finances going into a deeper deficit financing that would be required to ‘stimulate’ the economy.

 

The structural problem we face is that under the  current system of funding the economy and the Exchequer, our exports-driven model of economic development simply cannot sustain even the austerity-consistent levels of Government spending. The IMF projects that between 2012 and 2017 cumulative current account surpluses in Ireland will be €40 billion. This forecast implies that the 2017 current account surplus for Ireland will be €10 billion – a level that is 56 times larger than our current account surplus in 2011. If we are to take a more moderate assumption of current account surpluses running around 2012-2013 projected levels through 2017, our Government deficits are likely to be closer to €53 billion. Our entire exporting engine will not be able to cover the overspend of this state. In short, there is really no alternative to the austerity, folks, no matter how much we wish for this not to be the case.

 

Instead, what we do have is the choice of austerity policies we can pursue. We can either continue to tax away incomes of the middle and upper-middle classes, or we cut deeper into public expenditure.

 

The former will mean accelerating the loss of productivity due to skills and talent outflows from the country, reduced entrepreneurship and starvation of investment to young companies, rising pressure on wages in skills-intensive occupations, while destroying future capacity of the middle-aged families to support themselves through retirement. Hardly trivial for an economy reliant on high value-added exports, higher tax rates on the upper margins the income tax will act to select for emigration those who have portable and internationally-marketable skills and experience. Given that much of entrepreneurship is formed on the foot of self-employment, high taxation of individual incomes at the upper margin will further force the outflow of entrepreneurial talent. In addition, to continue retaining high-quality human capital here, the labour markets will have to start paying significant wage premia to key employees to compensate them for our tax regime. All of these things are already happening in the IFSC, ICT and legal and analytics sectors.

 

The latter is the choice to continue reducing our imports-intensive domestic consumption, especially Government consumption, and cutting the spending power of public-sector employees, while enacting deep structural reforms to increase value-for-money outputs in the state sectors. This, in effect, means increasing the growth gap between externally trading sectors and purely domestic sectors, but increasing it on the demand side, while hoping that corrected workplace incentives will lift up the investment side of domestic enterprises.

 

Both choices are painful and short-term recessionary, but only the latter one leads to future growth. The former choice is like giving vitamins to a cancer  patient – sooner or later, the placebo effect of the ‘stimulus’ will fade, and the cancer of debt overhang will take over once again, with even greater vengeance.

 

 

Looking back over the Treaty, the balance of the measures enshrined in the new treaty is most likely not the right prescription for Ireland today. It is probably not even a correct policy choice for the future. But the reasons for which the treaty is the wrong ‘medicine’ for Ireland have nothing to do with the austerity it will impose onto Ireland. Rather, the really regressive feature of the Treaty is that it will make it virtually impossible for our economy to deal with the issue of private-debt overhang and properly to restructure our taxation system to create opportunities for future growth.