This morning I am giving a talk to a meeting in Dublin of the chairpersons of the 27 EU finance committees. It’s my understanding that the meeting is being is being webcasted live at this site beginning at 8.15 Irish time. The text of my talk is available here.
I’m voting Yes to today’s referendum on the Treaty on Stability, Coordination and Governance. I know many people are voting No and I think the outcome is not the forgone conclusion the polls have lead many to believe.
I am concerned that many people are voting No for spurious reasons. If you’re voting No for any of the following ten reasons, perhaps you should reconsider.
1. It Means More Austerity for Ireland: No, really it doesn’t. See this post for an explanation of why the Treaty does not mean more austerity for Ireland than the current Stability and Growth Pact regime, this post for an explanation of the one-twentieth rule, and Seamus Coffey’s post on the idea that Ireland needs to implement €6 billion in new cuts in 2015.
2. Hauled to ECJ if We Miss Fiscal Targets: You’ve probably heard that the treaty means that Ireland can be hauled in front of the European Court of Justice if we miss future fiscal targets laid down by the European Commission. It doesn’t. Open the Treaty, hit Control-F and search for “Justice”. The only new role in this Treaty for the ECJ is to ensure that Ireland passes a fiscal responsibility bill that transposes the fiscal rules in the treaty into national law. Introducing such a bill is already a requirement of Ireland’s EU-IMF programme and a draft bill has been released. There is no question of Ireland being taken to the ECJ as a result of this treaty.
3. We’re Putting Detailed Fiscal Rules into the Constitution: Sounds like a bad idea but, no, we’re not doing that. The referendum merely allows the government to ratify the Treaty (here’s the question). There will be a national fiscal responsibility rule. It can be changed as long as it still meets the guidelines of the treaty and the treaty itself can be changed by mutual agreement with other countries. Unless those changes trigger new sovereignty-related issues, there is no reason they would require another referendum.
4. Reversing Austerity in Europe: This is a big emotional theme of the No campaign, that Ireland can join a Spring tide against austerity lead by Francois Hollande. In truth, Hollande is not planning to change the fiscal rules in the treaty one jot. Hopefully, his desire for pro-growth initiatives will bear some fruit but people who vote No on this ground will find themselves sorely disappointed by this particular Spring tide.
5. The Cost of ESM: You’ve probably heard that ESM is going to cost Ireland €11 billion and you’ve probably heard this compared with budget deficit gaps to be closed. In truth, Ireland will be providing €1.27 billion to ESM as part of its initial €80 billion start-up capital. The plan is for ESM to borrow the rest of its potential €700 billion capital fund from financial markets, so that Ireland will only have to provide €11 billion if ESM lends its full amount funds and they are all defaulted on. Even then, this is a once-off cost and does not compare with budget deficit savings which need to made every year (if our deficit is €15 billion, we need to make €15 billion in savings every year, not just once, to return the deficit to balance). ESM is likely to have to lend to Ireland. Over the next few years, the net flow of funds will be towards Ireland, so claims ESM is somehow going bleed us dry are very far from the mark.
6. The EU Won’t Let Ireland Default: Really? You haven’t heard of Greece then?
7. A No Strengthens Our Hand in Bank Debt Negotiations: I have followed the whole promissory note\bank debt debate very closely and I really have no idea why anyone thinks this. The EU is not going to bribe Ireland to sign this treaty as it doesn’t need us to sign it and is quite willing to let us default if we thumb our nose at the ESM. The ESM is also likely to provide the best possible source of funds to allow us to refinance the promissory notes over a longer period and at a lower cost.
8. There’s Always the IMF: No, there isn’t. Read this.
9. Wealth Tax\Pot of Gold: Some No campaigners argue that we can close our budget deficit with a wealth tax. Maybe we can, maybe we can’t (actually we can’t). But either way, there’s no reason why we couldn’t do this after a Yes vote. In truth, this argument amounts to “Vote No to avoid having to balance the budget but we’ll balance the budget anyway”.
10. Sure We’re Going to Default Anyway: Maybe so. But there are many different ways to default. A default that maintains access to ESM funds will allow for a smoother post-default adjustment. Simply voting No and announcing a default will lead to massive instant austerity as we have to reduce the budget deficit to zero immediately.
Which brings me to the legitimate argument for voting No. Cormac Lucey and others argue that we should Vote No, refuse access to ESM funds, undergo rapid austerity and leave the euro. There are legitimate arguments for this approach but I don’t believe it is what the majority of the country (or even a majority of No votes) want.
One of the components of the Treaty on Stability, Co-Ordination and Governance that has received a lot of attention from the No side in the Irish referendum is the so-called one-twentieth rule relating to the debt-GDP ratio. Here I want to describe what the rule is and whether it implies additional austerity than Ireland’s existing commitment to a medium-term objective
What is the One-Twentieth Rule?
The rule is mentioned twice in the treaty. The first mention is in the preamble:
RECALLING 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;
The second mention is in Article 4
When the ratio of a Contracting Party’s general government debt to gross domestic product exceeds the 60% reference value referred to in Article 1 of the Protocol (No 12) on the excessive deficit procedure, annexed to the European Union Treaties, that Contracting Party shall reduce it at an average rate of one twentieth per year as a benchmark, as provided for in Article 2 of Council Regulation (EC) No 1467/97 of 7 July 1997 on speeding up and clarifying the implementation of the excessive deficit procedure, as amended by Council Regulation (EU) No 1177/2011 of 8 November 2011.
Unfortunately, neither of these sections are well worded. The problem is the “reduce it” formulation. In both cases, it looks as though the “it” that needs to be reduced by one-twentieth is the debt to GDP ratio itself. In Ireland’s case with a peak debt ratio projected at 120% such a rule would require a reduction in the debt ratio of 6%. Such a rule would be a new and tighter fiscal requirement than already existed.
In fact, however, the one-twentieth rule is not intended to refer to anything new at all. The mention in the preamble is a “Recalling” mention, i.e. reminding people that a one-twentieth rule already exists. And Article 4 concludes by explaining that the rule is supposed to work in a way that is set out in EU Council Regulation 1177/2011, where the rule is worded as follows:
When it exceeds the reference value, the ratio of the government debt to gross domestic product (GDP) shall be considered sufficiently diminishing and approaching the reference value at a satisfactory pace in accordance with point (b) of Article 126(2) TFEU if the differential with respect to the reference value has decreased over the previous three years at an average rate of one twentieth per year as a benchmark, based on changes over the last three years for which the data is available
So the rule relates to an average rate of reduction over three years of one-twentieth of the gap between the debt ratio and the 60% reference value. In Ireland’s case, this would require an average pace of reduction of about 3 percentage point per year after the debt ratio has peaked. This rule is EU law and will still apply even if Ireland rejects the EU treaty.
Does the Rule Imply Additional Austerity?
The one-twentieth rule has been mentioned repeatedly by No campaigners as a source of additional austerity. For instance, here‘s Terrence McDonough:
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.
Where does this €5 billion a year figure come from? I’m assuming (and am happy to be corrected) that it comes from the following calculation. Our peak debt level will be €200 billion which will imply a debt-GDP ratio of 120%. At current levels of GDP, a debt ratio of 60% would require a level of debt of €100 billion. One-twentieth of the gap between €200 billion and €100 billion is €5 billion.
This “€5 billion a year debt reduction for 20 years” claim has two serious problems with it.
First, the treaty doesn’t make any reference to 20 years and it’s not a complex mathematical point that closing one-twentieth of a prevailing gap does not eliminate that gap in 20 years because the amount of gap being closed gets progressively smaller. So even if nominal GDP remained unchanged at its current level, the debt reduction needed would gradually reduce over time from €5 billion.
Second, and far more importantly, there is literally nobody who expects this rule to be obeyed by reducing debt levels with constant nominal GDP growth. Even the ECB is committed to having an average inflation rate in the Eurozone of 2% per year, so no nominal GDP growth in Ireland would require continuous ongoing contractions in real GDP of 2% per year.
If this outcome was to come about, the one-twentieth rule would be the least of our problems. In anything close such a scenario, debt sustainability would have to be restored via a major default.
So the rule cannot be thought of in isolation from discussions of potential growth rates of nominal GDP. Seamus Coffey has an excellent post here that discusses this issue. Seamus provides calculations of how much debt can be sustained while complying with the one-twentieth rule. Below is Seamus’s chart illustrating potential debt levels.
What the chart makes clear is that anything better than 2% per year nominal GDP growth (consistent with zero real GDP growth) will allow the one-twentieth rule to be obeyed without reducing debt levels at all. The €5 billion a year debt reduction scenario is well off the mark. Either we get some level of real GDP growth, in which case debt can rise, or else we will have to default.
Finally, I did some calculations to check whether the one-twentieth rule was in any way more binding that the commitment to a 0.5% medium-term deficit. The answer is no.
The chart below assumes 4% nominal GDP growth (2% real and 2% nominal). It shows that the debt ratio will fall much faster with a 0.5% deficit (the blue line) than it would be if we were sticking to the 1/20th rule (the black line).
So the one-twentieth rule already exists and will still apply to us even if we vote No, it doesn’t imply the need to reduce debt by €5 billion per year and in fact is likely to require less austerity than is required by the commitment to reach a medium-term objective of a 0.5% deficit, which we are still required to meet if we vote No.
The debate in the opening week of Ireland’s referendum campaign on the Treaty on Stability, Co-Ordination and Governance has largely been driven by those advocating a No vote. These campaigners argue that the treaty will lead to additional austerity in Ireland and hence advocate a No to the “Austerity Treaty”. The Yes campaigners respond by asking where Ireland will get the money to fund budget deficits. This morning‘s discussion on RTE’s Pat Kenny show between Joan Burton and Mary Lou McDonald largely conformed to this pattern.
What is odd about this pattern is that Yes campaigners have failed to highlight that the treaty does not, in fact, imply additional austerity in the coming years relative to what would occur if there was a No vote, even if the EU did decide to fund Ireland via EFSF or some other vehicle. The fiscal parameters laid down in the treaty are all part of the existing EU fiscal framework that Ireland is already operating within and would continue to operate within after a No vote.
Here I’ll focus on three different numbers that come up time and again in the treaty debate:
- The 0.5% deficit figure set out in Article 1(b) of treaty.
- The 3% deficit that Ireland is projected to reach in 2015 according to current projections.
- The 1/20th per year clause relating to debt reduction set out in Article 4 of the treaty.
The 0.5% Figure
The 0.5% figure does not represent a deficit limit that countries must obey at all times. Rather Article 1 of the treaty says that its terms are respected
if the annual structural balance of the general government is at its country-specific medium-term objective, as defined in the revised Stability and Growth Pact, with a lower limit of a structural deficit of 0,5 % of the gross domestic product at market prices.
So the 0.5% refers to something called a “medium-term objective” (MTO) for fiscal policy, which is already part of the existing Stability and Growth Pact. These MTOs vary across countries depending on their fiscal situation.
Do you want to guess what Ireland’s current MTO is? Yep, you guessed it: a deficit of 0.5%. Here‘s our latest Stability Programme Update. Go to page 31 and you’ll find this
Ireland’s ‘medium-term budgetary objective’ (MTO) currently stands at -0.5% of GDP.
So anyone who objects to this treaty on the grounds that it would make Ireland’s MTO be equal to 0.5% of GDP can go ahead and vote No if they wish. But Ireland’s MTO will still be 0.5%. Nothing will have changed and whatever role the MTO plays in generating austerity will remain as before. (See this post by Seamus Coffey for further discussion of MTOs.)
The 3% Figure
The No side regularly argue that the treaty requires more austerity because current plans see the deficit reduced to 3% in 2015 but the passing of the treaty would then require the deficit to be reduced further to 0.5%, hence extra austerity due to the treaty. This claim is wrong in assigning extra austerity to the treaty on three counts.
First, you might recall that 3% is the deficit level that triggers an excessive deficit procedure under the existing Stability and Growth Pact. A plan to stay at 3% would be a plan to remain permanently in an excessive deficit procedure.
Second, as just noted, Ireland’s MTO is a 0.5% deficit and compliance with the existing Stability and Growth Pact would require continued gradual movement towards this target.
Third, deficits of 3% would see Ireland maintaining very high debt ratios for a long time even if the economy returned to growth. See below for a chart showing the debt-GDP ratios that would occur after 2015 with 4% nominal GDP growth for two different fiscal policies: The first maintaining a 3% deficit and the second gradually reducing the deficit to 0.5% after 2017. It is extremely unlikely any responsible Irish government would choose the black line trajectory over the blue line.
The One-Twentieth Figure
I plan to write a separate post about the one-twentieth rule. For now, I just want to note that this rule also will still be in existence even if Ireland votes No. Last year, the EU agreed a comprehensive set of revisions to the Stability and Growth Pact process. This featured six legislative documents and is known as the “six pack”. Details here.
The first of the new regulations introduced is Regulation 1177/2011, which amends the previous regulation on the excessive deficit procedure. It introduces into EU law the following:
When it exceeds the reference value, the ratio of the government debt to gross domestic product (GDP) shall be considered sufficiently diminishing and approaching the reference value at a satisfactory pace in accordance with point (b) of Article 126(2) TFEU if the differential with respect to the reference value has decreased over the previous three years at an average rate of one twentieth per year as a benchmark, based on changes over the last three years for which the data is available.
So, as with the 0.5% MTO, if you don’t like the one-twentieth rule, voting No does nothing to get rid of it.
Note all of these rules will apply, irrespective of whether the EU decides to offer Ireland a bailout after a No vote, perhaps via the EFSF. The existing SGP rules will not go away just because some people wish they would.
At this point, it is incumbent on the Yes side to explain that, even if future bailout funding could be secured after a No vote, that vote would do nothing to reduce fiscal austerity. The additional point that a No vote does jeopardise bailout funding—and thus could trigger massive and instantaneous austerity—is also worth making. But not at the expense of debating the basic premise of the No side’s “Austerity Treaty” argument.
John McManus’s rather sad and sneering economist-bashing article today gives another public outing to my now-way-over-exposed sentence “All that said, although I think the economics of this treaty are pretty terrible on balance, the arguments favour Ireland’s signing up to it.”
I’ve been getting a number of responses to this sentence along the lines of “Why would an economist vote for a Treaty that he characterises as having terrible economics?”
By way of clarification, I’d like to point out that this was one single sentence in a two-page set of prepared comments for an Oireachtas committee. For anyone interest, the full set of comments can be found here or as part of the official transcript here. The sentence when uttered was not intended as a soundbite or leaflet material. Rather, it came after a long discussion in which I argued that the fiscal rules in the Treaty were too tight when applied across Europe as a whole. I had not mentioned Ireland once up to that point and I believe the context in which it was intended was perfectly clear.
So the “terrible economics” quote, which is being repeated out of context, relates to the wider European debate about this treaty. It was immediately followed by a brief explanation of why I believe Ireland should sign the treaty. Here’s how I concluded my presentation.
Economic policy-making rarely amounts to picking the best possible policy suggested by economic theory. In a choice between an overly restrictive and badly designed fiscal compact and the potential alternative of being denied funding for our fiscal deficit next year – and the more extreme possibilities of sovereign default or exit from the euro – we should stick with the European project and hope, however difficult this may be, that we can work to improve its design in the future.
Given the widespread context-free repeating of the sentence, I can understand why people may have been confused as to what my position was. Less understandable was the characterisation of my position by Sinn Fein’s Peadar Tobin on RTE’s The Week in Politics last night. Tobin said that the three economists quoted on their leaflet all disliked the economics of the treaty but were advocating a Yes vote for (unspecified) “political reasons”.
Frankly, this is nonsense. I am advocating a Yes vote because, for Ireland, I think the alternative is more likely to involve a quick sovereign default, massive austerity and economic collapse. These are assuredly “economic reasons” not “political reasons”.
I appeared on RTE’s Morning Ireland earlier today to discuss the possibility of Ireland obtaining a loan from the IMF. The audio can be found here.
The lead story in today’s Irish edition of the Sunday Times was titled “Treaty no bar to IMF bailout.” The missing-from-the-web story quotes IMF official Bill Murray (and yes there is a touch of the Groundhog Day about this story) as saying there is “no reason” why Ireland could not ask the IMF for another loan. It then contrasts this with statements from the Taoiseach and Tanaiste that appear to suggest Ireland will not have access to non-market funding if there is a No vote.
This story will most likely be cited in the coming weeks by those who advocate a No vote as somehow supporting their position. In reality, it does nothing of the sort. I’ll make a few points on this.
1. Less funding equals more austerity: Clearly, Ireland can apply to the IMF if it has no other source of funding. However, Ireland’s current programme from the IMF provides far more funds relative to the country’s quota than is normal for the IMF and it represents a fairly significant fraction of available IMF funds. Look at pages 98-100 of this report from December 2010 describing the decision to grant loans to Ireland.
Overall, the proposed access would entail substantial risks to the Fund. The Fund would be highly exposed to Ireland in terms of both the stock of outstanding credit and the projected debt service, for an extended period and in a context of high overall debt and debt service burdens.
The report, however, notes
the strong support of their European partners, and the Fund’s preferred creditor status
as mitigating factors. In other words, as long as there was a lot of European money being provided to Ireland, the IMF was likely to get its money back because of its preferred creditor status.
Also worth remembering is that the IMF is a global organisation and many of its members already resent the use of such large amounts of money to bail out first-world European countries. The use of IMF funds to help a country that thumbed its nose at European bailout funds to then repay the Europeans would be very badly received around the world.
At this point, I would not go as far as Jacob Funk Kierkegaard in stating definitively that the IMF would refuse to lend any further money to Ireland without European support. Murray is correct that no such stipulation would ever be formally set out in advance when considering any country’s application for funds. What is clear, however, is that any programme approved would provide Ireland with far less funds than a second EU-IMF programme. This will mean more austerity not less.
2. Would an IMF loan mean no sovereign default? The Sunday Times story quotes (I hope mis-quotes) Constantin Gurdgiev as saying:
If Ireland was locked out of the ESM and also the IMF, it would default. That means it would be defaulting on its current IMF loans. That would be a big no-no for the IMF. It is inconceivable that the IMF would not extend the current programme.
This argument is, in my opinion, completely wrong. A sovereign default for Ireland would not mean a default on IMF loans. Not only is a sovereign default not inconceivable, it is exactly what would happen if the IMF were the only providers of funds. They would conduct a Debt Sustainability Analysis and almost certainly conclude that Ireland’s debt was unsustainable. At that point, the IMF would oversee a full-scale debt restructuring to ensure that the Fund was repaid and its preferred creditor status preserved.
The likely default would probably be a bloodbath for private sovereign debt holders. With official debt (first programme loans, promissory notes, ECB holdings) accounting for about €110 billion of Ireland’s €200 billion in gross debt by the end of 2013, a deal to see Ireland’s debt ratio reduced to 80 percent would see these investors lose two-thirds of their investments.
It is also possible that this debt restructuring would see IBRC (and possibly AIB) defaulting on their government-guaranteed debts and this would certainly be cheered by those who resent the EU’s role in insisting that all bank debts repaid. That said, any bank debt write-down wouldn’t see a reduction in the austerity that Ireland would endure. In fact, the IMF would probably require the Irish deficit to be completely eliminated in a year or two to give the country some chance of returning to financial markets. And that’s all before factoring in the implications for credit availability of the sovereign default.
3. Would an IMF loan be cheaper? No. As Philip Lane points out, IMF loans above a certain percentage of a country’s quota carry a fairly hefty 300 basis point premia over the cost of funds (for loans with maturity above three years). Ireland is already above this percentage, so all future loans from the IMF would be charged this premium. In contrast, loans from European facilities now carry no margin over the cost of funds.
At this point, it appears that some of the No campaigners have forgotten what they’re really campaigning against. What most of the No campaigners are protesting against is fiscal austerity. However, ruling out access to the ESM and relying on whatever the IMF will be willing to provide to Ireland is a recipe for a far harsher near-term austerity than would occur with access to European funds.
I stressed that while I believe the fiscal parameters specified in the Treaty are overly tight, and will lead to fiscal contraction in Europe even in countries that don’t need to make such adjustments, there are strong arguments for Ireland to sign up for the Treaty and then work to promote growth-enhancing policies after we have signed up.
I’m guessing Stephen Collins would think that I’ve still left myself “open to misinterpretation” with these comments but if Labour had wanted someone to tell them the treaty has no flaws, I’m guessing they would have asked someone else.
I will post more detailed comments about various aspects of the treaty in the coming weeks.
I stressed the need to boost aggregate demand in the core countries as a key requirement for solving the debt problems facing the periphery. It is interesting to see the developments over the past few days in which many senior European politicians have begun to stress the need for pro-growth policies. As I stressed in this Vox-EU article from February, it is still not too late to make the Fiscal Compact less restrictive.
Someone has just shown me a leaflet distributed by Sinn Fein promoting the case for a No vote on the Fiscal Compact treaty. The back page contains quotes titled “What the Experts Said”.
One of the quotes is from me. It says:
… the economics of this treaty are pretty terrible …
Did I say that? Well, yes, I uttered those words at a meeting of the Oireachtas Committee on European Affairs. Here‘s what I said without the dots
All that said, although I think the economics of this treaty are pretty terrible, on balance, the arguments favour Ireland’s signing up to it.
The two other economists quoted are Colm (“Voting No is a Leap in the Dark that We Can’t Afford“) McCarthy and Seamus (“there is little to be gained from rejecting the Treaty“) Coffey.
The other expert cited is Jack O’Connor, President of SIPTU.
I’ll leave it there.