If Economics of the Treaty are Terrible, Why Vote for It?

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”.

Ireland and the IMF After a No Vote

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.

Vox-EU Article on Target2 & Some Thoughts on Central Bank Balance Sheets

I have written a new article on Target2 for Vox-EU titled “TARGET2: Not why Germans should fear a euro breakup.”

It is interesting to see how the debate about Target2 has changed over time. This is the third article I’ve written for Vox on this subject. The first two (here and here) largely dealt with serious inaccuracies that were being aired prominently, such as claims that the Target2 system was crowding out credit in Germany or that the Budesbank was being forced to sell securities to fund loans to the periphery. While new false claims about Target2 have since emerged (e.g. CESIfo’s claim that German commercial banks are having to alter the asset side of their balance sheet because of Target2) these particular stories appear to have been put to rest.

More recently, as the Euro crisis has escalated, the focus of discussions on Target2 has switched to the question of what would happen to the balances if there was a complete Euro breakup and those central banks with Target2 liabilities refused to honour their debts. This is a legitimate question and it is the one I address in today’s article.

My conclusion is that there will be no need to fiscally recapitalise the Bundesbank should its Target2 credit turn out to be worthless because the new-DM will, like the Euro, be a fiat currency and such currencies do not obtain their value from being backed one-for-one by hard assets held by the issuing central bank.

This conclusion will, I’m fairly sure, attract a lot of criticism, particular from the Northern European parts of the internets. However, I think much of the scare-mongering about Target2 reflects a general confusion about the nature of central bank balance sheets within a fiat currency system.

Consider, for instance, the constant stream of business press reports featuring various commentators worrying about the balance sheet of the ECB.  As I’ve noted before, much of the commentary on the potential credit losses focuses on the wrong figures by discussing the ECB’s capital when, in fact, loss-sharing on monetary policy operations is shared across the full Eurosystem, which has nearly half a trillion euros in capital and revaluation reserves to absorb losses.

Even when these articles focus on the right figures, they usually greatly exaggerate the potential problems associated with the ECB’s potential “solvency.”   Articles like this one, for instance, seem to be premised on the idea that the value of the euro as a currency depends on the Eurosystem having assets that “back” the currency: One euro more in assets than liabilities and the Eurosystem is fine, one euro less and disaster supposedly awaits.

The truth is that the euro is a fiat currency and its value as a medium of exchange does not stem from the public’s faith in the value of the assets held by the central bank. Commentary that hypothesises existential problems for the euro stemming from perceived issues with the Eurosystem’s balance sheet are simply based on false analogies between private sector and central bank balance sheets.

I’d like to be able to point to lots of other useful work on this topic but, unfortuantely, these issues are rarely discussed in mainstream economics textbooks or journals. Here though is a nice recent presentation by Columbia’s Ricardo Reis that touches on some important points in relation to central bank balance sheets. Hopefully Ricardo will produce a full paper on this soon.

Presentation on Fiscal Treaty to Labour Party: April 28, 2012

This morning I gave a presentation on the Fiscal Treaty to members of the Labour Party. The slides are available here as a PowerPoint slideshow and here in PDF.

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.

Presentation on Macro Imbalances to European Parliament ECON Committee: April 24, 2012

The slides from my presentation of macroeconomic imbalances to the European Parliament’s ECON Committee are available here as a PowerPoint slideshow and here in PDF.

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.

Monetary Dialogue Briefing Papers: April 2012

I’m off to Brussels in the morning to present my latest briefing paper to the Economic and Monetary Affairs committee of the European Parliament. You can see the full list of briefing papers here.  There are four papers (including one by me) on macroeconomic imbalances and four on non-standard monetary policy measures. I’m afraid the plastering of the word DRAFT on the pages of each of the papers is a recent piece of technological regress but I always find these papers really interesting.



Today in Selective Quotations: Sinn Fein Fiscal Treaty Edition

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.

No Mr. Noonan, NAMA Does Not Borrow From the ECB

One of the great myths about the Irish economy that has circulated in recent years is the idea that the National Asset Management Agency (NAMA) has borrowed money from the European Central Bank. I tried on various occasions in the past to observe that this is not the case without having any impact. However, I had hoped that the people running Ireland understood how NAMA works. Apparently this was too much to hope for.

Here‘s Minister for Finance, Michael Noonan, in the Dail yesterday (H/T NAMA Wine Lake):

The money which we accessed for bridging finance from NAMA was money which is due to be repaid to the ECB for the loans it gave to NAMA to acquire the impaired assets in the bank. Again, it is ECB money that is providing the bridge. What will happen is that when the circle is completed and the shareholders give their consent, which is my expectation, the NAMA funds will be restored and NAMA will do what it intended to do last month, namely, it will repay another portion of what it owes to the ECB.

Just for the record (and I know now for sure I’m wasting my time) NAMA has issued bonds to the Irish banks in return for property assets. It can redeem those bonds as it acquires cash for the property assets. The bonds can be used by these banks as ECB-eligible collateral. However, NAMA is not a bank. NAMA is not ECB-eligible counterparty. NAMA has never borrowed, and will never borrow, from the ECB.

CESIfo Embarrasses Itself Again

CESIfo Group, the research Institute of which Hans-Werner Sinn is president, has developed a fondness for issuing anonymous press releases that claim to “explain” Target2 balances to the general public. Today, their new press release claims:

Target credit levels in the Eurosystem are rising ever more steeply … Who are the losers from this process? The savers in those remaining European countries that still have sound economies. Without their knowledge or consent, the marketable securities owned by their savings banks, commercial banks and life insurance companies that usually cover their savings have been transformed into mere claims against their central banks, which in turn have acquired claims against the ECB system and indirectly against the central banks of Spain and Italy.

Let’s leave aside for a minute the fact that those coloured pieces of paper in your wallet are “mere claims against central banks”.  The idea that the assets of savings banks, commercial banks and life insurance companies have been altered by changes in Target2 balances is utterly false.

Target2 balances can only be accumulated (whether as a credit or a debit) by Eurosystem central banks. Take a look at any annual report of a German savings bank, commercial bank or life insurance company. You will not find that their marketable securities have been replaced by Target2 credits because this never happened and can never happen.

The anonymous person who wrote this press release has no clue what Target2 is or how it works. Its appearance should be a cause of great embarrassment to the CESIfo group and they should issue an apology and a retraction.

Anyone who has had the misfortune to read this press release and is now confused about what Target2 balances are should consult this short guide to the subject written by two Bundesbank economists and published (but then ignored) by CESIfo. Two other articles by me rebutting various CESIfo-inspired arguments can be found here and here.