Managing expectations in recovery will be a difficult task

April 20 2014

By: Dan O'Brien


HOW can the solid ground of fiscal stability be reached by the State? Last week, updated government economic and budgetary forecasts for the next five years set out the path to a time when the books will be balanced. According to the plan, closing the deficit is still a long way off and expected to happen only in 2018, a full decade after the crisis started.

In some cases, it's the first time big portfolios of loans have been put up for sale, raising a host of legal challenges for would-be buyers, such as local banking secrecy rules, consumer protection laws, and other regulatory hurdles.

But before analysing the future of the public finances, the starting point needs consideration. As it happens, last week also saw the publication, by the State's statisticians, of the full budgetary picture for last year. Though the numbers contained few surprises, there was no shortage of unsettling facts in the figures. Here are just three:

1. Last year, more than one in every six euro the Government spent was borrowed. The gap between revenue and spending was the third-highest as a percentage of GDP among the 28 members of the EU.

2. The total stock of public debt passed the 200bn threshold in 2013. This was the one of the highest among the EU 28, whether measured as a proportion of GDP, GNP or a composite of the two as used by the independent budgetary watchdog, the Irish Fiscal Advisory Council.

3. Interest payments on the national debt stood at 7.4bn last year, nearly four times higher than in 2007. One in every eight euro of government revenue in 2013 went on debt-servicing.

The yawning gap between government spending and revenue, which opened up when tax receipts began collapsing in late 2007, was still not half way to being closed as of 2013.

The deficit of almost 12bn last year may be down from the peak of 18bn in 2009, but there is clearly a long way to go (all figures in the second chart strip out the bank bailout costs incurred in 2009-2011). The Coalition's aim is to keep total public spending at around 70bn annually out to 2018, the same level, incidentally, at which it was seven years ago at the height of the boom (and, for what it's worth, well over double the level just seven years before that).

Containing spending at current levels will be painful as it will amount to a continuous decline in real terms, even in a very low-inflation environment. More painful still will be the ever-larger amount that is gobbled up by interest payments. By 2018, these are expected to hit 10bn, accounting for one in every six euro spent by the State, thereby reducing the amount that goes on the things from which citizens benefit.

The expectation is, therefore, that almost all the deficit-closing work will be done by raising more tax. The Government is forecasting that the strong increase in tax revenues in 2012 and 2013 will continue out to 2018. The hope is that this can happen painlessly after 2015 because, with more people at work and more economic activity, the Exchequer's coffers will fill without the need for new and additional taxes this is the magic of tax "buoyancy".

Will all this come to pass? The past 10 days have shown the range of views on the degree to which the economy will gain momentum, with the ESRI being very upbeat, while Department of Finance officials are more modest in their expectations.

The most optimistic people of all are the people who, for better or for worse, matter most bond traders. Despite Irish government debt now at multiples of its pre-crash levels, investors are seeking the lowest interest rates ever to lend to the Irish State. Other weak eurozone peripherals have been benefitting, too. The main driver of the extraordinary decline in interest rates demanded of fiscally weak European countries has been a transformed appetite for risk among investors.

Two years ago, most bond traders believed a number of sovereign defaults were looming and stampeded out of the European bond market. Now they believe that things are mostly rosy and have charged back in.

This is mostly irrational and, in my view, is too good to last. Interest rates on Irish, Greek and Portuguese government bonds simply do not reflect credit risk given the size of their debts and the uncertainties about economic growth upon which repayment of debt ultimately depends.

If there is a rational component to investor behaviour in the Irish case, it is that more than one-third of public debt is long-term, low interest debt in the form of bailout loans and the new bonds issued to replace the promissory note. As has happened in the past with Ireland and Portugal, the terms of these loans can be made even easier for the debtor countries so that a restructuring of the remainder of the debt owed to private lenders can be avoided. This is one of the reasons why these countries are all back in the bond market, something that was unthinkable just 20 months ago.

If the bond trading herd is gung-ho, the dismal scientists are more cautious. Economists at the Department of Finance, the Central Bank, the Irish Fiscal Advisory Council, the European Commission and the IMF don't want to frighten the herd by playing up the risks, but a close reading of their debt sustainability analyses makes clear that none believes Ireland is out of the woods.

The Government's own set of economic and public finances forecasts published last Tuesday make this clear. On demand for exports, the Department of Finance notes that "recovery remains fragile in many regions and downside risks remain". On pharma exports, which account for around one-third of foreign sales of goods and services, "the potential exists for stronger than expected output losses over the medium term". On the second biggest export, the report notes that technology services are "concentrated in nature, and firm- and sector-specific developments have the potential to impact considerably on both exports and value added".

The Department sees risks domestically, too. "Although the household debt-to-income ratio is falling, the post-crisis path for household savings is unclear."

Despite all the risks and the scale of challenge remaining in stabilising the public finances, expectations are growing that the era of austerity budgets is over. And with talk of tax cuts and public pay increases becoming more common, expectations look to be running out of control.

If the Government can claim, with some justification, to have managed the economy well, its management of expectations could end up being its undoing.