John Bruton

Opinions & Ideas

Category: economy

WHERE CAN THE EU FIND THE AMMUNITION TO FIGHT A CORONA VIRUS INDUCED ECONOMIC SLUMP?

The Covid 19 outbreak, and its deep financial aftermath, will put the European Union under unprecedented stress over the next five years or more. Brexit will add to these tensions for some members, notably Ireland. It is a matter of vital national interest for Ireland, that the EU gets its response to the crisis right, and does not allow it to create dangerous social distancing between the states of the EU.

A crunch point will be reached next Tuesday when EU Finance Ministers must make vital short and long term decisions.

 The existing structure of the EU is unfitted to a crisis like this. The public expect the EU to act, but has not been given the EU the powers it needs to do so. 

Unlike the states of the EU, the EU itself has no capacity to borrow money, and no capacity to raise taxation. So it  often lacks the financial clout to take decisive action.

 The amount it is allowed to spend is a mere 1% of GDP, whereas EU member states can and do spend around 40% of their GDP.

Membership  of the EU has been enlarged to include populations who have radically different understandings of the obligations and responsibilities of EU membership.

 Some think EU membership is compatible with authoritarian systems of governance.

 Others think EU membership is about entitlements, without commensurate responsibilities.

 Yet others see the EU as a means of creating a sphere of influence and projecting national power. 

Some (like the UK) see the EU as just a trading arrangement, with few political obligations at all.

 Many see membership of the EU as a transaction, from which they should always gain more than they were giving up.

 The countries and regions that gain most from the EU Single Market, are either unaware of the gains, or mistakenly think it is all due to their own efforts.

 A recent study by the Berthelsmann Foundation showed that the big objectors to Eurobonds (Germany , Austria and the Netherlands) gain almost three times as much per capita from the EU Single Market as do the assumed beneficiaries of the Eurobonds, Spain and Italy!

 If the Single Market were to fail, the objectors would lose the most. But their national politicians fail to tell them this. Incidentally the study showed Ireland to be a big gainer from the Single Market.

Meanwhile the countries and regions that gain comparatively less from the Single Market resent this, and fail to acknowledge that they too are gaining from being in the EU Single Market, albeit a bit less than the others are gaining. Envy blinds some to reality.

Of course, these contradictory feelings are rarely expressed publicly, but they there under the surface, ready to emerge when a crisis happens and decisions have to be made quickly. 

Covid 19 has been such a crisis.

 The first reactions of some EU members were revealing, and deeply troubling.

On 4 March, France and Germany decided to block export of personal protecting equipment outside their own borders, even within the EU. This was done notwithstanding the fact that restrictions on export to other EU states are forbidden by Article 35 of the EU Treaty.

 Two days later, Italy requested an extraordinary meeting of EU health Ministers. This was declined, notwithstanding the fact that the health crisis was worse in Italy than elsewhere, and Italy (like Greece) had already borne the brunt of the refugee crisis, with little or no help from its EU partners.

 It took several days of pressure before the export bans were lifted, and 1 million German masks eventually did reach Italy. Meanwhile China scored a public relations coup by getting equipment to Italy, equipment that Italy’s EU partners had failed to supply. 

The Institute Montaigne, a French think tank said this episode will leave “deep scars” in Italy’s relationship with its EU partners north of the Alps.

The restrictions on economic activity, as well as the direct health and income support costs, arising from Covid 19 will dramatically increase the debts of all states in the EU. 

Assuming a 20% drop in GDP as a result of Covid 19, an economist in the Bruegel Institute in Brussels  has estimated that the Debt / GDP ratio of Italy could rise from 136% of GDP to 189%, that of France from 99% to 147%, that of Spain from 97% to  139%, and that of Germany from 59% to 94%. 

 As all these countries can expect their workforces reduce in the next 20 years, because of past low birth rates, this is a very troubling prospect. A way needs to be found to spread the  debt as widely as possible and as far as possible into the future.

One of the proposals made to do this is Eurobonds which would enable counties to borrow with a guarantee from all eurozone states. The interest rate might be lower but it is still just another form of borrowing. If Italy issued a Eurobond, it would still be increasing its overall debt, and might face a higher interest rate on its ordinary bond issues. Another objection is that it might take 18 months or more to get these Eurobonds up and running, and the markets need something quicker.

Another proposal is that distressed countries borrow from the European Stability Mechanism (ESM). Some believe that the ESM is too small for all that needs to be done. Others worry about the conditions that might be imposed.

Meanwhile the ECB continues to buy the bonds of member states. For example it owns 26% of all German government bonds and 22% of all Spain’s bonds. This bond buying by the ECB enables governments to continue borrowing, but its support is confined to members who are in the euro. It is using monetary policy to achieve the goals of fiscal policy, which is controversial.

I suggest a better solution would  be to allow the European Union itself to borrow, up to a limit of (say) 0.5% of the EU GDP, to spend exclusively on Covid 19 related expenditures. 

Article 122 of the Treaty already makes provision for the EU to give aid  to help states suffering from “natural disasters and exceptional occurrences” beyond the control of a member state or states. Covid 19 meets this criterion.

 But the EU is not using this power, because its budget is fully committed to other things. It has no room to respond to sudden emergencies.  It would have such room if it was allowed to borrow. This power could then be activated to allow direct transfers of funds to a state in acute distress because of Covid 19 or the like, without adding to the recipient state’s debt.

Doing this would require an amendment to Article 310 (1) of the Treaty. This article presently requires the EU always to run a balanced budget. This could be amended to allow borrowing  that was confined to spending on matters, like Covid 19, that had arisen suddenly and were beyond the control of the state looking for help. Such a limited borrowing authority would command a lot of support from the electorate.

It would also be borrowing under the democratic control by the Council of Ministers and  European Parliament, something that does not apply to bond buying by the ECB.

The EU faces is an unprecedented situation which justifies unprecedented actions.

HOW TO REDUCE UNCERTAINTY AND INCREASE INVESTMENT

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Interest rates are low, so it should be attractive for companies to borrow to invest in new products and markets.

But United States companies are not doing so to the hoped for extent. Instead they are spending about $500 billion every year buying back their own shares.

Share buy backs keep up the value of their shares, which is good for their shareholders.  But they are not all that beneficial to the economy, in so far as they reward holders of financial assets, without creating new job opportunities through investment. They also may increase inequality in US society, because shareholders tend to be better off than the average citizen.

 But do the Companies have a real choice here?

Companies should only invest if the risk/ reward ratio of the proposed investment is good. Investment is inherently riskier than share buy backs, so the prospective rate of return on the investment must be above a hurdle that is set in advance. A lot depends on prospective demand in the market place.  If society is ageing, there may be fewer, and most cautious, potential customers, and that raises the hurdle which a proposed investment must surmount.

A related uncertainty, discouraging investment decisions, is the long run growth potential of mature developed economies.

Is it 3% a year, as in the past 60 years, or just 1%, as it was in previous centuries?  Economists differ on this. Some technologies add measurably to growth and GDP, other just make life easier without adding to the same extent to GDP.

If the political future is uncertain, and there are threats of protectionism, that also increases the risk of any investment that depends on exports.  Brexit is a good example of this, and so is the volatility and seeming irrationality of voter behaviour in other countries, including the US.

Against this uncertain background, Central Banks are trying to stimulate the economy by cutting interest rates.  This is supposed to encourage investment by reducing its cost, but that is happening very slowly, if at all. It also means that governments can borrow very cheaply, which may tempt them into mistakes.

A persistent low interest rate policy undermines the financial models of insurance companies and pension funds, which have to pay insurance claims and pensions out of interest they get on investments. If the interest rates stay very low, the money may not be there to meet the pension and insurance obligations. This is a further economic uncertainty.

We now have a big mismatch between savings and investments. We have a surfeit of savings, chasing very few convincing investment opportunities

So the policy of low interest rates cannot continue forever.

If low interest rates are not stimulating the economy sufficiently, what can, or should, be done?

If companies are not investing, perhaps governments should step in to stimulate the economy by investing on their own account.  This is what was done during the Depression of the 1930’s in some countries, like Germany and the US.

Whereas privately owned companies have to be satisfied that an investment will yield a return to their own bottom line, a government can take a longer and broader view of the return on the investment it makes.

An investment by government is financially justifiable if the eventual return, in extra taxes paid at some stage in the future, as a result of the extra economic activity generated by the investment, exceeds the cost of servicing and repaying the extra debt undertaken.

It can also take non financial benefits into account if it is satisfied it will have no problem servicing its extra debts from other sources.

But because the factors to be taken into account in assessing a government investment are so much wider, the calculations to be made are much more subjective and uncertain.

For example, how does one compare the return on an investment in additional places in a university sociology faculty, with the return on an investment in improving a lightly trafficked road?

It all depends on future trends and needs, and a multiplicity of other factors which are matters of pure judgement.

There is, however, another limitation on government investment that must be considered…the impact of ageing on the solvency of governments, thirty or more years from now.

A government’s   debt/GDP ratio may be 90% or less today, and, on that basis, it may be able to justify borrowing more to invest more.

But some important future liabilities of governments are left out of these official Debt/GDP calculations.

Predictable future increases in public pension liabilities and age related expenditures generally are not included in the Debt/GDP ratio.

Apparently an average 64 year old consumes six times as much healthcare as an average 21 year old.

When, over the next 20 years, the number retired increases relative to the number at work, and the number of 64 year olds increases relative to the number of 21 year olds, the resultant increase in government spending, relative to its receipts, will worsen dramatically, unless policies are changed in the meantime.

The numbers aged 65 or over in Ireland will increase by 97% by 2060, as against an average increase of 60% in the EU as a whole. By then, on present policies, age related spending by government would absorb 8.7 percentage points more of GDP than it does  today, which is twice the average EU increase.

Most EU countries could see their debt to GDP ratios increase to 400% of GDP by 2050, if pension and age related policies are not changed.

Uncertainty about how this might be done is a factor holding back countries, like Germany, which seemingly can afford to invest more, from doing so, because Germany is ageing rapidly on the basis of  its historic low birth rate.

All this uncertainty is leading to stagnation.

I believe the best way to avoid stagnation induced by uncertainty would be for governments in developed countries to produce a comprehensive, demographically based, scenarios for the economy for the next 30 years.

These scenarios should set out the menu of decisions that  may need to be taken and the consequences of taking, or of not taking them.  Obviously the EU could coordinate some of this work and the assumptions used, but the choices to be set out would be for national politicians.

These scenarios would be extremely controversial and subject to vigorous questioning from all sides.  But they would orientate  politics towards the things we can actually change, and away from the localism, emotionalism, and xenophobia we are seeing at the moment in some countries.

 

PARTY RHETORIC, AND MANIFESTO SPECIFICS, TOLD VERY DIFFERENT STORIES………

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The economist Jim O’Leary has circulated a postscript on the Irish General Election.
It is very good, says something new, and I am republishing it here so it gets a wider readership.
It shows that the description of the relative economic and fiscal policy positions of the two main parties, as set out in their manifestos, is completely different from the characterization of their policy stances during the campaign by the media and by one another.
It would appear that neither the media, nor the politicians themselves read, and added up the cost of, their own, and opposing party, manifestoes!
Here is what Jim wrote:
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“I’ve just been doing a bit of digging into the election manifestoes of our two largest political parties in order to get a handle on how difficult it might be to bridge the ideological chasm between them. After all, Fine Gael is a party that sits firmly on the right of the spectrum and wants to slash taxes even if it means compromising standards of public service provision, while Fianna Fail has reinvented itself as a social democratic party with a more measured approach to reducing taxes and a much stronger commitment to the public sector. Or, at least, that’s how the narrative of the last few weeks would have it.

Well, the thrust of that narrative receives some slender support from the respective parties’ plans for government current spending.

FF proposed to devote €4.8bn to raising current spending over the next five years; the corresponding FG figure is €4.2bn. The difference between them hardly amounts to a whole hill of beans however, equating as it does to just about 1% of the current expenditure base. (Indeed, by this standard, the Sinn Fein plan to raise current spending by €6bn by 2021 doesn’t look dramatically out of kilter.)

On the other hand, FG is the more ambitious party in relation to investment spending having proposed an extra €4bn for the capital budget for the 2017-21 period, compared with FF’s €2.7bn.

So, if we just add current and capital together (and ignore their differential impact on the dreaded ‘fiscal space’), FG’s plans would result in higher public spending than FF’s. A slightly surprising conclusion when set against the prevailing narrative.
Much more surprising (indeed ‘surprising’ is an understatement of how it struck me when I discovered it a few days ago) is the comparison of the cost of the two parties’ proposals in relation to taxation.

The cost of the FF proposals? Just over €2.9bn.

And FG’s? A bit less than €2.5bn.

In other words, FF was proposing to devote almost €0.5bn more to tax cuts over the next five years than FG. If you don’t believe me, check the two sets of numbers in their respective manifestoes.

So much for FG being the ‘tax slashers’. The cost of their commitment to abolish USC, at  almost €3.5bn over the 2017-21 period, was to be offset by a net €1bn of increases elsewhere, including a 5% levy on incomes over €100k, a range of base-broadening measures for high earners, a steep hike in cigarette duties and a new tax on sugar-sweetened drinks. In contrast, FF’s more modest plans in respect of USC, costing €2.6bn, were to be accompanied by a net €300m of tax reductions in other areas.

It seems to me that FG’s proposal in relation to a single tax, the USC, was adopted as shorthand for its overall position on taxation (and was taken as emblematic of its attitude towards public service provision), and the rest of its tax platform was pretty well ignored.

Lazy analysis perhaps, but what else would one expect from hard-pressed(!) political commentators (not to mention political opponents).

What is bewildering is that FG made no serious attempt during the election campaign to counter what proved to be a damaging narrative.

Not once did a FG spokesperson say; ‘Hold on folks, Fianna Fail are actually proposing to cut taxes by more than we are!’ Or am I missing something?  “

UKRAINE NEEDS ECONOMIC REFORM AND A TRULY IMPARTIAL LEGAL SYSTEM

The economy of Ukraine is a mess. It’s income per head is only half that of Russia.

Yet it has a balance of payment deficit of 8% of GDP. In other words, even though it has a low standard of living, it is not earning enough to pay for what it consumes.

Its government also has a deficit of 8% of GDP. The Government  pays subsidies to its coal industry and subsidizes gas consumption. But its pension payments are in arrears and it has not the money to meet its immediate debt repayments. Tax collection is poor.

There has been substantial embezzlement of government funds, and public contracts have not been allocated to the lowest bidders.

These problems were there when the Mrs Timoshenko was in power, and were not tackled then.

They must be tackled now, or any aid the EU, the IMF or the US might give will simply go down a black hole. Any aid programme will involve tough conditions, which will further reduce living standards in the short term, and living standards are already low.

Much is made of the ethnic conflict between Russian speakers and Ukrainian speakers. This should be put in proportion. When Ukraine voted originally to leave the Soviet Union, the proposition got 90% support, so the pro independence voters included a lot of Russian speakers.  The issue should not be seen in Cold War terms, as a sort of “Russia versus the West” struggle.

I heard the new Ukrainian Prime Minister, Arseniy Yatsenyuk speak at a conference in Poland a few months ago.

He spoke out strongly for a truly independent Public Prosecutors office and an independent judiciary. He was against selective justice. He must live up to that now, and ensure that any prosecutions of members of the former regime are dictated solely by legally justifiable, and non political considerations, and that any law breaking by his own supporters is pursued with  similar vigour.

He also insisted that Russian should not be an official language of the country, alongside Ukrainian. Given that Russian is the first language of so many Ukrainian citizens, this seems to be an unproductive line to follow. Eastern Ukraine is Russian speaking, and the Crimea is predominantly ethnically Russian as well as Russian speaking.
It is also important to acknowledge that Russia may have some legitimate concerns of its own. For example, many Russians believe that Russian gas, transiting through Ukraine on the pipeline, is being stolen.

The  proposed  EU/Ukraine Association agreement is not a military alliance. Its value lies in the fact that  it will require Ukraine to overhaul its system of government in a way that will dramatically reduce corruption,  improve the rule of law, and improve growth prospects.  The Agreement does not prevent Ukraine  having a trade agreement with Russia, as well as with the EU.


There is no reason why the proposed EU/Ukraine Agreement should not benefit Russia too. A prosperous Ukraine will help the Russian economy, and  an unstable and impoverished Ukraine would be bad for ALL its neighbours.

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