Another day passes and lots more reading done. Some of it interesting but a significant amount of it tedious even enraging. I hum my mantras as I read to stay calm. But among the things I read there were some stand outs – not all of which I will have time to write about today. But this news report – Estonia Wants Stricter Euro Budget Rules – came in overnight, which caught my eye. Further examination, revealed how skewed policy priorities have become over the course of this economic crisis. The most costly things for an economy are ignored and aspirations that will impose future costs are promoted. Driving this policy agenda (madness) are the false messages that the IMF continually put out which spread a mélange of lies and non-sequiturs across the policy debate. I came up with a fiscal consolidation plan myself today as a result. I will disclose it later.
Estonia – update
Apparently Estonian Finance Minister Jurgen Ligi said “the euro area needs stricter fiscal controls to ensure existing members adhere to the rules”. This statement followed the EC agreeing on May 12, 2010 for Estonia to enter the EMU as its 17th member in January. Another lamb to the slaughter I thought.
Ligi, was quoted as saying:
In general we support stricter rules and control mechanisms that would prevent such financial problems in different countries … The idea of a common currency doesn’t work if fiscal policies are so different as they are at the moment.
In general, confidence is always a good asset. And Ligi is not short of that. His Ministry of Finance regularly pumps out press releases telling us how good things are. For example, in this March 4, 2010 release – Estonian General Government Budget Deficit in 2009 Clearly Below 3% of GDP – we read:
… the Estonian general government budget position in 2009 remained within the limits of the Maastricht criteria … the general government accrual budget deficit amounted to 3.7 bln EEK or 1.7% of GDP, in 2009 … Jürgen Ligi, the Minister of Finance, stated …. “… such a good result is not achieved alone by the government or one ministry, but with an effort by all of the society. In difficult times Estonia has shown remarkable strength in cooperation and budget consolidation. This stands out in the international arena …”
The achievement in 2009 was by no means a final goal in Estonian fiscal policy. “Although the deficit of 1.7% of GDP is going to be much lower than in most European countries, it is still a deficit. The expenditure still exceeds the revenues and this situation can not be sustained for a long period”, said Ligi. “Estonia has to restore the budget surplus in the coming years”.
So you get the impression that the Treasury function in Estonia is in the hands of a person with rather skewed priorities.
I have dealt with the Baltic States in the past – When a country is wrecked by neo-liberalism and The further down the food chain you go, the more the zealots take over. Today’s blog updates things a bit.
The 1.3 million population of Estonia is having to tolerate a government that in the midst of its worst recession as an independent nation runs a budget deficit equal to 1.7 per cent of GDP (which as I note below must be hugely contractionary) and boasts that its public debt ratio is 7.2 per cent of GDP the lowest in the EU.
Yes, and its real GDP loss and unemployment rate is around the highest in the EU. That is no coincidence. Last year the Estonian government reduced public spending by 9 per cent of GDP as it was already contracting.
Earlier, on January 29, 2010, Ligi released a press release – Euro is the result of responsible budgetary policy – in which he said:
Estonia will meet all the criteria for transferring to the euro. “We met the inflation criterion in November. We believe that Government’s decisions and efficient collection of revenues in 2009 will allow us to meet the budget criterion with a small safety margin. We will continue to improve our budgetary position in following years,” said Minister Ligi.
So you might think from reading these statement that Estonia is merging into Shangri-La. Its all about “good results” and “remarkable strength” and “efficient collection of revenues” and “improving our budgetary situation”.
Pity about the things that matter though. But then, why would we worry that real GDP is about 18 per cent lower than before the crisis began and is still falling and unemployment is now above 20 per cent and still rising and per capita incomes are still falling. Meagre detail.
The fundamental goal of the Estonian government is to get themselves into the hell-hole that is the EMU as soon as they can (next year) without regard for what else has to give to get there.
It also demonstrates how nonsensical the Maastricht criteria are that they require a nation to have 1 in 5 (at least) people unemployed for an indefinite period so that the budget numbers add up.
Estonia is also one of the IMF “deregulation darlings” and that criminal establishment has on several occasions extolled the virtues of Estonia’s currency board arrangement with the Euro and its capacity to recover quickly from the current crisis
In 2002, this IMF paper was full of self-congratulation (which seems to be an in-house style in its publications – praise ye the IMF for it is all knowing) for Estonia. It said that the currency board “made an important contribution to the early success of Estonia’s economic stabilisation and reform program”. But then the financial and economic crisis hit and the currency board system performed as its design dictates poorly and has delivered disastrous consequences for the citizens in that country.
In its December 2009 IMF Survey publication, the IMF ran a story – Baltic Tiger’ Plots Comeback – and said of Estonia:
Known as one of the three “Baltic tigers,” Estonia is now undergoing a severe recession. But unlike some other countries in emerging Europe, this small country of 1.3 million has managed to escape a full-blown crisis, thanks in large measure to prudent policies during the boom years of 2004-07 …
Estonia was hurt badly by the crisis, mainly through a decline in foreign trade. But its public finances were not as exposed as many other countries’ to the drying up of global financial markets. This was because the country had accumulated sizable fiscal reserves during the boom years and had virtually no public debt going into the crisis. That proved to be a life saver …
The government also acted forcefully to address the budget deficit when the crisis first hit … +Fiscal policy has been strong, not only during the current downturn, but more importantly, during the good years, which shows that this is a country that has an inherent, strong sense of policy discipline … [but] … Slacking off at the finish line would be an unforgivable mistake … So is there a feeling that the worst is over … the economy has most likely bottomed out, confidence is gradually returning.
So the Estonian government intent on forcing their budget parameters into the Maastricht Treaty straitjacket ran pro-cyclical fiscal policy as the economy it is meant to safeguard melted down. It is hard to describe how venal that strategy is as poverty rates rise and a generation or more of workers lose their accumulated wealth and a new generation of workers entering the labour market face disadvantage from the outset.
The other part of this which is almost unbelievable is that the existing EMU members have adopted fiscal positions that violate the Maastricht Treaty whereas hopeful new entrants like Estonia were not able to – at the threat of being denied entry. As it happens it just comes down to when you take the big hit that is built into those stupid rules. Estonia and Latvia front-loaded the misery while the worst is yet to come in Greece, Spain, Ireland etc, although Ireland and Spain are pretty well advanced down the road to impoverishment.
In terms of some background. Estonia and Latvia are not unlike Ireland is some ways but very different in other ways. The three nations were held out by the neo-liberals as the World’s so-called economic success stories in the period leading up to the crash although a significant component of the growth was tied in with real estate booms and a massive accumulation of private debt.
Now each is mired in deep recession with living standards falling rapidly and their governments are pursuing policies which will make things worse. That is the similarity.
The notable differences relates to their currency systems. Ireland is an EMU member nation and is thus straitjacketed by that insanity – Please read my blog – Exiting the Euro? – for more discussion on this point.
Both Latvia and Estonia chose, as a precursor to entering the EMU (which remains their blind aspiration), to peg their currency to the Euro and run currency boards.
Estonia pegs its currency at 15.60 krooni per Euro (after joining the European Exchange Rate (ERM) system in June 2004. Latvia pegs its currency at 0.71 lat per Euro and joined the ERM in 2005. Estonia initially pegged against the German mark when the Soviet system collapsed and they abandoned the rouble. Latvia switched their currency anchor from the IMF Special Drawing Rights bask to the Euro on January 1, 2005.
So Estonia and Latvia are both running currency systems similar to Argentina in the 1990s which ultimately collapsed and led to its default in 2001 (Argentina pegged against the US dollar). Pegging one’s currency means that the central bank has to manage interest rates to ensure the parity is maintained and fiscal policy is hamstrung by the currency requirements.
A currency board requires a nation have sufficient foreign reserves to ensure at least 100 per cent convertibility of the monetary base (reserves and cash outstanding).
The central bank stands by to guarantee this convertibility at a pegged exchange rate against the so-called anchor currency. The Government is then fiscally constrained and all spending must be backed by taxation revenue or debt-issuance.
A nation running a currency board can only issue local currency in proportion with the foreign currency it holds in store (at the fixed parity). If such a nation runs an external surplus, then reserve deposits of foreign currency rise and the central bank can then expand the monetary base. The opposite holds true for nations running external deficits.
The problem is that in those cases a crisis quickly follows because the economy has engineer a sharp domestic contraction to reduce imports but also runs out of reserves and has to default on foreign currency debt (either public or private). It is a recipe for disaster.
Anyway, all this was a precursor to some data analysis to update my understanding of what is happening in the Baltic. Today, I analysed Statistics Estonia data.
Now, in early December 2009, the IMF (as above) was claiming that the recession in Estonia was over. Now we have some more data available. Has the economy bottomed out and has confidence gradually returned.
In releasing the GDP flash estimates for the first quarter 2010, Statistics Estonia said on May 11 that:
… gross domestic product (GDP) of Estonia decreased by 2.3% in Estonia in the 1st quarter of 2010 compared to the same quarter in the previous year.
Deceleration of the economic decline continued successively already for the third quarter. In the 3rd quarter 2009, the GDP decreased by 15.6% and in the 4th quarter 9.5% compared to the same quarter of the previous year.
A deceleration in negative GDP growth is not a bottoming out. It is a further decline.
Further, “the domestic demand was small, the sales of manufacturing on the domestic market were still in downtrend. The decrease in the value added of the construction even accelerated as its output is mainly targeted on the domestic market”.
The data shows that real GDP in the first quarter 2010 was at the level it reached in five years earlier. So the Estonian economy has made no gains in real income in five years. The crisis has thus so far wiped five years of economic growth. That is a huge cost.
The following graph is taken from Statistics Estonia and shows the evolution of real GDP over that period.
In seasonally-adjusted terms, the nation has lost 17.7 per cent of its real income since the September quarter 2006 (when the peak GDP was reached). Per capita income is down around 15 per cent in 2009 alone.
If we translate the real GDP performance into human terms, the following report from news item is relevant – Estonia: number of jobs is the lowest in the past 25 years The statement was released on May 16, 2010, the day after Finance Minister Ligi was praising the budget figures and the progress towards entering the EMU and calling for even tighter fiscal rules.
The official labour force data release from Statistics Estonia said:
Similarly to the beginning of the previous year, the unemployment increased rapidly also in the current year. The unemployment rate rose from 15.5% in the 4th quarter of the previous year to 19.8% in the 1st quarter of the current year. In the 1st quarter of 2009 the unemployment rate was 11.4% … The unemployment was record high in the beginning of the current year … In the 1st quarter the estimated number of employed persons was 554,000, which is the smallest during the period after the restoration of independence in Estonia. Compared to the previous quarter, the number of the employed persons decreased by 4.6%, compared to the same quarter of the previous year by 9.6%.
The following graphs show the sorry story. The left panel in the first graph shows Total employment in 000’s while the right-panel shows Total unemployment and Long-term unemployment (spells longer than 12 months) also in 000’s. The correspondence between employment loss and unemployment increase is nearly 100 per cent which negates any neo-liberal explanations based on supply-side withdrawal (workers becoming lazy or enjoying excessively generous welfare benefits).
The next graph shows annual employment growth (%) in blue-bars and the unemployment rate (%) in grey bars. It is a horror story.
It is no wonder domestic demand is so low. Rising unemployment is a deflationary force and coupled with the fiscal drag there is little hope for significant improvement in domestic spending in the foreseeable future.
Note that the fact that the 2009 budget deficit of 1.7 per cent of GDP was probably highly contractionary given the extent of the meltdown in the economy. The automatic stabiliser effect on the budget balance alone would have been multiples of 1.7 per cent so you can gauge how hard they have the fiscal brakes on.
In my world of values, the discretionary fiscal position of the Estonian government represents a criminal act. By entering the EMU, Estonia will have a long period of diminished living standards and foregone income. They might have thought they were escaping the socialist yoke when the Soviet system crumbled. But it is difficult to see how things will be materially better in the space they are heading too.
Then I read the latest IMF Fiscal Monitor
I was sidetracked a little today by Estonia. The juxtaposition of the statements from the Finance Ministry and the national statistical agency in that nation was so stridently at odds that I had to make a note of it for posterity.
But my main aim was to write a little about the latest IMF Fiscal Monitor which provides a comprehensive statement of where that organisation is at in terms of its understanding and appraisal of fiscal developments over the last few years. It was not very rewarding reading I can tell you that.
The IMF boss Dominique Strauss-Kahn in his Forward to the Fiscal Monitor said this (it is a large document by the way if you intend downloading it):
The global crisis has entailed major output and employment costs, and in many economies, particularly the advanced ones, it has left behind much weaker fiscal positions.
That sets the tone for the whole document. There is only one complication with this – there is no such thing as a weak or strong fiscal position for a sovereign government. The concept of fiscal strength or fiscal weakness has no meaning for most countries.
So a rising budget deficit is not a weaker position nor is a move into surplus a stronger position. One has to judge policy positions by where the real economy is. A move into surplus with strong net exports and private domestic meeting their saving desires which results in full employment is a strong position. But a move into surplus (a la Estonia) with weak net exports and rising private domestic indebtedness and persistently high unemployment is a weak position. I could construct examples for rising deficits that would convey the same message.
Then you read this from the main text in the Fiscal Monitor:
… underlying fiscal trends have further deteriorated since the November Monitor
Except, there is no such thing as a deteriorating or improving fiscal position when we are talking about a sovereign government. The real economy can improve or deteriorate. A household’s wealth holdings can go up or down. But such descriptors are of no relevance or meaning to the budget position of a sovereign government.
Then, soon after, this:
… while a widespread loss of confidence in fiscal solvency remains for now a tail risk …
So how is the probability density function (PDF) specified that puts, for example, a sovereign debt default in Australia, the US, Japan 1.96 standard deviations or more from the mean. What is the mean? Zero?
Upon what basis is the probability distribution derived?
The point is that this is all beat-up. There is no PDF that can be reliably constructed in this context. Quite simply, the US for example has no default risk. So you would have most sovereign countries with no default risk. And a host of others with some risk. The difference between the monetary system they are working within (convertibility/non-convertibility; fixed exchange rate/floating exchange rate; monetary union/fiat currency etc).
There is thus no basis to put events that may arise in one monetary system together in probabilistic terms with events that will not happen in another monetary system.
Then, soon after, this:
… high levels of public indebtedness could weigh on economic growth for years.
How exactly? The servicing of the debt provides an income
So you get the impression that the IMF Fiscal Monitor mostly misses the point at the most elemental level.
The other problem with the Monitor, which is a recurring theme across a wide spectrum of commentary, is that they conflate fiscal outcomes in non-sovereign nations (EMU, Estonia, etc) with outcomes for sovereign countries (US, UK, Australia etc). The fact is that there is no meaningful comparison between the two groups of nations because they have different monetary systems.
You cannot understand the implications and opportunities for fiscal policy unless you also relate it to the specific operational characteristics of the monetary system in question.
So they keep quoting ratios, and averages across all the countries in their study (or subsets of them) as if they mean something. Averaging fiscal balances across the EMU and other countries is a meaningless exercise. The resulting average has no cognitive content.
But the Report provides some interesting insights into how much of the rise in public debt (and the deficits) were the result of discretionary government stimulus packages. At this point start chanting some mantra along the lines of “profligate, engorged and wasteful government spending”. Then read on.
The IMF says (Page 14):
In advanced G-20 economies, the debt surge is driven mostly by the output collapse and the related revenue loss. Of the almost 39 percentage points of GDP increase in the debt ratio, about two-thirds is explained by revenue weakness and the fall in GDP during 2008-09 (which led to an unfavorable interest rate-growth differential during that period, in spite of falling interest rates … The revenue weakness reflected the opening of the output gap, but also revenue losses from lower asset prices and financial sector profits. Fiscal stimulus – assuming it is withdrawn as expected – would account for only about one-tenth of the overall debt increase.
Did you read 1/10th?
Given the biased way the IMF decompose the actual budget outcome into cyclical and structural components the 1/10th might even be an overstatement. Please read my blogs – Structural deficits – the great con job! and Structural deficits and automatic stabilisers – for more discussion on this point.
But you can easily start to understand why the smarter deficit terrorists out there have moved onto the long-run argument and are attacking public pension and health systems. They know full well that the stimulus packages were pitifully inadequate and that is why the recession has lasted so long and has been so deep in most nations.
They know that once growth starts to emerge the automatic stabilisers will eliminate most of the increase in deficits and start eating into public debt. So to continue their attack on the public sector (to get more real GDP for themselves) they have to confuse the current situation and start introducing the ageing population agenda.
But the fact is that the fiscal stimulus packages were so politically-constrained in most countries, that governments across the world have pushed unnecessary misery onto the citizens who elected them. That is, some of the citizens – the top-end-of-town will have been less damaged if at all.
They devote a whole chapter to the “implications of fiscal developments for government debt markets” but all you get from it is:
- That governments will continue to issue debt – yes, if they don’t finally wake up to the fact that most run fiat currency systems and are not financially constrained.
- Apparently sovereign debt markets will become flooded because central banks will unwind their balance sheets – yes, but there is no reason for central banks to do so. They could just delete the accounts recording the asset purchases and no-one would be any worse off.
- That “average government debt maturities have shortened” – which means that more public debt has been issued in the maturity-ranges of the yield curve controlled by the central bank in most cases. So yields will be stable.
- That “Yields on government securities in most advanced economies remain relatively low, but spreads have risen sharply in some countries” – yes, in non-sovereign nations (they list the PIIGS). Yields in advanced sovereign nations are still low. Japan has been running yields below 1.5 per cent for years.
- That “Other indicators of the risk attached to investing in government securities in advanced economies also remain relatively muted, except in a handful of countries” – which are? EMU nations which are not sovereign.
These “insights” are followed by an array of colourful graphs that mean nothing. Not once during this Chapter does the IMF reveal an understanding of what they have concluded. That EMU nations are in trouble because of the design flaws in their monetary systems and the rest of the nations are in trouble because they have not expanded fiscal policy enough in the early months of the crisis.
On Page 28, the IMF go AWOL:
Major fiscal consolidation will be needed over the years ahead. The increase in budget deficits played a key role in staving off an economic catastrophe. As economic conditions improve, the attention of policymakers should now turn to ensuring that doubts about fiscal solvency do not become the cause of a new loss of confidence: recent developments in Europe have clearly indicated that this risk cannot be ignored.
Remember: 1/10th! Growth will wipe out the rest. What all nations still need is a significant renewed fiscal stimulus to really get the growth engines moving and to mop up the build-up of idle labour as quickly as possible. Fiscal austerity is anti-growth.
Remember: “recent developments in Europe” have no relevance for fiscal solvency anywhere else. The only relevance they have is if they provoke more private sector spending uncertainty or bank collapses which hits the start button for the global crisis again. But there won’t be a solvency issue in the US or Japan or elsewhere. They will just find they are heading back into recession.
Also on Page 28, one reads:
A distinct, but equally important risk to be averted is that the accumulated public debt, even if does not result in overt debt crises, becomes a burden that slows long-term potential growth.
This is one of the emerging strands coming out of the mainstream econometrics literature. Some studies have estimated that “a 10 percentage point increase in the debt ratio is likely to lead to an increase in long-term real interest rates of around 50 basis points over the medium run”. Further the IMF claims that new evidence “on the impact of high debt on potential growth … shows an inverse relationship between initial debt and subsequent growth, controlling for other determinants of growth”.
I have read all this literature as it has come out. It is quite technical and not suitable for summarising here. The results are highly dependent on specifications chosen and the studies typically fail to sort out what econometricians refer to as “endogeneity problems” which in laypersons language might be terms causality problems.
Countries with rising debt almost always are countries with slowing economies as a result of private demand collapses. So what is driving what? Further there is not robust relationship ever been found between budget deficits and interest rates. So the claim that most of this impact arises because interest rates are higher is unsustainable.
In general, these results that the IMF seeks to promote are not reliable and also defy a reasonable understanding of how monetary systems operate.
The IMF Monitor then spends many pages reiterating the impact of changing demographics on fiscal positions without once realising that rising dependency ratios are problematic because less people are available to produce real goods and services. They fail to understand that the real goods and services that are produced can always be purchased by a sovereign government.
So the ageing issue is not a financial problem for governments. But it will become a political problem.
And now … to my fiscal consolidation plan.
Governments around the world might start to reduce their fiscal positions by withdrawing all funding they provide to the IMF. This expenditure is in the category of wasteful and unproductive spending which I would always eliminate.
The IMF staff could then be retrained to address serious issues like climate change, health problems and the like. Net gain to the world.
That is enough for today!