Wednesday, 20 November 2013

Are there policy alternatives to Ireland's austerity?

This is a response to the PKSG presentation by Stephen Kinsella on 19th November 2013.

In essence, the stock-flow-consistent approach is ‘to a very large extent an exercise in accountancy – or perhaps logic is a more congenial word’ (Godley, 1983). The paper by Stephen Kinsella extends this approach with a five sector model, estimated using OLS. Applying different spending and tax shocks, he concludes that Ireland's austerity could have been less severe.

Leading into the crisis, Ireland was running small government and current account surpluses. As expected under the 'New Cambridge hypothesis', the private sector ran a deficit. Unfortunately, this was due to investment in property rather than production. Remarkably, the assets and liabilities of the banking sector doubled between 2005 and 2008. 

Then, the Irish economy saw major shifts in the composition and direction of capital flows after 2008. Households became net savers, the foreign sector moved deposits our of Ireland and shifted to investment in equity. These effects are dwarfed, however, by government which, in the form of an IMF bridging loan, bailed out the financial sector (purple and red):

The 'run on deposits' followed the sale of Merrill Lynch to the Bank of America, on the same weekend in 2008 that Lehman Brothers collapsed. If the Federal Reserve had not prevented the collapse of AIG and Merrill had been left to fail, the story would be different: Bank of America is still being pursued by AIG for alleged fraud at Merrill. With the subsequent deleveraging, Irish banks are reporting costs higher than income and Merill looks the most fragile:

So while the paper recommends less austerity, the banking sector remains a risk for the Irish government. Yet fiscal policy is hemmed in by budget rules from the European Commission. The Treat of Maastricht requires that the government runs a deficit of no more than -3%, while the European Commission Alert Mechanism Report asks for a current account balance between -4% and +6%. Ireland has missed these targets every year since 2006:

The trajectory, above, suggests some uncertainty that Ireland will reach the green (private sector surplus) or red (private sector deficit) triangles (government deficit less than 3%, and a current account balance between -4% and +6%).

While the SFC model in the paper fits the data very well, like any SFC model it might be further disaggregated: in particular the treatment of shadow banking (ie: leverage); the derivatives book and the effects of currency and duration mismatch. Of course, such data are not readily available. Household spending might also be impacted by wealth, with realised and unrealised capital gains affecting behaviour to varying degrees: Minsky's hedging, speculative and Ponzi modes of financing. Ireland's low corporation taxes also encourage profit retention via foreign investment.

There are other policy alternatives for Ireland: having symmetrical rules for government budgets at the EU;allowing fiscal transfers from 'core' to 'periphery'; and similar mechanisms such that surplus countries pay towards adjustment costs. So as well as the risks from a weak household sector under austerity, there is a risk that foreign capital will dry up or reverse due to tax treaties or tax harmonization being imposed at the EU level. Not that there are many calls for this in Ireland. As Stephen put it succinctly: 'turkeys don't vote for Christmas'.

Wynne Godley (1983), Personal correspondence with J.K. Galbraith

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