Troika or bond markets – external forces still master our universe
One way or another, albeit through different channels, the troika will also be exercising influence.
Left to right: Klaus Masuch of the ECB, Istvan Szekely of the European Commission, and Ajai Chopra of the IMF at a troika press conference in Dublin following the third review of the EU/IMF programme.
Financial and economic life in a post-bailout world will, initially at least, not feel that different. In a sense, we just exchange one set of external masters for another, both of whom have pretty similar ways of judging us. As the troika leaves town, symbolically at least, the bond market moves back in. Bond investors are less visible, perhaps, than the regular visitors from the ECB, IMF and Brussels, but they are likely to be just as tough to deal with.
Debt sustainability is not a particularly complex matter: in some ways it is just about arithmetic, the relationship between how much we hope to borrow, its price and how fast our economy is growing. One way or another, albeit through different channels, the troika will also be exercising influence. Our debt arithmetic is finely balanced: it is perfectly possible for us to get through the next few years without regretting the lack of a financial backstop – but there are plenty of risks.
Ever since we joined the then EEC, we, like all other members, have been subject to rules not of our making. The financial crisis has prompted much soul-searching and identification of what must come next: lots of change. In fits and starts, greater centralised control over nation states has been hard-wired into the evolution of the EU.
Indeed, if we had made greater progress on both political and economic union, the worst effects of the crisis may have been avoided. In any event, there is widespread recognition that deeper integration is necessary if the euro is to survive over the medium term, if it is to survive its next crisis, whenever that might occur.
The euro was poorly designed, with politics taking precedence over the economics. The technical shortcomings of the euro have to be fixed over the next few years. This is widely accepted but agreement on both method and timing remains elusive.
If fixing the euro’s design flaws is likely to remain troublesome, the single most obvious financial shock wave that awaits us is either a Greek default or exit. The likelihood of this arises from the almost hopeless nature of the trajectory of the key Greek debt-GDP ratio.
If another Greek meltdown is likely, its timing is extremely uncertain: it could take several years before the true extent of the problem prompts a final denouement. Either that or the new German government figures out how to tell its electors (and courts) that a large cheque now has to be written.
Some in the hedge fund community (in particular) think that Italy could prove to be as big a problem as Greece. The Irish Government needs to think carefully about a possible – probable – resumption of the euro crisis. It may not come in the next 12 months, but it is there waiting for us unless there is a dramatic policy change.
How the EU chooses to evolve will present many different challenges, particularly over the medium term. By contrast, our immediate future will be shaped almost entirely by how much economic growth we manage to achieve.
Our growth rate will be the single most important indicator monitored by the bond market; a growth disappointment will be serious, a negative growth shock could prove fatal – or at least drive us back into second bailout territory.
Back in the spotlight
In such circumstances the price will not just be the interest rate on any new loans; our corporate taxation regime will be back in the spotlight. Indeed, our corporate tax rate will remain a constant source of tension for some of our European partners.
We are fortunate that as we exit the bailout our nearest – and still largest – trading partner has managed to engineer something of a mini-economic boom. We must hope that it continues. The UK is now one of the fastest-growing economies in the world. To say that this was unexpected, only a few months ago, is something of an understatement.
Of course, while we can celebrate the upward revisions to forecasts for UK growth over the next year or two, we should always remind ourselves just how little we really know about the economic future. Growth surprises can come from either direction.
The economic consequences of political decisions will remain an ever-present challenge. The EU and the euro exist because of the link between politics and economics. A cursory examination of history serves up a sober reminder of how Europe’s politics have often changed with great drama and speed. Only two European nation states have retained a distinct, separate sovereign existence in the years since Columbus stumbled on the Americas.
Germany and France have fought 17 wars over that same time period. Europe will change again – it has to if it wants to keep the euro. Europe’s success in keeping the peace means, as memories of conflict fade, more questions are asked about just is the EU for? The imperative of more integration, more Europe, its very rationale, is not obvious to many people.
If deeper integration is both necessary and inevitable, both political and economic, we need to ask: for whom? The UK, if it were to hold its promised referendum on EU membership today would, almost certainly, emphatically vote to leave.
Before then, of course, the UK itself may have begun to split apart in the wake of the Scottish referendum on the question of independence.
It would seem reasonable to suggest that UK upheaval will hardly be a positive for Ireland and it is, therefore, likely that the bond market will react accordingly. Our only defence in such circumstances will be to have solved the borrowing problem: if we don’t ask the bond markets for much, they in turn will make few demands on us.
If we want to be ready for the turbulence that the outside world seems likely to generate for us, we need to keep going with fiscal consolidation. The smaller our borrowing needs, the less vulnerable, financially at least, we are to external shocks – and we have only mentioned those potential negative outcomes that are dimly discernible today; most of the time, what happens next is rarely foreseen.
If the downside risks are easy to identify, can we think about potential pleasant surprises? Growth could resume in Europe as suddenly as it has in the UK, for example.
While this seems unlikely, humility over our ability to forecast economies means we at least have to allow for this possibility. A domestic economic renaissance? This has a higher probability outcome than a robust European recovery but that isn’t saying all that much.
Sensible fiscal policies
Bond markets will expect sensible fiscal policies from what is left of the coalition’s lifetime and from any future government elected over the next few years. While “sensible” is suggestive of greater leeway than troika-driven “austerity”, it probably will be hard to tell the difference.
Our debt overhang is nowhere near Greek proportions but it still leaves us very exposed to nasty surprises. We should be confident that we can manage this, but only if we continue to reduce, during the relatively good times, that vulnerability.