The reputations sent up in smoke

 

Certain economies have been mired by financial ‘experts’ with little understanding of the fundamental forces behind the headline numbers, writes MICHAEL CASEY

NIGEL LAWSON once became irritated by the comments of some financial “experts” about the British economy. He referred to them as “teenage scribblers jumping up and down”. His angst was not unfounded. Journalists can have disproportionate effects on financial markets and on the perceptions – and possibly the credit ratings – of certain economies. People who work in financial markets are not known for deep reflection; knee-jerk reactions are how they make money.

They also have a superficial way of labelling countries. Hence the unfortunate acronym Pigs, which refers to Portugal, Italy, Greece and Spain. These countries were originally labelled Club Med. The prejudicial view was that these countries of southern Europe were not on a par with the German-led northern countries and that a monetary union between unequals could not possibly work. There was a sort of schadenfreude when Britain decided not to join the Economic and Monetary Union (EMU) and the teenage scribblers enjoyed reminding us “pigs can’t fly”. Recently, they’ve been telling us people don’t want to hold euro notes printed by any of the Mediterranean countries. This sounds like pure fabrication.

Most exaggerations, however, contain a grain of truth. The designers of the EMU were particularly worried about Italy locking into the euro. This was because Italy frequently resorted to devaluing lire in previous years and because of its lax fiscal discipline and frequent tax amnesties. In fact, the EMU’s fiscal rules (the Growth and Stability Pact with its maximum deficit of 3 per cent of GDP) were introduced primarily because of the threat Italy could pose to the stability of the new currency. Countries like Portugal and Ireland were small enough to stay below the radar.

The EMU is not well-designed; this is because the single currency was little more than a political symbol of unity, greatly desired by Germany and France. Fiscal federalism was never considered, even though this is an important part of other monetary unions. In the US, for example, if Montana has a local recession it will receive automatic fiscal transfers from the Federal government in the form of unemployment and other social welfare benefits and subsidies. In a way, this is compensation for not being able to devalue. This notion of automatic fiscal transfers was never seriously considered when the EMU was being designed. It is a serious flaw, though not necessarily a fatal one.

Cohesion funds were supposed to help countries become more “Germanic” before the currencies were locked together. The various eligibility tests for EMU membership – the Maastricht convergence criteria – were also designed to help applicant countries become lean and mean. (Ireland rose to the challenge, qualified for membership and then went on a binge of pay increases, agreed by Government and social partners over many years in the full knowledge that devaluation wasn’t an option. This policy was suicidal and contributed largely to our present difficulties.)

Neither was much attention given to whether or not the Eurozone would be an optimal currency area. In other words, were the structures of the different economies sufficiently similar so that no one economy would ever have to devalue? The UCD view at the time was that sufficient similarity did not exist between the countries; hence locking them together into the same currency would be a mistake, especially when there were no automatic fiscal transfers.

That said, it is likely that if some EMU countries face extreme difficulty the stronger economies of Germany and France will come to the rescue. Already we see the EU Commission is working closely with Greece to reduce its fiscal deficit. Greece may enter a rather formal “disciplinary procedure” which is more or less the European equivalent of an IMF programme.

To some extent Ireland has already been through this process. Our last three budgets were largely dictated by Brussels, as will the next two or three. (So much for sovereignty.) Spain, it seems, will be next to visit the Euro-doctor. And, no doubt, Italy and Portugal are already sitting nervously in the waiting room.

Against this background it seems odd that the rating agencies are marking down these European countries. No one denies these countries are experiencing difficulties but they are all under the European duvet, and the risk of sovereign default is negligible. Greece has recently had its credit rating reduced to single A and has to pay up to three percentage points more for borrowed money (over 10 years) than Germany. This may reflect the presence of a socialist government rather than economic problems per se. Rating agencies are far from reliable and are not renowned for integrity or analytical ability.

These agencies are, in essence, adopting the same model used by the sub-prime lenders who brought down the international financial system. If the rating agencies believe lending to a particular government is risky, what is the point of increasing the interest rate charged? A child of five would know how silly that is. But, unfortunately, rating agencies go along with the outmoded view about pricing for risk. The entire system needs to be overhauled (see panel on previous page).

In any event, the idea of putting four different economies into the same group is superficial. Every economy has its own personality. Some commentators have put Ireland and Iceland in the Pigs grouping. Iceland is sui generis and does not belong in any group; its banking problems are extreme and it has its own currency which has been severely devalued. Ireland’s position is less clear-cut. Our headline numbers are certainly bad enough to qualify for the Pigs group.

In terms of negative growth, fiscal deficit and unemployment, we are certainly no better than Portugal, Italy, Greece and Spain, although Spain’s unemployment rate is around 20 per cent. Our fall in growth to date (about minus 11 per cent) is worse than in the other four countries. Our banking difficulties and burst property bubble are also more challenging.

On the other hand, Ireland has had a better record over the last 15 years and has fewer long-term structural problems. This means, other things being equal, we should have a smoother recovery from recession. We have healthier demographics and future pension difficulties are not as pressing.
We have a much lower debt-to-GDP ratio and this should remain reasonable as far as 2050. Greece, by contrast, could face a ratio of 500 per cent on unchanged policy assumptions. Ireland also has a healthier export profile, thanks mainly to pharmaceutical companies based here.

We have earned plaudits from our European colleagues for carrying out their wishes in our last three budgets and we have accepted their targets up to 2014. The fiscal adjustment measures – and Nama – prove the Irish government is sufficiently right of centre to reassure capital markets. Ireland’s credit rating and costs of borrowing have already improved significantly. By voting in favour of the Lisbon treaty we have also earned some additional brownie points. There is no risk of Ireland defaulting on government debt. There was never any doubt about this, even in the early 1980s when our debt-to-GDP ratio was a staggering 120 per cent.

On balance, Ireland does not fit in the Pigs group. And if foreign direct investment picks up our economy could bounce back quickly.

Loss of competitiveness will continue to be a fundamental problem for a number of EMU countries. Between 2000 and 2007, unit labour costs in Germany actually fell slightly (wages increased but productivity rose faster). Unfortunately, the rise in unit labour costs for Portugal was 17 per cent, Italy 21 per cent, Greece 14 per cent and Spain 23 per cent.

The increase in Ireland was the highest, 25 per cent, and that is why competitiveness was lost. Jean-Claude Trichet, president of the European Central Bank, has suggested a unit-labour-cost stability pact for the EMU. That may be the only way of ensuring stability in the Eurozone. Ireland should advocate such a pact. Social partnership failed and is unlikely to be revived.

Doubt has been thrown on the EU’s fiscal rules and the 3 per cent deficit rule seems arbitrary and mechanistic. It was designed for “normal” growth recessions; what many countries are experiencing now could almost be classed as depressions. While Ireland originally planned to reach the 3 per cent by 2013, this date has now been extended to 2014. This suggests there is a degree of flexibility being shown by the EU Commission. This target could still be deflationary and it should be remembered that all of the adjustments are being done to impress the rating agencies and international capital markets, none of whom cares about unemployment or emigration. Our Government and the EU Commission have sold out to the rating agencies. In a way, the teenage scribblers are now dictating national policies.

There is a danger that the euro will rise further against the dollar if China pulls out of US securities. Currency instability can be damaging, especially for the smaller countries of the EMU, even if they are doing their best to maintain cost competitiveness. I have argued before that there is a need for a global currency along the lines of the SDR substitution account. When Brian Lenihan is restored to health, he should make this proposal at the next annual meeting of the IMF, of which he is a governor. He should also propose the IMF take over the credit-rating function on a global basis; it is too important to be left with the teenage scribblers. These proposals would need to be cleared with our European colleagues in advance.

Lenihan should also encourage Trichet and others in the Eurozone to develop a stability pact for unit costs of production. This would prevent Ireland and other countries abandoning the discipline needed for EMU membership. Lenihan is held in high regard internationally and proposals coming from him would be carefully considered.

Some countries deserve their poor economic reputations but many others are unfairly tarred with the same brush by people who set themselves up as experts but who have little understanding of fundamental forces operating behind the headline numbers. National reputations are too important to be treated in such a cavalier manner.

Michael Casey is a former chief economist at the Central Bank and board member of the International Monetary Fund