ANALYSIS:If there is even the slightest hint of cronyism or political interference in Nama, it could end up a disaster, writes MICHAEL CASEY.
IT IS well known that uncertainty undermines decisions to spend and invest, and is generally inimical to economic activity. Despite the recent supplementary budget and the decision to set up a National Asset Management Agency (Nama), there remains a good deal of uncertainty – as well as pain.
The €1.8 billion tax/levy increases and the €1.5 billion expenditure cuts will still leave us with a huge budget deficit at the end of this year. Tough fiscal consolidation will have to continue over the next few years until the deficit is reduced to 3 per cent of GDP – a magic ratio that will be acceptable to Brussels.
The fact that some fiscal numbers have at last been pencilled in does not constitute a national economic recovery plan. Uncertainty remains for the following reasons:
First, the forecasting (and budgeting) record has been poor. It is hard to remember many occasions in the last 15 years when the Department of Finance came close to an accurate prediction of revenue. Too many statements made by government and other official bodies about the state of the economy and of the banks have been proved wrong. It is not that long ago when we were told that the boom would continue and that the banks had plenty of capital. When these versions of events were not believed by the public and the markets, the stories began to change.
When the Government sought to cajole the unions into a pay freeze they painted a more downbeat picture of the economy. In the event this made no difference to the unions, and social partnership failed its first real test. Then we were told a depressing story about the public finances and the virtual impossibility of borrowing. This was designed to soften up taxpayers for the pain to come. Much of the uncertainty is caused by inconsistent stories designed to manipulate public opinion.
Second, the Government takes the view that stabilising the public finances will restore confidence in the economy. This is far from certain. The tax hikes could have the opposite effect. Bear in mind that the marginal tax rate has been raised by nine percentage points. If this does not have serious disincentive effects then everything the Progressive Democrats stood for must have been utterly wrong.
The Budget was equitable – few can deny that – but it bears down heavily on the middle-class which is the economic backbone of the country.
It should be remembered that the middle-class has also suffered a major write-down of personal assets – houses and pension funds – which will undoubtedly produce a negative wealth effect.
This, combined with the prospect of other taxes – including a property tax – will hit consumption and investment.
The middle-class does not usually demonstrate in the streets or seek public sympathy, but it does vote with its feet. It may not be merely a question of lower consumption and investment; it could be a question of capital flight and a brain drain.
Taxing the middle-class could damage the productive capacity of the economy now and in the future. This is the major uncertainty created by the recent Budget.
The Budget was framed in accordance with guidelines laid down by the EU. Having lost all control of interest – rate and exchange – rate policy we have now virtually ceded fiscal policy to Brussels – probably feeling apologetic over the Lisbon Treaty referendum.
The fact that we have so few instruments of economic policy left adds to the uncertainty being felt by Irish consumers and investors.
Third, no one knows exactly how the economy will be affected by the Budget.
Budgets in Ireland are rarely more than book-keeping exercises which ignore wider economic effects. There should be a structural model of the economy which can be used to run policy simulations. Without this kind of analytical apparatus there is little possibility of predicting the impact of budget measures.
Fourth, Nama which is designed to satisfy the European Commission on the treatment of impaired assets, could work well – or it could be disastrous. It is a blank cheque. We do not know how it will work in practice. Much will depend on the quality and integrity of the people appointed to value assets and negotiate discounts with banks.
There are at least three groups of stakeholder: taxpayers, shareholders, property developers. Until the agency is up and running we have no idea how these groups are going to fare. If there is even the slightest taint of cronyism or political interference the entire exercise could end in disaster. There is also the probability of expensive legal challenges, exorbitant fees and every conceivable form of rent-seeking.
Fifth, even if banks offload their toxic assets and even if they get fresh capital there’s no certainty that they’ll start lending to enterprises again. Banks lend in boom times; they don’t lend much in recession. And they certainly don’t lend to firms in difficulty.
Nominal GNP is likely to fall this year by about 10 per cent; why would we expect any growth in lending? Having lost all credibility, banks are likely to be more risk-averse than ever before. If the Budget does lead to a further fall in demand then it is not clear why banks would lend at all. Indeed, we cannot rule out a liquidity trap i.e. a situation where despite low interest rates there is no increase in borrowed funds or in the money supply. The deflation of prices could reinforce this trend.
Sixth, several important pieces of the jigsaw are still missing – proposals of the Commission on Taxation, and of An Bord Snip. Public sector reform which has long been promised has still not commenced. A possible second round of social partnership is still being discussed. The Smart Economy Plan turns out not to have been a plan at all but only a framework. When are all of these disparate pieces going to be joined up? Since they’re all being done separately it is doubtful if they can ever be brought together into a coherent whole.
Seventh, the hope that Budget decisions would improve Ireland’s reputation abroad is not being borne out by bond spreads and credit default swaps. This may be partly due to an unusual statement made by Government to the effect that budgetary policy was designed to bail out the economy rather than the banks. It is not clear why this statement was made but it unfortunately gives the impression that the economy is in worse shape than the banks.
There is no such thing as perfect information but good leadership should aim at reducing uncertainty as much as possible to help get the economy going again.
Irish people are trying to be as upbeat as possible, but without some degree of certainty or overall plan it is going to be difficult to maintain a positive outlook.
Michael Casey is a former chief economist with the Central Bank and a member of the board of the International Monetary Fund