The time to take hard decisions on public pay is now

 

Make graduated pay cuts in the public sector, reduce welfare payments and take the PR hit – if the Government is seen to fudge, international investors will pass harsh judgment, writes Rossa White

POLICY DECISIONS over the next year will shape Ireland’s economy for a generation. Yet it is barely appreciated that the Irish taxpayer won’t really determine whether choices made are correct or not. International investors have the call. The outcome to this week’s deliberations over public expenditure cuts will be an important watershed: the Government must signal to the rest of the world that it knows what is required. The right decision is to cut the public pay bill bravely and avoid any sort of fudge.

There are three considerations for saving the €2 billion in Government spending budgeted for earlier this month.

First, urgency is needed. It has to happen quickly and must deliver easily realisable savings. Each day sees the public service garnering a greater share of the economy.

This year, day-to-day public expenditure will reach its highest share of GNP since 1986. Taxpayers know that they may have to shoulder a much heavier tax burden in future to pay for an unsustainable expenditure bill, unless the problem is addressed. Fears about a sharp rise in the tax wedge on private labour may stymie household spending and private business investment.

Second, the initiative must enhance the economy’s long-run potential by delivering competitive gains. Ireland’s absolute wages are too high relative to its trading partners and its prices are the second-highest in the 27 member states of the European Union.

Note that public sector average hourly earnings were 49 per cent higher than in the private sector in 2006 – the latest data available. If anything, quarterly data suggest that the disparity has increased since. It is also worth highlighting that a majority of goods and services are now dropping in price, according to the Consumer Price Index. Tellingly, none of those deflating goods and services is influenced by government.

Third, the government bond market has to like the plan. Thanks to our widening deficit, every cent in extra spending now has to be borrowed from international investors (91 per cent of our government bonds are owned by foreigners). Apart from increasing the future tax burden (the bonds have to be repaid), accessing the funds wouldn’t usually pose much difficulty because lending to governments is considered safer than to anyone else. Ireland currently has the best possible credit rating.

As recently as the first week of the year, the National Treasury Management Agency (NTMA) sold €6 billion in bonds on behalf of Irish taxpayers. Since then, Ireland’s bond price discount to Germany (considered the safest credit in the euro area) has widened.

According to the latest pricing, the NTMA would have to provide investors with another half percentage point sweetener vis-a-vis the German benchmark to sell an equivalent bond. Increasing worries about Ireland’s repayment capacity have mushroomed for a number of reasons: the nationalisation of Anglo Irish Bank; increased risk aversion in financial markets; and a torrent of reports in the international financial media speculating wildly on the country’s fiscal position.

What the bond market now wants is firm action from the Irish Government. The salient task is to show international investors that the monthly bleeding in public finances has been stemmed through measurable savings, even if small in the context of an annual deficit that would otherwise exceed €20 billion.

A reduction in public service pay rates meets all three criteria. For the sake of efficiency and productivity, a 10 per cent pay cut across the board is not ideal: the decreases should be relative (eg, some take bigger hits than others) and on merit.

Discarding the slated increase in public pay in 2009 (arising from the carry-over of the last pay deal, increments and the new pay deal) is a given. But even a further 10 per cent cut on average from that level will not quite deliver the €2 billion as a result of payroll and consumption tax revenue forgone.

Not increasing social welfare rates will cover the remainder immediately. Those subsisting on welfare would still enjoy a substantial real hike in income if rates stayed at the 2008 level, because the Consumer Price Index will drop sharply this year.

If the Government is forced to make a unilateral decision because agreement cannot be reached with the unelected social partners, so be it. In the private sector, managers are cutting jobs, pay and pensions. The Government is the management team for all public sector workers.

Public servants don’t have much bargaining power right now, as alternative employment (at an equivalent level) is hard to come by in the private sector. Moreover, industrial unrest is unlikely to endure: the public’s tolerance threshold is probably low in view of major job losses across the rest of the economy.

International observers, particularly potential investors in Irish government paper, won’t tolerate soft options. The worst-case scenario would be vague aspirations towards public pension reform and postponement of capital spending, rather than cuts in core pay. Later this year, however, numbers employed and pension entitlements in the public service must also be on the agenda. For all that, the long term is tomorrow right now. Policy decisions are required that may eventually lift Ireland’s output back to potential. Three targets should be set: to restore the banking system to health; regain competitive edge; and reform the public finances structurally.

The key task is to design a coherent plan to repair our banking system. That strategy has to have two targets: to increase the availability of fresh finance for creditworthy households and business; and limit taxpayer losses from bad loans granted in recent years.

I propose a framework that may reach that twin objective. Before any restructuring begins, it necessitates a war-chest of liquid assets. The National Pensions Reserve Fund’s equity portfolio should be sold carefully, so that about €15 billion is readily available as cash on deposit or in short-term securities.

That fund was our only countercyclical policy measure in the last eight years and we need it now to cover potential banking write-offs. The Government would have capital to play with, without resort to the bond market.

Next, set up an asset management company capitalised with the €15 billion. Transfer the most troubled Irish loans from the books of AIB, Bank of Ireland, Anglo and Nationwide to the new company: these mainly relate to development, and total about €40 billion. These loans could be swapped in a non-cash transaction for a type of government bond (possibly without an annual coupon) repayable any time in the next 10 years.

That transaction would not necessarily take place at par. Because the risk-weighting on development loans and government bonds is vastly different, the banks could take a modest write-down on the transferred loans while crucially leaving capital ratios unchanged.

The taxpayer needs an added kicker apart from the potential interest earned from the assets (this would pay the asset management company running costs). So the taxpayer might be granted warrants for an equity share in the banks (apart from Anglo) of say 25-40 per cent exercisable within the next five years.

The asset management company would attempt to recoup the maximum value from the loans to repay the bond and limit the loss for the taxpayer – ideally keeping it below €15 billion. The cleaned-up banks could lift credit supply and help stop the deflationary momentum of our falling money supply.

Ireland has lost competitiveness in recent years. Perhaps the best way of capturing that is to look at our share of exports from all euro zone countries: it dropped from 5 per cent in 2002 to 3.8 per cent by 2008. That contrasts with Germany, whose share jumped from 28.5 per cent to 31 per cent in the same period. The relative performance is explained by divergent trends in nominal wage costs, rather than differences in productivity.

Germany kept wages almost flat for a long period to regain competitiveness lost after reunification. Ireland probably has to go even further, because the alternative is not worth contemplating, ie leaving the euro.

To deliver relative wage depreciation, a new social contract is required. Partnership, as it was originated, is dead. Tax cuts cannot be traded for wage moderation because we need to broaden the tax base over time (although not immediately, as it would worsen the recession). The Government should negotiate directly with the public sector as of now on productivity and pay. Leave the private sector to return to local bargaining.

But there is more to competitiveness than price: that is only part of the route to boosting productivity. One of the ways in which Ireland has boosted productivity and, hence, living standards, is by attracting foreign investment.

A competitive advantage that isn’t often alluded to is reputational capital. The country’s business reputation abroad has been eroded rapidly. As a first salvo to help restore our reputation we need to make hard decisions on public pay. But other initiatives would help, including a stated commitment to factors including the 12.5 per cent corporation tax rate, budgeted capital investment and membership of the euro.

With regard to public finances, there are serial boom and bust offenders around the world. Think of Argentina, Italy and Spain. Ireland has a foot in that camp. Twenty-odd years after beginning the process of restoring order to the government accounts, the country is back in the same nasty place.

We must not make the same mistake again. Once the deficit has stopped rising, the Government must design a framework to prevent a repeat. Policy should always be counter-cyclical – possibly aggressively so in the next upswing, for good discipline.

Here are two suggestions. Ireland adopts a properly functioning “golden rule” (borrow only to invest over the cycle) where, unlike in the UK, responsibility for dating the economic cycle passes to a newly-formed independent body free from political influence. After implementation of the rule, cyclically adjusted budget surpluses could be siphoned into a rainy-day fund, ready for when the economy turns for the worse next time around.

Rossa White is chief economist at Davy Research, a division of Davy, the Dublin-based stockbroking, wealth management and financial advisory firm