Kiberd – “We need debt rescheduling and resolution….this is an economic war…

The targets seem modest enough. The capital budget can go hang. Current spending is to be cut by €2bn a year in both 2010 and 2011.

Central Bank governor Patrick Honohan thinks its not enough. He’s furstrated by lack of progress. He’s worried stiff that we won’t get borrowing down to 3% of GDP by 2014, as promised. He wants deeper and deeper cuts.

His proposal, in isolation, is dangerous and simplistic. The cutbacks are being imposed on an economy where there is zero credit creation, even credit contraction and where the propensity to save is at destructively high levels. Savings and credit fall within Honohan’s remit. The cash problems faced by Irish business stare him in the face every day.

Trying to turn around a cashless real economy by slowly draining it of more cash is plainly futile. It’s like a slow bleed. A quick surgical strike designed to achieve a sustainable budget deficit might be endured by business and accepted by the wider population. Right now, we’re not derlivering results and we’re not offering hope either.

Since August 2008 we’ve imposed spending cuts with a full year value of €10bn and tax hikes that should technically yield €5bn a year. But the budget deficit remains at a horrible 11.6% of GDP.

We’ve taken 10% of GDP out of government spending but we’ve gone precisely nowhere in terms of deficit cutting. The total tax take has actually dropped like a stone from €48bn to €32bn.

We might have killed off massively generous pension tax breaks. We might have given the public service unions a fixed percentage of GDP each year (for wages) to be divided up as they saw fit. We might have imposed a flat rate property tax.

But instead of widening the tax base since 2008 we’ve allowed the real economy to implode. As a result there are now only three major sources of revenue being tapped: VAT, excise duties and income tax. The fourth is Corporation Profits Tax. The future yield from profits tax, however, will be severely affected by “tax losses forward” which were €14bn at end 2008 and which have risen since.

After all the cutting and taxing it’s by no means clear what we can cut next, and whether doing so would serve a useful purpose.

Public pay cannot be cut further. In the Croke Park deal the unions insulated public pay rates from future attack. The net public pay bill at €17.4bn dropped 6.2% in 2010 after falling 1.5% the previous year. These numbers include the yield from pension related deductions averaging 7% applied in 2009 and pay cuts ranging from 5% to 10% imposed from January 1st 2010. But there’s no more that can legally be taken from this source.

The Croke Park deal is simply a multi-year wage freeze, masked by mumbo-jumbo about swapping lost pay for enhanced competitiveness. It will not cut the pay bill further in 2011.

Public service numbers were frozen in March 2009. While the number of full-time public servants has finally flattened out at 278,000 the number of public service pensioners continues to rise. It will hit 103,000 this year compared to 72,000 in 2005. Many civil servants took early retirement, going off one state payroll and onto another.

The pensions of these workers have been better protected during the recession than the wages of serving public servants. And after the fiasco over the aborted removal of automatic medical cards for over-70s a politically weak government won’t visit the pensions issue any time soon.

The welfare bill is the second major component of public spending. The government is terrified of the elderly and won’t touch old age pensions.
Meanwhile dole queues increase.

The rate of unemployment hit 13.8% in August, up from 13.2% in Q2. It may peak well above 14%. Although the attrition of jobs in building is over, job losses in retailing and financial services are becoming severe. The anaemic output recovery evident since Q1 of 2010 is export based and not labour intensive.

Seeking to convert short-time workers into full-time workers by paying labour subsidies to firms for two days a week massages the top-line dole numbers. But it won’t make any substantial difference to the cost of the welfare bill.

The government has already cut weekly welfare rates by 4% or by 6% if you count the end of the double welfare week in December. But would it make a second attempt to cut welfare transfers?

Welfare rates are high compared to Britain and Northern Ireland. The minimum wage is among the highest in the EU too. But living on

€8-60 per hour (minimum wage) or on €196 per week (dole) is not easy in a country which -according to Aer Lingus chief Christoph Muller- is as expensive as Switzerland.

There remain the 820 quangoes that developed during the boom years. The Report on Public Service Numbers and Expenditure suggested many should simply be axed. This won’t be done. The people at the top of these quangoes are often well-connected political insiders. This is a problem of deeply embedded, superannuated privilege. Confronting this mess we have an invertebrate government. The solution does not exist at present.

Cutting borrowing by pumping up income tax or indirect taxes is not easy either. Although the shrinkage of employment is tapering off, the Quarterly National Household Survey suggests that by June the number in work was down 80,000 year on year. Retail sales are weak, hit by the credit lockdown.
Even the “buoyant” car trade -boosted by car scrappage payments- is selling 85,000 units a year -roughly equivalent to car sales in the early 1970s.

The Department of Finance accepted some time ago that increasing income taxes won’t work. It’s already imposed income levies of up to 6% and health levies of 5% but the yield has not responded.

Under domestic fire for its cutbacks two years ago the government cited the chorus of global approval as proof that it was correct.

Now the reverse is the case. Commentators like like Nouriel Roubini, Paul Krugman, Jospeh Stiglitz and George Soros say policy is misguided. Standard & Poors, Barlcays, the FT and the Wall St. Journal simply state the
obvious: that budget policy is heading for a brick wall. There is a well worn definition of insanity: repeat the behaviour that caused you nothing but trouble previously and anticpate a different outcome next time.

We might pay attention to decent people looking in from outside. Yet the reaction to S & P and Barclays suggests we prefer to live “in denial”, to dismiss their ideas completely.

The latest wheeze suggests that next December’s budget will see a single social insurance levy that replaces employee PRSI, health levies and income levies. En route a sizeable tax will be slapped on low paid workers who don’t at present pay income tax. This will allow the Minister to meet his €2bn “cuts” target if accompanied by more and higher meddlesome indirect taxes. But this is not tax reform. Neither will it arrest our drift to bankruptcy. The extra burden placed on the poor will be matched by a precisely equal decline in spending on low cost essentials: food, clothing and fuel. Expect more shop closures.

There is no space to examine the cost of debt service here. But government projections of this cost are inadequate. Ignore Nama’s Floating Rate Notes if you must, but even promissory notes carry an interest charge which will have to be capitalised by government. Global rates could rise from current artifical levels. And the cost of rolling over Irish debt has gone, as we know, through the roof.

It’s not a pretty sight. We need debt rescheduling and resolution, not just budget reprogramming. We need a national development bank. And we need a properly targeted plan for economic stimulus. This is an economic war not some pale re-enactment of the early-1990s.

PS: Many want to punish the subordinated bondholders at Anglo Irish. This is happening already: the subordinated debt halved to €2.5bn in the past year as bonds were bought out at a discount. These bonds trade at between 17% and 38% of face value. The holders have accepted they won’t be repaid in full and have probably reinsured the debts elsewhere. They would welcome a final deal to cap their losses. But this does not offer a solution to the wider Anglo problem. It’s just a drop in the ocean. Meanwhile JP Morgan told clients last week to buy some of the €16bn in state guaranteed “senior” bonds. These offer attractive returns to maturity at very little risk, they say.