The Fiscal Compact – informing the 50% who don’t understand it

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OK, so according to the Sunday Times Behavioural and attitudes Survey on the 22nd April 50% of the electorate/those intending to vote (not sure which) in the upcoming Fiscal Compact referendum apparently do not fully understand the Fiscal Compact (downloadable here). This is a worry for me because if you are going to vote on something that will have profound implications for your fellow citizens you owe it to yourself and the rest of the country to fully inform yourself as to the implications of the treaty. Afterall, would you sign a contract without knowing it’s terms? Well, I suspect the answer would be no and as such therefore you should be approaching the fiscal compact with the same mindset. It is a contract between this state (through it’s citizens) and the EU.

However with the results of the survey in mind I thought it timely to set out some simple to understand comments about the treaty.

What are the primary purposes of the treaty and how might it affect the economy?

1. The Government Deficit

Governments will be required to ensure that the annual budget deficit (Tax revenues minus current expenditure) does not exceed 3% of Gross Domestic Product (“GDP” which includes multinational profits whereas Gross National Product does not) at “market prices”. The reference to “market prices” is a curious comment for me.

Taking this in isolation from any other objectives of the treaty we need to ask ourselves what was the 2011 budget deficit. According to publicly available data from the Department of Finance the current account budget deficit for the year 2011 was €11.223bn. The detail for this can be found here on the Department of Finance website or here on this blog.

According to data published by the Central Statistics Office (or from this blog here) the 2011 GDP figure was €161.034bn. Therefore, on the face of it, the current account deficit of €11.223bn represents circa 7% of the 2011 GDP figure. However, on the 23rd April 2012 Eurostat issued a briefing document (or downloadable here on this blog) stating that the Irish budgetary deficit for 2011 (including bank recapitalisations) was 13.1%.

However this is a question that you, the reader, should consider when assessing if the focus on the current account deficit as a percentage of GDP is excessive or not:

With emigration at record levels (some of whom were unemployed at the time of emigrating and some who were not) together with unemployment at circa 14.6% what is likely to happen from further “austerity” in the absence of employment growth?

“We” all know that things are difficult in Ireland but not all are “feeling” it and forcing the budget deficit down further through regressive tax increases will probably worsen unemployment with the spiral continuing. So society needs to switch it’s focus from the deficit to employment growth which will go toward reducing the income inequality highlighted in the Survey on Living Conditions for 2010 which the Central Statistics office recently published.

2. The ratio of “Government Debt” to Gross Domestic Product

The compact or treaty requires Governments to reduce “Government Debt”1 to 60% of Gross Domestic Product (at “market prices”) over a period of 20 years “at an average rate of 1/20th per year” where the public debt (general government debt) is not equal to 60% of GDP. Note the use of the phrase “average rate”. This suggests to me that there is scope for the Government of the day to reduce the “debt” by more than the 5% (1/20th) envisaged by the treaty. Indeed it could be less depending on the prior years.

Ireland’s general Government debt, according to a document published by the NTMA (and downloadable here on this blog), as at the end of 2011 stood at 107% of Gross Domestic Product or approximately €172.36bn. This correlates with an information note on Ireland’s Debt published by the NTMA in May 2011 (downloadable from this blog here) where they estimated the final Government Debt figure for 2011 would be €173bn.

The NTMA  further estimates in this note that general Government Debt (the figure which must equate to 60% of GDP) in 2015 is expected to be €203.6bn with GDP itself in 2015 being estimated to be €182.7bn. This means an expected GDP growth rate between 1st January 2012 to 31st December 2015 of just under 13.4% (in total when compared to the GDP figure for 2011) whereas a GDP growth rate of 110.7% is needed in order to reach a GDP figure in 2015 of €339.33bn which would mean that the expected debt figure in 2015 would be equal to 60% of the general Government Debt.

For this figure of €203.6bn to equate to 60% of GDP the GDP figure would need to be €339.33bn (note that for 2011 GDP stood at €161.034bn so what is the likelihood of a doubling of GDP in 4 years?). For the debt to GDP ratio to be satisfied  one of two things will be necessary. Either GDP savagely grows (this might be achieved by attracting more FDI into the country meaning their profits are counted in the GDP statistic) or the debt is savagely paid down. This latter option can achieved in one of three ways, namely severe expenditure cuts, severe tax increases (which type of tax increases) or a combination of both of these two options. To-date we have seen the direction being taken in relation to the type of taxes being chosen by current and last administrations.

What are the implications of this requirement you may ask.

Well, Gross Domestic Product is a moving target (in theory at least) so when it comes to the budgetary process on an annual basis a Government will not know in advance what the GDP figure for the following 12 month period will be and so this could materially alter how a Finance Minister will frame his/her budget having regard to the ratios. He/she might like to be prudent and push for a greater “adjustment” in achieving the ratio that is required. On the other hand, the Minister of the day might not be that prudent and find that they did not achieve the required rate of adjustment and so you might even see a “mini-budget” mid-year. This will affect, or is likely to affect, those not in employment more than those in employment insofar as those relying on social welfare will be more adversely affected by cuts in expenditure or by regressive tax increases and the response of many Governments in the EU since the onset of the EU crisis in mid 2007 has been to focus on increases in consumption taxes (namely VAT and other such taxes, e.g. property taxes and water taxes in Ireland) rather than increasing either “income tax” or Corporation Tax. The OECD apparently favours this approach as they suggest that increases in these two latter taxes is more harmful to “economic growth” than increases in property taxes or consumption taxes.

Note the increase in VAT at the standard rate to 23% from 21% with many calling for it to be reversed on the basis that it is damaging retail (so is an increase in VAT harmful to economic growth in that context?) Note also the introduction of property and water taxes. These are regressive in the context of high unemployment, and affect those without incomes/employment (these two generally go hand in hand) more than those in employment, more particularly those with high enough incomes so as to not be classified as the “working poor”.

Are there any downside risks to this requirement other than those highlighted above?

Well the answer to that question is yes. Currently, there is debt of the Irish state that is considered off balance sheet (NAMA & it’s Special purpose vehicle for example) meaning that it’s not counted in the figure of €203.6bn mentioned above. If Eurostat were to change the debt measurement rules of the Irish state such that this off balance sheet debt were to be counted in the debt thus INCREASING the debt figure then the affect of such a change would be even greater “budgetary adjustments” in the event that GDP doesn’t savagely increase if the 60% ratio is to be satisfied. It’s difficult to know if many “ordinary” people in Ireland consider this fact.

2.1. The excessive deficit procedure

The fiscal compact incorporates the revised Stability and Growth pact in the context of the “debt brake” rule, i.e. the 60% debt to GDP rule. A consolidated version of the revised stability and growth pact can be found here and downloaded from here. What is an excessive deficit programme you will ask? Well, according to a document issued by the EU in December 2011 Ireland and 22 other member states of the EU are undergoing excessive deficit procedures. In summary, the type of austerity we are “all” experiencing at present is the “excessive deficit procedure”.

According to a document issued to members of the Oireachtas in March 2012 by the Oireachtas Library & Research Service (available here) the excessive deficit procedure is automatic where the general government debt is in excess of 60% of GDP. This appears to be the case regardless of whether the current budget balance is in deficit or surplus. In order words it would appear that Ireland will continue in an “excessive deficit procedure” (i.e. the type of austerity being experienced now together with future predicted cuts) until such time that the general Government Debt to GDP ratio comes back to 60% regardless of whether the annual budget is in surplus or in deficit. It is conceivable that a fiscal year would see the Government in budgetary surplus but with the Fiscal Compact passed there would still be an “excessive deficit procedure” in place due to the general Government debt to GDP ratio being in excess of 60%. In other words the objective of the fiscal compact appears to be to ensure that any future budgetary current surpluses are used to pay down the Government Debt to the 60% ratio. In theory of course this might make perfect sense but does it make sense in light of some of the components of Government Debt? It’s up to you to conclude whether that is a good or bad thing for the Irish economy.

The excessive deficit procedure can only be avoided in the event of a qualified majority vote of the EU Council/Commission NOT to implement such a procedure. In other words, a state is nearly locked into an excessive deficit procedure where the 60% ratio is broken. This seems to be the basis on which some campaigning groups call this treaty the “austerity” treaty.

3. The Structural Budget Balance

A separate element to the fiscal compact is the concept of “the structural budget balance”. Basically, the compact sets a deficit limit of HALF of ONE PERCENT (½%) stating that the requirement to have a “budgetary position of the general government shall be balanced or in surplus” will be treated as satisfied if the deficit is not in excess of the HALF of ONE PERCENT. If you consider that the current account budget deficit for 2011 ranged between 7% and 9% but was revised UPWARD by Eurostat recently as mentioned above it is difficult to envisage how this HALF of ONE PERCENT requirement can reasonably be met.

Generally speaking economic commentators seem to differ on what is meant by “the structural budget balance” of the exchequer, in many circumstances saying that it cannot be definitively defined, but it should be noted (Vincent Browne regularly refers to this on the Tonight with Vincent Browne programme on TV3) that in 2007 the Structural Budget Balance of the Irish State was deemed to be in surplus by the IMF I believe but that they have since revised their assessment to a negative “structural budget balance”, i.e. a deficit. In other words, what this effectively demonstrates is “uncertainty” in the minds of those tasked with measuring the “structural budget balance” and so that means it’s something of a moving target with the consequent effect of budgetary fiscal uncertainty on an ongoing basis. This, in my view, could have the effect of freezing the economy even more. Signing up to such a policy is not wise in my estimation.

Other economic commentators have written on this issue including Tom McDonnell (his background profile can be found here) through TASC and copy of a recent piece of his can be found here. The linked piece essentially states that between 2015 and 2018 there will be further “austerity” of circa €5bn in order to meet the .5% structural budget balance requirement and even then there is no guarantee that with such “adjustments” (more often referred to as cuts in expenditure or tax rises) that this budgetary requirement will be met. Afterall, if GDP falls, tax revenues can fall and so the overall budgetary position at a given point in time is altered.

Summary

Despite what our Government says about this treaty not being an “austerity” treaty it is just that. Despite what our Government says about this treaty being a referendum on membership of the European Union it is not that. I think it is fair to say that “austerity”, while “helping” to reduce the deficit in the short term, is actually undermining the entire domestic economy and actually leading to increasing levels of unemployment which will lead to further austerity which in turn will lead to a further deterioration in the economy. The only way that is going to be reversed is for employment growth to recommence. This cannot happen from within the “job-seeking” community itself.

Other commentators within the Irish sphere have written on the topic of the fiscal compact of late, namely Professor Brian Lucey of TCD on his blog here and Cormac Lucey (a former Government advisor) and an accountant (who like me is going to be well versed in these matters) in his blog on two separate occasions of late here and here. In fact the latter Mr. Lucey has declared his intention to vote no in the upcoming referendum. In addition to this commentators have written on the continuous programme of austerity in an open letter to the Irish Times recentlystating that such a policy is going to lead to stagnation. This is not a healthy direction to be heading in but it will only be re-enforced by passing the Fiscal Compact referendum.

I would also direct you to recent Dáil debates on the matter (link here) in which there are frequent references to continuous austerity after 2015.

Professor Terence McDonough of NUIG (National University of Ireland Galway) stated on Morning Ireland on the 27th April 2012 that the European Stability Mechanism (ESM) is not the only source of external funding available to Ireland in the event of a No vote. Furthermore Eamon Gilmore stated on the same programme that “it won’t be possible for new applications to be made to the European Financial Stability Facility (EFSF) after the ESM comes into force”. The ESM cannot come into force until the relevant treaty has been ratified. The ESM treaty has not been ratified and will not be ratified until after the Fiscal Compact treaty meaning that if the ESM treaty is not ratified in the event of a rejection of the Fiscal Compact Treaty then the EFSF would continue to be available as the ESM would not have come into force. Therefore, it is possible to vote No and continue to have access to external funding sources.

If I am honest enough to offer my view of the treaty I would say that it is not something which should be passed by referendum. It deserves a no Vote as it is too restrictive on the Irish economy. It does not offer any form of budgetary flexibility now, or at any time in the future. Such flexibility is required now and into the future and should not be surrendered. It might help you think of the Irish economy like a business for a moment that is looking to grow. Ordinarily a business looking to expand and grow might re-invest a portion of any profit made from it’s activities in order to facilitate that expansion. Under the Fiscal Compact that is not going to be possible. Budgetary surpluses (in their entirety) are going to be required for financing debt repayment until such time as the 60% debt to GDP ratio is satisfied.

It’s now over to you.

The following text was taken from the blogpost by Professor Brian Lucey that I have linked above. I think it is a very useful summary of the treaty.

BOX: What is the treaty -
  • Budget must be in structural balance or surplus, defined, as structural deficit cannot be higher than 0.5 percent of GDP
  • Countries, which have debt/GDP below 60%, can have a structural deficit of 1% or less
  • A country with debt/GDP above 60% has to reduce the excess by one-twentieth a year
  • If the budget is not in balance, automatic correction rules must be enforced
  • If a euro zone country does not write the balanced budget rules into its national law, it can be sued in the European Court of Justice and can be fined 0.1 percent of its GDP.
  • The agreement will enter into force once 12-euro zone countries ratify, or on January 1, 2013. – Euro zone countries will coordinate national debt issuance plans in advance.
  • Only countries that have ratified the fiscal compact and written balanced budget rule into national law will be eligible for bailouts from the European Stability Mechanism.
  • all EU countries, whether in Euro or not, apart from Czech Republic and UK, are signatories to the compact.

1. General Government Debt is a gross measure and does not allow for the offsetting of Exchequer cash balances. As well as the National Debt it includes the promissory notes issued to certain financial institutions, local government debt and debt of non-commercial State bodies. GGD ratios are as published by the Department of Finance in Budget 2012.

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7 Responses

  1. Seamus Coffey

    May 1, 2012 3:14 pm

    I’m not sure this is an information piece; it contains plenty of opinion and we’ve being over this ground before.

    The emphasis is on the debt brake rule but it is the balanced budget rule that will have the greater impact.

    There is no requirement to get the debt down to the 60% of GDP limit within 20 years. In fact neither the Fiscal Compact or the Stability and Growth Pact make reference to such a timescale.

    This is also no need for “savage” GDP growth or “savage” debt repayment to satisfy the debt brake rule. It is actually a benign requirement.

    Consider a country with a debt of 100% of GDP. That country must reduce it to 98% of GDP by the following year (1/20th of the gap between 60% and 100% equals 2%). Assume that GDP is 100 and debt is 100 to give the 100% ratio.

    In the year in question it is forecast that real growth will be 2% and inflation will be 2%, thus nominal GDP will rise to around 104. In order to satisfy the debt brake rule the allowed debt at the end of the year is 0.98 * 104 = 101.9.

    The country can meet the requirements of the rule by INCREASING its debt from 100 to 101.9.

    This did not require “savage” growth. 2% growth and 2% inflation are very achievable and it did not require “savage” debt repayment. In fact the country was able to borrow more. It is a brake meaning its intention is to slow down the accumulation of debt rather than force its repayment.

    The debt brake rule becomes effective for Ireland in 2018 so there is little value in applying it to current figures.

  2. Mark McCutcheon

    May 1, 2012 4:26 pm

    Hello Seamus,

    Yes we have. Yes, it does have opinion in the piece. But that opinion as at the end with facts front loaded. I think that’s important to explain the opinion that follows. If I gave no facts then that would be misleading.

    Firstly the treaty states at article 4 as follows:

    “When the ratio of their general government debt to gross domestic product exceeds the 60 % reference value mentioned under Article 1 of Protocol (No 12), the Contracting Parties shall reduce it at an average rate of one twentieth per year as a benchmark, as provided for in Article 2 of Council Regulation (EC) No. 1467/97 of 7 July 1997 on speeding up and clarifying the implementation of the excessive deficit procedure, as amended by Council Regulation (EU) No. 1177/2011 of 8 November 2011. The existence of an excessive deficit due to the breach of the debt criterion will be decided according to the procedure set forth in Article 126 of the Treaty on the Functioning of the European Union.”

    Note the use of the word “shall” in the article regarding the 60% and the timescale. The treaty does mention timescale therefore in that context. It needs to be recalled that this is a legal document and much like, lets say tax legislation, the use of the word “shall” indicates a mandatory obligation on the part of a member state. This is how the word “shall” functions in tax law in any event and the interpretation of law is generally the same regardess of which type of law one might be speaking about.

    There is nothing in the text of the treay which says it DOES NOT come into force until 2018. Article 16 says it must be legislated for “within five years at most” following the treaty coming into force. That’s a window within which the Irish legislation can be enacted and that means (in factual terms) that it could come in before then.

    Secondly you are entirely correct by saying that the reduction of the debt may prove to be 2% (2% of the starting base of 100 but that’s playing with numbers on paper rather than realities) but one twentieth of the gap is still one twentieth and one twentieth of anything is 5% of something. In your example you start with a GDP of 100 saying that reducing that to 60% (i.e. 60) equates to 2% (of the 100) but the reduction of 2 is also 5% of the 40 which is the gap between 100 and 60 so as I say it’s playing with percentages to disguise realities.

    If the gap between GDP and 60% of GDP in say 2015 (I did say in my piece that 2015 was entirely illustrative but that the compact could be legislated for NO LATER than 2018 – rather than NOT BEFORE) is €73.08bn (€182.7bn @ 60%) then one twentieth of that figure is €3.654bn (ANNUALLY) assuming there is no growth in GDP. You are correct if you were to say that if there were was growth in GDP in the future than the €3.654bn would be less but we can only deal with facts just like I can’t go out and buy a house based on the hope that I will win the lotto. However, growth in GDP does not always translate into growth in employment and that’s my focus, growth in employment.

    I fully agree with you that the balanced budget rule will have greater impact. That’s why I explained in the piece that following the passing of the compact (if it is passed) that it will result, even in full surpluses (while the 60% rule is breached) being used to bring down the ratio. Of course if the reduction amount was less than a surplus then of course there would be an amount of the surplus remaining but again, that’s an academic dicussion which doesn’t necessarily deal with realities.

    Once again, yes, the piece does express opinion, but at the end of the piece which is informed entirely based on published fact which I have also referenced in the document. This is about choices and how those choices are made. I offered my choice and explained the reasons for it. It’s up to others to take them on board or disagree but my reasons are based on my professional expertise of tax and financial law.

    Regards,

    Mark McCutcheon

  3. Seamus Coffey

    May 1, 2012 10:29 pm

    Mark,

    There is no timescale in Article 4 and definitely not a ‘twenty year’ one. I don’t know where this comes from.

    Consider again a country that has a starting debt ratio of 100% of GDP. One-twentieth of the excess over the 60% threshold must be reduced each year. Starting at 100% here are the indicative debt limits for the first twenty years applying the debt brake rule.

    100.0; 98.0; 96.1; 94.3; 92.6; 91.0; 89.4; 87.9; 86.5; 85.2; 83.9; 82.8; 81.6; 80.5; 79.5; 78.5; 77.6; 76.7; 75.9; 75.1

    After 20 years of the rule the debt ratio would need to be reduced to 75.1%. There is still a bit to go to reach the 60% threshold.

    The Treaty is not the part of the EU law that introduces the debt brake rule. The Treaty only restates it. The rule comes from Council Regulation (EU) No. 1177/2011 which is referred to in the Treaty. This regulation clearly states that:

    A transitional period should be introduced in order to allow Member States subject to an excessive deficit procedure at the date of adoption of this Regulation to adapt their policies to the numerical benchmark for debt reduction. This should also apply to Member States which are subject to a Union or International Monetary Fund adjustment programme.

    and then says

    For a Member State that is subject to an excessive deficit procedure on 8 November 2011 and for a period of three years from the correction of the excessive deficit, the requirement under the debt criterion shall be considered fulfilled if the Member State concerned makes sufficient progress towards compliance as assessed in the opinion adopted by the Council on its stability or convergence programme.

    The final column in the table in this press release gives the year for each country when this transition period ends. Ireland is the last country in the table and it clearly states when we will be subject to “the numerical debt reduction benchmark”.

    Growth may be lower than I presumed and this is also allowed for in the Regulation

    In implementing the debt ratio adjustment benchmark, account shall be taken of the influence of the cycle on the pace of debt reduction.

    There is always a get-out clause. Of course growth is not the only thing that can do the heavy lifting. Lets assume that growth is zero.

    A country with a 100% of GDP debt ratio can satisfy the debt brake rule if there is 2% inflation (the ECB target) and a balanced budget for two years returning to small deficits (i.e. increased borrowing) after that.

  4. Mark McCutcheon

    May 2, 2012 10:28 am

    I’ll have to come back to you on the above. Only just picking up. One thing I would say is that press releases do not form part of the law in this context. They are only guidance in this context.

  5. Seamus Coffey

    May 2, 2012 11:50 am

    Ah Mark,

    The law (Council Regulation No 1077/2011) says:

    For a Member State that is subject to an excessive deficit procedure on 8 November 2011 and for a period of three years from the correction of the excessive deficit, the requirement under the debt criterion shall be considered fulfilled if the Member State concerned makes sufficient progress towards compliance as assessed in the opinion adopted by the Council on its stability or convergence programme.

    That is the law. The press release only reflects that.

    2015 + 3 = 2018

  6. Mark McCutcheon

    May 10, 2012 2:14 pm

    Seamus,

    Apologies for the delay in coming back to you. I have a couple of questions for you to understand your projections, frame of mind etc in the above. The reference to the legislation being enacted not before 2018 is accepted but that, to a certain extent, is a small matter (from my perspective anyway). However, that being said my questions for you are as follows:

    (1) I have read your comments above, combined with your post on Irisheconomy.ie which is also replicated on your blogblog and my reading of your thoughts is that the ratio target can be met solely by growth in GDP while simultaneously limiting the growth in Debt to the structural deficit requirement, (i.e. 0.5% where the 60% ratio is breached, otherwise max of 1%) as set out in the Fiscal Compact Treaty and that your thoughts don’t factor in any debt repayments. Debt repayments, from my perspective, in this context do not include interest payments. Is my reading of your thoughts correct in this aspect?

    Complying with the structural deficit requirements will, as you say, have more of an impact but I am curious to fully understand your thoughts on it hence my questions above.

    If you manage to reply then great but if you don’t then that’s fair enough also.

    Regards,

    Mark McCutcheon A.I.T.I., B.B.S.
    A.I.T.I. Chartered Tax Advisor (CTA)
    My Blog

  7. Seamus Coffey

    May 10, 2012 2:47 pm

    Hi Mark,

    We do not even need to keep the deficit to the structural deficit limit to meet the debt reduction target. The articles you link show how we can meet the debt reduction benchmark using IMF projections. By 2017 the IMF project that Ireland will have an overall deficit on 1.9% of GDP (and a structural deficit of 2.4% of GDP). Even with those deficits requiring further borrowing we can still meet the debt reduction benchmark as it is based on the debt ratio.

    The reason why I think the structural deficit will have more of an impact is because it requires a lower deficit than the debt brake (assuming the output gap is not sufficiently negative).

    The IMF projections still have a structural deficit of more than 2% GDP when we satisfy the debt rule but that would have to be reduced to 0.5% of GDP to satisfy the balanced-budget rule. If we are satisfying the balanced-budget rule we will be exceeding the requirements of the debt brake rule.

    Remember the debt rule only formalises the expectation of the 1992 Maastricht Treaty where deficits of 3% of GDP would see the debt converge on the 60% level when nominal growth was 5%. The numerical requirement of the debt rule is exactly the same. With 5% nominal GDP growth the rule can be satisfied with deficits of 3%. The numerical requirement gives a benchmark that must be achieved and is applicable to all nominal growth rates. The expectation has been formalised.

    The aim of the balanced-budget rule is to bring deficits “close to balance” in cyclically-adjusted terms so that why it will have more of an impact in my view. Under most scenarios the deficit allowed by this rule will be less than that required under the debt brake.

    In both cases it is unlikely that they will be any debt repayments. There will of course be interest costs but that is debt servicing and that is counted in the deficits. I always assume that debt interest is covered and paid, but I do not see any need for capital repayments on the debt, particularly because of the debt brake rule.

    If we do ever get to a stage of running surpluses there will be no requirement to use them to repay debt and the surpluses can be saved. That is not a likely scenario for the foreseeable future though.