Thursday 29 September 2016

Let the good times roll . . . but be aware they won't be here forever

Those engaged in election manifestos must pay caution to budget policy

Published 06/12/2015 | 02:30

Michael Noonan
Michael Noonan

The stream of good economic news in Ireland shows no signs of letting up. The budget deficit for 2015 will come in under target, due mainly to healthy growth in tax revenues, while unemployment continues to fall. But the external developments which have fuelled the turnaround are not guaranteed to last. When things improve so quickly it is foolish to extrapolate: the good times could roll a little longer but they will not roll forever.

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The European Central Bank's governing council last Thursday disappointed the markets by easing monetary policy less than had been expected.

The ECB has a target inflation rate of 2pc and has failed to meet it since the sovereign debt crisis struck in 2012. The cumulative under-shoot means the general price level in the Eurozone is already 4pc below where it should be relative to 2012.

On the ECB's own forecasts it will be almost 6pc below in 2017 even if the inflation rate, currently close to zero, begins to pick up next year. A stagnant price level is bad news for debtors, since the real burden of debt is not eroded by inflation as would normally occur. Hence, the ECB's belated conversion to the virtues of looser monetary policy and the disappointment with its latest measures on Thursday.

The expectation was that the ECB would continue with its policy of low interest rates and would intensify and possibly prolong its commitment to buying debt securities beyond its previous horizon of September 2016.

They did both, but to a lesser extent than the markets had bargained for, so the exchange rate strengthened. The policy, called 'quantitative easing' or QE, in place since March this year, essentially sees extra central bank money created through purchases of (mainly) government bonds.

The idea is to spread the low official interest rates out through the bond market, cheapening borrowing costs for business and boosting the near-zero inflation rate in the Eurozone back towards its target of 2pc. It is very difficult though to engineer low interest rates and a higher inflation rate, and the ECB's efforts have been hampered by the slow start and divergent national interests on its governing council.

Low interest rates, while a boon to borrowers, are a burden on savers. They also create a difficult environment for financial firms, including banks and insurance companies.

In the Eurozone the regime of ultra-low rates and central bank bond purchases was introduced later than in the USA and Britain, and will now persist at least into 2017.

In the USA the QE phase is over and the Federal Reserve is expected to raise rates through 2016 and beyond. The Fed could start the process the week after next when there is a key meeting of its policy- setting committee and Britain could follow suit early next year.

But recovery in Europe is so sluggish that very low official interest rates will be around for quite a while. This compresses the net interest margin of banks and makes it harder for them to regain profitability.

In Ireland they have managed to improve margins regardless, since so many banks have departed the market that competitive pressures are now very weak. But in continental Europe the banks are not too happy with the continuing QE policy. Nor are the insurance companies which are raising premiums.

The banking bust in Ireland was so extensive and damaging that the problems in the insurance sector have rather passed below the radar. Two insurers, Quinn and Setanta, have gone bust, the Irish operations of RSA had to be re-capitalised by the UK parent and most companies in the market have seen difficult trading conditions these last few years.

The problems have arisen mainly through high claims costs relative to premiums but the low interest rate environment is also a factor. Insurance companies tend to be cash-rich: they receive premium income upfront and pay out claims much later. They earn income through investing the cash and have a natural preference for low-risk investments like short-dated government bonds. Some of these are now offering, courtesy of ECB policy, negligible (even negative) interest rates so the insurers are suffering.

The temptation is to invest in something else which offers a better return but there are good prudential reasons to avoid risky investments: the cash has to be there to meet claims costs and the regulators have rules. The preferred low-risk assets are yielding several percentage points less today than the companies might have expected and in the Eurozone this situation may not change for several years yet.

Weak investment income means upward pressure on premiums, other things equal. In Ireland the pressure has been exacerbated by recent court decisions which are likely to result in higher awards to accident victims. Since Ireland still has a system of lump-sum compensation, a low-return environment encourages the courts to make higher awards and the companies face higher costs of settling claims.

The profit recovery in the banks owes something to the willingness of the authorities to countenance high margins on some categories of lending business. In particular the holders of variable-rate mortgages can feel with some justification that they are helping to subsidise the losses banks are still making on the tracker products. These losses will continue until the return of normality, namely a higher inflation rate and official interest rates which are higher again.

The low interest rate environment creates other side- effects besides headaches for banks and insurance companies. One of the risks is that plentiful and cheap liquidity stimulates asset price bubbles, particularly in equity and property markets.

When normality returns there will be a sharp jump in government borrowing costs, and countries with high government debt are exposed. Ireland's improvement in the budget balance this year is partly due to lower debt service burdens created by the low interest rates.

This happy state of affairs means that the Government can roll over maturing debt at low cost. But most of the Irish debt matures in the medium and longer term and will have to be re-financed at more normal (which means higher) interest rates.

There is a natural tendency to extrapolate recent good fortune out into the future. Add in the temptation for incumbent politicians to credit the economic upturn to their own efforts rather than to a run of good luck and the recent tiff between the Government and the Fiscal Council is readily understood. The Government is not wrong to draw attention to the pace of recovery. It has been very impressive. Nor are they entirely wrong to claim some credit: they stuck reasonably closely to the overall fiscal plan inherited from their predecessors, courtesy of the three-year EU/IMF official lending programme.

The problem is the presumption that current conditions are normal and hence likely to prevail out into the time-frame adopted by the Fiscal Council. The Council quite rightly takes a longer view of budget sustainability.

Ireland remains heavily borrowed and locked into a common currency area which is unhelpful to members which get into trouble. The Council makes a convincing case for caution in budget policy over the next few years and all those engaged in drafting election manifestos should be paying attention.

Sunday Independent

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