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Health of world economy may bode ill for recovery

Colm McCarthy


Ireland should start reviewing its spending now - and hope that the ECB doesn't steer us toward another crash.

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ECB president Christine Lagarde got off on the wrong foot a couple of weeks back when she said: “I don’t think anybody should expect any central bank to be the line of first response”.

ECB president Christine Lagarde got off on the wrong foot a couple of weeks back when she said: “I don’t think anybody should expect any central bank to be the line of first response”.

Bloomberg

ECB president Christine Lagarde got off on the wrong foot a couple of weeks back when she said: “I don’t think anybody should expect any central bank to be the line of first response”.

As the public health measures intensify it is natural to focus on the figures for confirmed cases, hospital admissions and, tragically, fatalities. But the epidemic will end, the measures will be relaxed and the steep collapse in economic activity will reverse. With luck, this could happen in months but none of the experts can rule out a longer emergency, perhaps lasting until a vaccine is available sometime next year.

In the Dail last week, Fianna Fail leader Micheal Martin argued that it is not too early to begin planning for recovery from this unavoidable recession.

The Irish government published just such a plan in November 2010, and it formed the basis for the three-year troika programme implemented by the government elected in February 2011.

The relative success of the Irish rescue was attributed subsequently by IMF officials to the availability of this plan, which had been prepared by the Irish government before help from official lenders was required.

There is no current expectation that the downturn will lead to Irish exclusion from the bond market and another troika-style programme, but the debt overhang has not gone away, and nobody knows how well or badly the sovereign debt market will function in the months ahead.

In any event there will be no more troika-style programmes in Europe, since the IMF has been socially distancing itself from its erstwhile European partners. The European Union, more specifically the eurozone, will be in charge should any member face bond market exclusion.

The Economic and Social Research Institute (ESRI) has taken a shot at quantifying the likely downturn and the resultant budget deficit. It thinks the dip in activity and the deficit will not be as great as in the post-2008 period, but that the unemployment rate will go even higher. It also thinks that the recovery will get going sooner, after about 12 weeks of severe disruption.

The speed of recovery, whenever it comes, will reflect policy measures taken in Ireland but will also depend on the health of the international economy. Even if the public health measures taken here prove superior to those taken in major trading partners, the weaker external environment will be a hindrance.

It should be remembered that it was external demand and foreign direct investment which pulled Ireland out of the slump from 2013 onwards. A poor outcome in the USA would hurt Ireland more than any other European country.

Some of the joblessness that the ESRI has called 'unemployment' might eventually get measured as something else - people whose pay gets to be subsidised by the Government will not show up on the Live Register if their employers do not take them off the payroll. The wage subsidy plans make economic sense in face of what is expected to be a temporary supply shock. Why dis-assemble viable firms which may be difficult to put together again, particularly when the net cost is not as great as it seems, since dole would have to be paid anyway?

There is less sense to proposals to support aggregate demand at this stage in the epidemic, since the downturn is the deliberate intent of government policy. The policy is to suppress supply, inducing involuntary saving for those not dis-employed. There is something to be said for government keeping some of its powder dry for deployment later, when a demand boost, with or without helicopters, might be better timed.

Ireland is exposed to external events in a more direct way if the sovereign debt market is not stabilised quickly, and the European Central Bank, courtesy of its president, Christine Lagarde, got off on the wrong foot a couple of weeks back. She said: "I don't think anybody should expect any central bank to be the line of first response", triggering a sell-off in the Italian bond market, Europe's largest and the likely epicentre for any outbreak of financial contagion. The ECB rowed back quickly and announced a new bond-buying programme but unfortunately capped it at €750bn and with constraints on its freedom to deploy around the eurozone.

The eurozone has just one central bank and it is not located in Rome - only the ECB can prevent an explosion in bond spreads and the indecision of 2011, when the common currency area almost sundered, remains a possibility.

The ECB governing council (of no less than 25 members) appears to be split, with the usual suspects (Germany, the Netherlands, Austria) reluctant to commit to 'whatever it takes', the course finally chosen under Mario Draghi in July 2012. Contrast the statement of Jerome Powell, chairman of the Federal Reserve, the US central bank, interviewed on NBC last Thursday: "When it comes to this lending, we're not going to run out of ammunition. That doesn't happen."

The Fed will buy US treasuries and Powell mentioned no limit or target for the scale of intervention. If things work out badly in the USA it will not be the Fed's fault but the ECB needs to accept quickly that a stabilisation of bond spreads, necessary if eurozone fragmentation is to be avoided, requires unlimited willingness to buy the bonds of the weakest link, which is Italy.

An Italian default on eurozone exit would destroy the prospects for recovery everywhere. Should the eurozone manage to augment the pandemic with a financial crash the common currency experiment will have deserved to fail.

If the Irish government is permitted to fund itself regardless of the size of the deficit there will be no need for an emergency budget - the next one is due soon enough, in October. But the budget, given the size of the debt overhang, will have to be brought back toward surplus from 2021 onwards and Micheal Martin's Dail speech should be the spur for an early commitment to review current and capital spending.

Everyone knows that climate action will eventually require extra taxes and a commitment here could persuade the Greens to think again about joining Fianna Fail and Fine Gael in government.

Policy has had to be made on the hoof and the granting of a blank cheque to the health sector is unavoidable. The health workers have been inspirational, but the sector has a long string of previous convictions in the matter of expenditure control and it is important that no platform is created for a permanent expansion of unit cost.

While the banks are much smaller, and better capitalised, than was the case when disaster struck in 2008, they have been instructed to go easy on distressed borrowers and will see a big rise in bad debt provisions.

The State owns a stake in Bank of Ireland and most of AIB and Permanent TSB. It might be sensible to pre-empt any pressure on capital adequacy by injecting more equity up front, even if they believe they don't need it just yet.

Some of the State companies could feel the strain too - the ESB reported 2019 profits after tax of €338m last week and plans to pay a dividend of €88m to the Exchequer. But some of the others may be facing ratings downgrades and it is silly to extract cash from weak companies - the Government can borrow cheaper.

Sunday Independent