Thursday 25 April 2019

With debt still rising, pay hike talks are unnerving

It will be at least a decade before the public purse can bear pay increases - not before

CHEERS: Raise a glass to cheap money. The German government is borrowing 10-year money at just 1pc and two-year money at precisely zero
CHEERS: Raise a glass to cheap money. The German government is borrowing 10-year money at just 1pc and two-year money at precisely zero

Ireland's borrowing costs in international bond markets have fallen dramatically over the last two years, the improvement dating from the 2012 announcement from the European Central Bank that it stood ready to buy eurozone sovereign debt if the markets came under stress. Yields have fallen everywhere, so the improvement cannot be attributed uniquely to the conduct of policy in Ireland, or to any improved performance of the Irish economy.

The ever-so-serious 
Financial Times knows how to keep its tongue in its pink cheek. The paper's coverage of the world's government bond markets - a dutiful recitation of th e previous day's events - has recently been appearing under the new heading 'Bubble Alert'. No explanation has been offered to the Pink Un's faithful readership, since none is needed. Quite simply, the low yields at which government bonds are trading around the world reflect easy money from central banks and make no kind of long-term sense. Something's got to give. Admittedly, that something might not give anytime soon - it was Keynes who cautioned that the markets can stay irrational longer than investors can stay solvent. But the current level of government bond yields will eventually come to be seen as an aberration and they will rise sharply.

In Europe, the German government is borrowing 10-year money at just 1pc and two-year money at precisely zero. On the latter deal, if you lend the German government €100, they will hopefully return the full amount over the two years but will deliver no interest whatsoever. That is to say, hanging on to your €100 note is a better option. Of course, the bond market is for institutional investors, currently so flush with liquidity, courtesy of the various central banks, that they are happy to have someone take care of their funds for a year or two with no return required. This is not some kind of 'new normal', it is unprecedented and it will not persist. The US central bank, the Federal Reserve, has already signalled that the next move in official US interest rates will be upwards and other central banks will do the same, some sooner than others. Interest rate increases in the UK are likely sometime in early 2015, but will perhaps come later in the eurozone.

The bond market bubble is not confined to developed western economies. Remarkably some governments, which had never been able to sell government paper to volunteer investors, have been issuing debt at yields which long-established and solvent borrowers struggled to achieve a few short years ago. In recent weeks, the government of the Ivory Coast has sold 10-year bonds at a yield of 5.6pc and Senegal at 6.3pc. Both Pakistan and Rwanda have managed to conclude medium-dated bond deals for the first time ever.

In Europe, the untested commitment of the European Central Bank to step in if things go wrong has propelled yields downwards. The Irish government can sell 10-year paper (realistically in modest amounts) at yields of around 2.2pc, a lower yield than was on offer 10 years ago when the country was regarded as safe and solvent. If the ECB commitment to support the euro zone bond markets was to be withdrawn, or to be qualified in some material way, these yields would shoot upwards in double-quick time.

For example, what do you think would happen if the ECB announced it would not intervene to stem a eurozone bond sell-off until yields in the troubled countries were back at say 4pc or 5pc? The objective capacity of the peripheral eurozone countries to meet their debt obligations would take over and the debt and deficit figures would be worse than they were when bond yields were double today's levels. Recovery in Europe has also stalled, with second-quarter growth rates at zero or below in France, Germany and Italy. In Ireland, the outstanding debt has reached 120pc of GDP, but GDP is a measure of output rather than of national income, the tax base. As a percentage of income the debt is a whopping 140pc, second highest in the eurozone after Greece, where a further debt restructuring is widely expected. The Irish debt burden continues to rise, since the Government has still not managed, six years into the crisis, to get the annual requirement for fresh borrowing back to zero. The outstanding debt, over €200bn, will continue to grow until the budget deficit is eliminated. It is by no means assured that the Irish public debt is sustainable and default risk remains high.

The Government would have you believe that the markets have simply acknowledged their terrific work in getting the public finances back in order. But that cannot be correct, since the public finances are not back in order. Alternatively, the markets believe that the Irish economy is about to take off like a rocket, that tax revenues will blossom (for a decade at least, since that is what it would take) and that the budget will soar into surplus and all will be well.

There are good reasons to doubt that the markets believe any of this. More likely they believe that the ECB will mop up eurozone peripheral government bonds by the billions if yields push up only a little, and they believe that low official interest rates (cheap financing for bond market positions) will be available for a very long time. They might be right on the second point but nobody knows about the first. Except the Financial Times, which has chosen to flag a 'Bubble Alert'.

The Government has gone drearily into pre-election mode. It is the primeval instinct of Irish politicians to proceed on the basis that the electorate is possessed of a burning and recurring desire to have their votes purchased with their own money, and moreover that they will never learn.

Over the last six months, and especially since the (for Fine Gael and Labour) poor local and European election results, there has been a multiple defenestration of Labour ministers; a cabinet restructuring; and more consequentially, a succession of nods, hints, winks and specific commitments to ease up on the efforts to fix the public finances. It should be clear that the deficit-reducing efforts have not reached a point where it is safe to ease up. The ongoing budget deficit remains too high to be sustainable. Things are certainly in better shape than they were when the Government took office and it deserves credit for that, but it will have dissipated that credit if it proceeds on a Rake's Progress into the next election, with promises to cut taxes, increase public service pay and generally to proceed as if the war has been won. The economy may be about to recover but there is no conceivable rate of economic growth that will make the sums add up if budgetary restraint is abandoned. A durable recovery is in any event dependent on better export markets and the recent data around Europe is not promising.

In the past week, Public Expenditure Minister Brendan Howlin has invited the public service trade unions to begin negotiations about a new round of pay increases. Public service pay rates were cut because the payroll (including pensions) is such a large portion of total spending that no credible programme of fiscal adjustment could have succeeded otherwise. The cuts were justified by reference to the over-stretched public finances - a position which has not changed. Nor is there evidence that the gap between pay and conditions in the public and private sectors has been closed.

Thus both of the justifications for the public service pay cuts - over-stretched finances and the perceived public-private gap - remain operational.

Mr Howlin's Fine Gael colleague Paschal Donohoe responded promptly to the proposed public pay increases by suggesting that private sector workers should expect to join in this emerging distribution of unexplained largesse.

Given the enormous debt overhang, the Irish public finances will not prove sustainable until at least a decade of budget surpluses has been achieved. This will take, at least, three successive governments devoted to prudent fiscal management.

It is standard practice for opposition politicians to behave as Fine Gael and Labour did when they were out of office, promising higher spending and lower taxes. But it is unnerving to see this Government embark on a promises competition with the opposition, a Demolition Derby for budgetary prudence which outgoing governments rarely win.

Sunday Independent

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