Collapsing Government borrowing costs to change the discussion on Irish public debt (and on Budget ’20?)
04 July 2019
Irish government borrowing costs tumble further, with 10 year yield dropping to all-time low of just 0.03%( 3 bps) meaning marginal cost of funding Irish government spending/tax adjustments now negligible
€10 billion additional spend would cost just €3 million per annum to fund for next ten years. At the peak of the financial crisis, it would have cost €1400 million
Role of budget policy actions becoming more important globally
Irish fiscal policy likely to become looser; will it happen by accident or design?
Fiscal policy more sustainable if focussed on stability of Irish economy rather than debt reduction
Analysis by Austin Hughes, Chief Economist
In line with a marked decline in global interest rates, Irish government bond yields have fallen further today to unprecedented low levels. At noon today (July 4th), Ireland’s ten year bond yield stood at just 0.03% (3 basis points), about 75 basis points lower than a year ago. The continuing decline in government borrowing costs is a reflection of strong market expectations that the European Central Bank will soon ease policy further.
In addition to the anticipation of further unconventional monetary policy measures, there is growing support for a more active role for fiscal policy to underpin global economic activity. In this context, the current exceptionally low marginal cost of funding additional Irish government spending at just 3 basis points may soon prompt calls for a wide range of adjustments to current Irish government plans for public spending and taxation.
This raises the strong possibility that the setting for Irish fiscal policy will be re-assessed before long. In turn, this suggests that Irish fiscal policy will be looser than now envisaged in coming years. But will changes in the stance of Irish fiscal policy occur (as in the past) by accident rather than design?
This note looks at the emerging trajectory of Ireland’s public finances and the sharply changing momentum in the debate around fiscal policy globally. It argues that these influences call for a shift in focus to a policy framework prioritising the stability of the Irish economy rather than reducing the level of public debtthat would markedly enhance the outlook both for the Irish economy and the public finances.
Back to the future in the Irish public finances?
The Government’s Stability Programme Update (April 2019) and Summer economic statement (June 2019) envisage that in the absence of a Hard Brexit or other significant adverse economic shock there will be a small but steady increase in budget surpluses in coming years (dotted element of dark blue line in diagram below). If achieved, this would bear comparison with the sequence of surpluses that were recorded in each year between 1997 and 2007 with the exception of 2002.
Importantly, the Government’s new projections envisage budget surpluses in coming years as the product of a very different economic and fiscal environment to that of the late 1990’s and early 2000’s. The official projections for the period from 2019 to 2023 envisage conditions of stable and comparatively modest growth in the Irish economy accompanied by relatively prudent management of the public finances that would stand in stark contrast to the boom and ’when I have it, I spend it’ climate of the Celtic tiger years.
It is expected that a combination of solid if unspectacular growth and sensible if accommodative fiscal policy will produce a further fall in Ireland’s Government debt to GDP ratio in the next five years (dotted element of light blue line). While this drop is significant at around 13 percentage points of GDP, it is altogether more modest than the 50 percentage point drop in the debt to GDP ratio recorded in the past five years (incidentally in its April 2013 review of Ireland’s adjustment programme, the IMF forecast a 16 percentage point drop in the ratio by 2018) .
Judged on previous growth and budget dynamics, there is a reasonable prospect that a ‘measured’ fiscal policy against a reasonably stable economic backdrop could deliver a notably more significant improvement in Ireland’s debt metrics in coming years than is now envisaged.
This raises the question as to the optimal stance of fiscal policy in coming years. It is important to recognise that fiscal constraints do not all lie on one side. Clearly, financial markets and/or EU rules would constrain or punish a fiscal stance that threatened to put debt on an unsustainable increasing path. However, it is equally the case that a policy focussed primarily on debt reduction is likely to be seriously sub-optimal economically as well as politically and socially unsustainable.
An important lesson from the recent boom/bust episode is that in practical terms there are lower limits to Irish public debt that reflect a combination of economic, social and political considerations. When upper limits on debt no longer apply as was the case in the early 2000’s, there may be little capacity to limit the scale or range of pressures for public spending increases and/or tax cuts that come under consideration
The experience of the recent boom/bust period teaches us that low debt levels do not provide protection against major economic problems. Instead, it could be argued that they may create conditions of complacency that can quickly translate into unsustainable paths for public spending and taxation as was the case in the early 2000’s.
If the Irish economy remains on a solid growth path through the next couple of years, it is likely to create conditions in which economic, social and political pressures to loosen fiscal policy materially will build. Both the direction of global policy discussions and the exceptionally low cost of government borrowing are likely to add further impetus to this push. Efforts to counter such pressures by calling for further reductions in debt will ring increasingly hollow as EU debt rules will no longer be binding. In such circumstances, it is very likely that Ireland will move to a looser fiscal stance either by accident or design.
It really matters whether fiscal policy is loosened by accident or by design. In the case of design, the debt on the Government balance sheet should be more than offset by the assets in the shape of improved public infrastructure. If policy loosens by accident, it is unlikely that the rise in debt will be compensated for by a material improvement on the asset side of the balance sheet.
An environment dominated by downside risks calls for fiscal caution but also for fiscal support
Of course, it could be the case that Irish growth disappoints in coming years reflecting the crystallisation of one or more significant near term risks to the downside. In light of the unravelling of the public finances as a result of the financial crisis, the understandable reflex action when considering downside risks to the Irish economic outlook is to focus on the budgetary implications. While this is an important consideration, it is important to consider the extent to which the painful deterioration in the fiscal position was a consequence rather than a cause of the downturn. Only then, can we properly decide what current downside risks might imply for the stance of fiscal policy
The key question is what fiscal stance that should imply. A significant strand in Irish economic commentary suggests that downside risks to growth might require a more restrictive fiscal stance against the prospect that the materialisation of those risks would weaken the public finances and prompt a further weakening of the growth outlook. This line of reasoning might suggest that developments in the public finances set the conditions for subsequent economic growth. There has been much academic debate around this issue-most notably seen in the controversy about the validity of the results presented by Reinhart and Rogoff in their 2010 paper that appeared to suggest countries with high debt ratios appear to grow more slowly. However, there is no strong consensus as to whether high debt causes slow growth or simply that slow growth leads to high debt.
Diagram 3 examines the historic relationship between Irish public debt and economic growth. It compares nominal growth rates in GNI* with the debt to GNI ratio, suggests that for Ireland through the past five decades causality has tended to run from economic conditions to the public finances rather than the other way round. An examination of the cross correlation function between the two variables suggests the maximum correlation (around -0.35) occurs between values of GNI* growth lagged up to four years and current year values in the debt ratio. This implies that growth conditions tend to determine the path of debt rather than the other way round and, not surprisingly in such circumstances, implies strong Irish economic growth tends to be associated with lower public debt ratios in following years.
In such circumstances, the priority for fiscal policy would appear to be to adopt a stance that maximises the prospect that economic growth will remain on a solid and sustainable path rather than one that is primarily focussed on the path for public debt. While this doesn’t argue against the need to factor in the implications of downside risks to growth on the fiscal outlook, it implies that putting in place a coherent budget framework to enhance the economy’s growth capacity should be a more critical driver of policy.
The changed interest rate outlook is changing the fiscal arithmetic and outlook
The room for manoeuvre in relation to Irish fiscal policy is heavily influenced by the mood of financial markets and the associated pricing of government borrowing costs. Financial markets now see the global rate cycle turning downward with expectations of near term rate cuts in the US, the Euro area and the UK now firmly in place. ECB rates are seen lower than at present until well into 2022 and are not seen moving into positive territory until 2024.
Apart from this cyclical improvement in the rate outlook, there is also a strong view that structural changes in the global economy mean the more permanent ‘natural’ level of interest rates is now notably lower than in the past.
This ‘lower for longer’ interest rate environment enhances the outlook for the Irish economy by underpinning the cash-flow of borrowers. It also translates into lower borrowing costs for the Irish Government.
Six years ago, the April 2013 IMF review of Ireland’s fiscal adjustment programme estimated that envisaged the Irish government’s interest bill would amount to some €9.4billion in 2018. Official data indicate that the actual outturn for 2018 was €5.2 billion. This year’s outturn should come in comfortably under €5 billion and on the basis of recent interest rate trends could fall notably further in coming years.
In this context, the yield on ten year Irish government bonds was 3.53% at the end of April 2013.On October 9th last , the day Budget 2019 was presented to the Dáil, the Irish 10 year bond yield was 1.05%.Today it is 0.03%. Markets increasingly take the view that the current softness in global interest rates is not a temporary phenomenon and instead could be an enduring feature of the Irish fiscal arithmetic into the medium term.
The current exceptionally low level of Irish government borrowing costs suggests a wide array of feasible policy options that would generate a return to the economy and, as a result to the to the exchequer, that would be markedly greater than the related cost of funding such measures. Additional public spending or tax adjustments amounting to €10 billion would cost just €3 million per annum to fund for next ten years, compared to a peak cost during the financial crisis of €1400 million. This underlines how much the borrowing environment has changed. However, a preoccupation with reducing debt means that, as in the past, when as seems likely some initiatives are considered, the appraisal may not be sufficiently rigorous or wide-ranging.
Can we afford to ignore R-G?
Of course, it can’t be assumed that borrowing costs will remain at current levels indefinitely. However, even on conservative assumptions, it appears likely that Irish economic growth will be well above the prevailing interest rate on Government debt for some significant time. Is this likely to remain the ‘new normal’ or and just a temporary aberration? For some perspective on this, we looked back at the relationship between Irish economic growth and interest rates over the past five decades.
We used nominal GNI* growth as our measure of activity to avoid distortions related to Ireland’s multinational sector that affect GDP. We used the yield on the ten year government bond as a measure of the interest rate as this could be thought to be ‘real time’ marginal cost of Government funding. On average, over the past two decades, the ten year yield has been very close to the implicit interest rate on Government debt.
As diagram 5 below illustrates, Ireland’s nominal economic growth rate (as indicated by the green line which reflects modified GNI) has been higher than the prevailing 10 year interest rate on Government bonds (red line) in 31 of the past 47 years. Over the entire period, the positive growth gap has averaged 1.4%. Such circumstances create favourable public debt dynamics even if the crisis illustrates how dramatically those dynamics can change.
The blue area indicates periods of growth outperformance and underperformance relative to borrowing costs. The dotted line indicates that the trajectory of public debt (in this instance given by National debt because of the longer series for these data) quickly follows twists in the arithmetic of R-G.
The graph suggests difficulties in this regard tend to be sparked by deteriorations in growth performance rather than surges in borrowing costs. This further emphasises the priority to policies that seek to ensure the economy as a whole remains on a healthy path rather than those focussed on a pre-set mechanical target for the pace of debt reduction although it bears repeating that the latter cannot be ignored not least because of the continuing importance of EU fiscal rules.
Fiscal space is opening up globally
The implication for fiscal policy of an environment of restrained borrowing costs has become an increasingly important topic globally of late. A significant contribution in this regard was Olivier Blanchard’s presidential address to the American Economic Association on January 4 2019. In this paper he argued that ‘the signal sent by low rates is that not only debt may not have a substantial fiscal cost, but also that it may have limited welfare costs’. This, the paper argues is because ‘If the interest rate paid by the government is less the growth rate, then the intertemporal budget constraint facing the government no longer binds’.
Blanchard finds that in the US the 10-year rate has been lower than the growth rate for 4 out of 7 decades. He then constructs an adjusted borrowing cost to reflect the average maturity of US government debt and some taxes on the interest paid which he finds has been notably less than US growth on average since 1950. However, as the diagram below illustrates, in just 23 of the past 50 years has the ten year Government bond yield exceeded the US growth rate. On average over this period, growth exceeded 10 year borrowing costs by just 0.1 percentage points but in 2018 the gap widened to 2.4 percentage points. Blanchard concludes that both the fiscal and welfare costs of debt may then be small, smaller than is generally taken as given in current policy discussions. …The purpose of this lecture is most definitely not to argue for higher debt per se, but to allow for a richer discussion of debt policy and appropriate debt rules than is currently the case’.
Blanchard’s argument have gotten significant amplification of late as a result of recent comments by ECB president Mario Draghi at the ECB’s policy conference in Sintra last month where he noted ‘ But fiscal policy should play its role. Over the last 10 years, the burden of macroeconomic adjustment has fallen disproportionately on monetary policy. We have even seen instances where fiscal policy has been pro-cyclical and countered the monetary stimulus.
If the unbalanced macroeconomic policy-mix in the euro area in part explains the slide into disinflation, so a better policy mix can help bring it to a close. Monetary policy can always achieve its objective alone, but especially in Europe where public sectors are large, it can do so faster and with fewer side effects if fiscal policies are aligned with it.
Recreating fiscal space by raising potential output through reforms and public investment, and respecting the European fiscal framework will maintain investor confidence in countries with high public debt, low growth and low fiscal space.
These arguments suggest a more expansive role for fiscal policy at a global level is increasingly likely. This suggests that the major focus around Irish fiscal policy should be around choosing the optimal set of spending and taxation measures to enhance the economic outlook. It is critically important that Ireland’s fiscal stance happens not by accident but by design.
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