European Commission latest to convert to Fiscal Expansionism

The widely accepted view on the Great Depression is that it was exacerbated by a series of policy errors- trade protectionism, tight monetary policy and contractionary fiscal policy. Consequently, given the lessons learned,  the Great Recession in 2008-9 prompted a substantial policy reaction across the globe, with a massive easing in monetary policy accompanied by counter cyclical fiscal policy. Oddly, though, policy makers then decided that debt reduction should take priority, and fiscal policy generally became contractionary even when the global recovery began to falter and lose momentum, with monetary policy seen as ‘the only game in town’. That emphasis on the  perceived dangers of high and rising  sovereign debt resulted in new and stricter fiscal rules in the Euro Area (EA), emphasising the need for a steady and persistent reduction in budget deficits.

Policy doubts eventually began to emerge, including from the IMF, with evidence questioning whether ‘austerity’ actually reduced debt levels and claiming that the  negative multiplier effects of contractionary fiscal policy were steeper than previously believed. Doubts also grew about the effectiveness (and  possible adverse consequences ) of loose monetary policy particularly after the adoption of negative interest rates and large scale QE. The ECB has also changed its tone of late, accepting the need for monetary policy to be complemented by some expansionary fiscal policy in the EA, albeit while still respecting the existing fiscal rules.

Academic debates  on fiscal policy have also intensified, with the case being made that budgetary policy can be more effective at or around the zero rate lower bound, but  events have transpired to take fiscal policy centre stage in the real world. The UK government has already announced , post the Brexit vote, that it has abandoned its previous pledge to balance the budget by 2020, and is expected to announce a more expansionary fiscal path later this month. In the US,  markets now expect fiscal policy to be far more expansionary under the incoming Trump Administration, although it remains to be seen how much of the campaign rhetoric will translate into policy action.

Closer to home, the European Commission has just announced , for the first time, a recommendation on the overall fiscal stance in the EA, and is advocating that it should be expansionary in the coming year, amounting to 0.5% of GDP , equivalent to a €50bn budgetary injection. On existing  national plans , the  overall  EA fiscal stance is expected to be neutral in 2017, after being modestly expansionary in 2016, and the Commission believe that a number of countries have the fiscal space available to raise spending and/or cut taxation, although it cannot force any action. The group comprises Germany, Estonia. Malta, Latvia, Luxembourg and the Netherlands. In practice, the Federal Republic is the only member with the size to affect the EA as a whole, and while calls for Germany to adopt a more expansionist policy in the interests of the wider zone have been made before, it is novel and perhaps surprising to see Brussels join in that chorus.

The Irish Economy has some serious Capacity Issues.

The Irish recession was long and extremely steep but it ended over six years ago and the economy is now growing rapidly; real GDP has risen by 25% from the cycle low and is now over 10% above the previous peak. Indeed, according to the Department of Finance, Ireland is now operating above full capacity. Others, including the ESRI and the Irish Fiscal Advisory Council have queried this but all agree that the degree of spare capacity in the aggregate has  diminished. It is also true that one does not have to look hard to observe capacity issues in specific sectors of the economy, particularly in and around the capital.

Take tourism, which is booming; last year the number of visitors to Ireland exceeded 8.6mn, having grown by 13.7%, and on the evidence of the first quarter the figure for 2016 will exceed 9.5mn. That has put pressure on accommodation, and the price of a hotel room rose by over 5% in May alone and is 9% up on the previous year. One could not give a hotel away not so long ago but now rooms are scarce and are 22% more expensive than in 2012. Housing in general is also scarce , of course, particularly in Dublin. Rents, nationally, are at record highs and on the CSO data there is no evidence of any significant change in trend, with the latest figure for May showing a 9.7% annual rise.

Irish residents are taking more foreign trips too ( up an annual 13% in the first quarter of 2016) and it is not surprising that Dublin Airport is now seeing record passenger numbers, with 2.5mn in  May alone , an 11% rise on the previous year, implying the 2016 figure will be well in excess of last year’s 25 million. The Airport is building a new runway to help cater for the increased demand, and it is instructive that the planning permission was initially granted in 2007 and then put on hold.

Car ownership is also growing strongly again, with sales up 31% last year following a 29% increase in 2014. The latest data for this year points to a 25% rise which would take the annual figure to over 150k for the first time since 2007. Hardly surprising then that record numbers are using the M50, with gridlock at peak times not uncommon.

The growth in the population as a whole is also putting pressure on schools and hospitals, although one could be forgiven for thinking the population is falling given some media coverage of emigration. The reality is that the population surged by over half a million in the six years to 2009, reaching 4.53mn, and by 2015 had risen to 4.64mn, as net migration has slowed to virtually zero and is anyway offset by the natural increase.

The conclusion has to be that Ireland needs to embark on a huge programme of capital investment in order to tackle capacity issues, particularly in and around Dublin. Borrowing costs for both corporates and Governments are at historically low levels and there has been some increase in building, both residential and commercial, although the former is still well below the annual demand, so exacerbating  the existing supply/demand imbalance. Unfortunately it is  a mark of the absurdity of the current fiscal rules imposed on euro members that capital spending  by the State  is not excluded from the expenditure constraint (  only some incremental spending is allowed) and so any amelioration in these capacity issues is unlikely to occur any time soon.

Ireland is a High Wage and High Price Economy

The euro is now is its seventeenth year and although consumer prices across the zone have shown some convergence  there is still a wide divergence and one that has actually grown again over the last five years. Prices in Germany and Italy in 2013 were around the euro average, in France  7% above and in Spain 9% below. Finland is the most expensive country  (20% above the euro norm) followed by Luxembourg, with Ireland in third place; prices here are 17% above the average in the euro area. For those looking for a cheap holiday, prices in the Baltic states are 30%-40% below average , or for a warmer climate, Portugal and Slovenia ( around 20% cheaper than the norm)

Ireland’s inflation rate, as measured by the HICP,  generally outpaced its euro neighbours in the first decade of membership but fell below the euro average from 2009 to 2013. That latter period of price convergence is not as apparent  when measured on the broader household consumption deflator  used by Eurostat for comparative purposes, although it also shows that Ireland’s relative price position has improved, with the  current 17% differential  compared with over 23% a decade earlier and 19% in 2009.

Prices in Ireland are also substantially higher  when measured at the micro level, as confirmed by a recent ECB  survey (1) of grocery prices across the single currency area,  using data from 2011. That found prices  in Ireland on a basket of household  items  to be 17% above the euro average and a massive 32% for branded goods only, and that excludes VAT. The study found that competition at the retail level had a role to play  in explaining cross-border price divergence, alongside consumer shopping patterns ( the degree to which people buy in bulk for example) but macro factors such as the level of national income play a strong part.

One would therefore expect to find a close relationship between the price level and  the wage level in a given economy , as the latter  is the main cost of production and  as well as a key determinant of household incomes. That does appear to be the case; there is a 96% correlation between the price data discussed above and wage levels across the euro area as revealed in the latest Eurostat  data on hourly labour costs for 2014 ( the survey  excludes agriculture and public administration)

The figures reveals that in Luxembourg hourly wages are 45% above the euro average, with Belgium in second place at 32%. Given the price data one would expect to see Ireland towards the top of the wage league and that is indeed the case; hourly wages in Ireland were €25.8 against an average of €21.4  or 20% above the euro norm. That is an average figure ,of course, and hides a wide distribution around the mean, but it is undeniable that the average wage level in Ireland is among the highest in Europe.

Against that, the non-wage  cost of employing labour here (mainly employers PRSI) is remarkably low , and at 13.5% of total labour costs is around half the euro area average. Consequently, Ireland’s overall ranking in terms of  labour cost is very different to that using wages alone, with total  hourly labour costs less than 3% above the euro norm.

High wages, per se,  need not be damaging to competitiveness as long as they are supported by high productivity and that may well be the case in Ireland for some of the main export industries if perhaps less so for non-traded services. What is clear is that Ireland is a high wage and high price economy in the euro area ,  however uncomfortably that sits with the narrative some prefer, with implications for the type of industries and companies the country can attract.

(1) ‘Grocery prices in the euro area’, ECB Economic Bulletin No.1, 2015

Irish Household deleveraging enters 7th year

The Irish Central bank has just published an update on the Financial Accounts of the Irish economy, incorporating figures to the third quarter of 2014. The data provides some positive news on Irish household wealth and the sustainability of household debt while confirming that deleveraging remains the order of the day.

The amount of outstanding loans to Irish households peaked at just over €200bn in the third quarter of  2008 and has been falling since, declining to €160.6bn , bringing the debt figure back to levels last seen in mid-2006. The scale of the deleveraging (over €43bn) is remarkable, as is the duration; net mortgage debt  continued to fall in the final quarter of last year according to the monthly data, implying that the household debt figure , when updated, will have declined for over six years.

Debt relative to household income is a standard measure of debt sustainability and on that metric the situation continues to improve. That was not the case at the onset of the deleveraging as household income was also falling. Consequently the household debt ratio did not peak until late 2009, at 218%, and was still above 200% three years later. Disposable income has  finally started to pick up so the debt ratio is now falling at a more rapid clip, declining to 177% on the latest figure, the lowest in nine years.

On the other side of the balance sheet Household assets have been rising in value. Financial assets have been boosted by the bull market in equities ( captured in insurance company reserves)  and  housing wealth by the upturn in residential  prices and completions. Consequently the net worth of Irish households ( i.e. housing and financial wealth minus liabilities) now stands at €574bn. This is well short of the figure at the peak of the boom (over €700bn) but is €84bn above the figure a year earlier and is further confirmation that household wealth is recovering.

What are the implications of these trends?. Rising wealth is generally  supportive of consumer spending, and a paper from the ESRI  by McCarthy and McQuinn  found that in Ireland a 10% rise in housing wealth would boost consumer spending by 1.1%. On that basis we can say that the 14% rise in housing wealth seen over the year to the third quarter could have boosted spending by 1.5%, or by €1.2bn. Of course other factors have been at work and consumer spending has emerged well below most forecasts, which brings in the second implication- deleveraging has undoubtedly had a strong negative influence on household consumption, with the gross savings ratio averaging over 14% in the first three quarters of 2014, double the figure  in 2007.It is impossible to know how long household deleveraging will continue and as such it represents a risk to any forecast of future household spending.

One final implication. Irish banks have seen an improvement in net interest margins but their assets are still falling, with deleveraging a significant factor. They are making new loans, of course, but that is being offset by debt repayment, both by households and firms, and again the recent monthly figures from the Central bank showed that the trend decline in bank assets was still evident in December.

Dublin House Prices: Bubble or not?

The CSO recently released the latest Irish house price data, for October, revealing that residential property prices excluding Dublin  are picking up at an accelerating pace; prices rose by 4.8% over the past three months, bringing the annual increase in October to 8.7%, an inflation rate last seen in early 2007. Yet prices are still only 12% up from the lows recorded eighteen months ago and  so few would consider that the market over the bulk of the country is overheating, particularly as national prices still look far from overvalued relative to affordability, incomes or rent.

The price trend in Dublin is very different. Prices there have risen by 46% from the lows recorded in the summer of 2012 and are now 38% below the levels seen in early 2007, a peak now generally considered the height of a Bubble. That term is now reappearing in the context of commentary on the residential property market in the capital and it does arguably satisfy some of the usual criteria employed to categorise a Bubble. One is rapid price appreciation and that is certainly the case ;  the annual increase in October was 24.2%, a pace rarely seen and then only back in 1997 and 1998, in the run-up to euro membership. Moreover, the pace of price inflation has accelerated this year and  the past three months has seen a 9.3% rise, or over 42% at an annualized rate. Expectations of further price gains is also a common feature of asset Bubbles and that also appears to be present; a recent survey showed respondents expect Dublin prices to rise by an average 12% over the next year, up from 6% twelve  months ago, even though  only 15% believe housing in the Capital is still good value (the  value figure for housing ex Dublin is 50%).

Price expectation is an important determinant of  the actual house price trend , notably in terms of the user cost of housing ( the total cost of buying a home with a mortgage, including the mortgage rate, maintenance, depreciation and any tax breaks). That user cost is now negative, particularly so in Dublin, because the expected capital appreciation from buying a home exceeds the other costs, including the mortgage rate.

Bubbles are also often associated with leverage and Dublin fails the Bubble test on that measure as credit is clearly not a driver, or at least credit from the main Irish mortgage lenders. Data from the Banking and Payments Federation Ireland (formally the IBF) showed that the number of new mortgages for house purchase  in Ireland amounted to 5763 in the third quarter, against total property transactions of 11,257 as reported in the Property Price register, so 51% of transactions were funded by Irish mortgages, a proportion that has risen through the year ( from 46% in q1) but is still well below the 80%-85% one associates with more normal market conditions.

A final Bubble test is whether  asset prices make sense relative to fundamentals and here there is often room for debate (witness the range of views on US equity markets and Euro bond yields). In terms of housing one metric is to compare prices with  private rents , as the latter represents the amount consumers are willing to pay for the utility housing provides . Rents nationally, as reported by the CSO, have been rising now for four years, by a cumulative 21%, and have picked up momentum again in recent months after a sluggish period earlier in the year, increasing by 2.5% in the  three months to October. The CSO does not provide a regional breakdown but does , and their figures broadly track the official data. The website shows  strong double digit growth in Dublin rents (around an annual 15% of late, with growth elsewhere at less than half that pace)  and provides detailed rental figures across housing size and type. For example , a 3-bedroom house  in Dublin currently rents at an average €1,518 per month, or €18,216 a year. In theory, the price of any house, discounted at an appropriate rate, should give a present value equal to the rent. If we use the average new mortgage rate as our discount rate ( 3.25%, as quoted by the Central bank) that  Dublin rent implies a house price of €560,000. The Central bank data has been criticized and is going to be revised so an alternative would be to use the standard variable mortgage rate of around 4.25%. On that basis the house price would be  €430,000.

How much is the average price of a house in Dublin? Our own estimates, based on updating the Irish Permanent index (no longer published) with the CSO index gives an actual  figure around €300,000, which is broadly consistent with the average asking price of €325,000 quoted by The median price of Dublin property transacted  in q3 on the Property Price register was under €280,000 so the implication is that prices in the capital are still not excessive relative to rents, despite the recent pace of price appreciation.The latter reflects ,in part, a recovery from over- sold territory but nonetheless ticks a few Bubble boxes, but not all.

Tax Take in December implies weak consumer spending

The  Irish Exchequer returns to end-December showed tax receipts for the full year at €37.8bn which is in line with the revised estimate published by the Department of Finance in mid-October. This represents a 3.2% increase on 2012 although still €150mn adrift of the original Budget projection, which was predicated on stronger economic growth than eventually emerged. The last month of the year often throws up surprises and so the authorities will no doubt be relieved that the (revised) target was met although that satisfaction may also be tinged with some disappointment following a very buoyant tax intake in November, which opened the prospect of a strong end to the year for the Exchequer. In the event December proved a very weak month in terms of receipts, with tax revenue coming in €360mn behind profile, or 12%, with all the main headings  adrift, including a very large shortfall in VAT, which came in at €89mn instead of the projected €211mn. The implication is that Irish consumers did not spend as freely as some expected in December, at least before the post-Christmas sales.

Non-tax current receipts were stronger than expected, however, ending the year at €2.7bn against an original forecast of €2.4bn (thanks in the main to the ELG scheme and increased dividends) so total current receipts ended the year at €40.5bn or €200mn ahead of the Budget projection. Voted spending came in 0.4% below profile for 2013 as a whole although again that masks a very strong spending round in December, particularly on the capital side, as the undershoot was over 2% at the end of November. Total current spending actually rose over the full year, by 1.6%, but this reflects higher debt costs and masks a sharp (4%) fall in day to day expenditure.

The combination of revenue growth and spending restraint has led to a steady fall in Ireland’s fiscal deficit although 2013 still saw a Current Budget shortfall of €10.6bn. The capital Budget was boosted by the State’s decision to sell various financial investments in Bank of Ireland and Irish Life with the result that the Capital deficit was  around €5bn smaller than originally envisaged, at €870mn. The overall Exchequer deficit came in at €11.5bn against an original target of €15.4bn and broadly in line with the revised projection of €11.3bn made a few months ago.

On the funding side the authorities drew down the last of the monies available from the Troika , raised some €2bn from State savings products, and used the proceeds from bond issuance early in 2013 to buy back some of the bonds due for redemption this month. That transaction meant that net funding broadly matched the Exchequer deficit leaving cash balances at the end of 2013 at €23.6bn and as such largely unchanged from the previous year. This cash pile is expensive to hold ( given short term yields are virtually zero) but means that the authorities do not have to fund this year unless they want to, but will have to weigh the costs of increasing those balances against the benefit of  returning to the bond market in the near term.