Roadmap

By Eoin Fahy, Monday, 8th November 2010 | 0 comments
If Ireland is to be able to borrow the €15bn or more gap that will exist next year between total spending and total income, the Government needs to pass several tests in the weeks ahead. In each case, it seems likely that the test will be passed. But the Government needs to pass each and every test to stave off the need to call in the IMF and the EU.  The next four weeks are crucial, and among the most important in the history of the State.
 
The Irish authorities could be forgiven for thinking that they have a bad case of déjà vu. Just over a year ago the markets, and the Government, were looking at the following issues, each and every one of which needed to be dealt with successfully if the markets were not to react very badly:
  1.  The Green Party and Fianna Fail had to conclude very difficult negotiations about a renewed Programme for Government.
  2. Assuming that agreement was reached between the negotiators, the deal still had to be passed - by a two-thirds majority  - at a special Green Party conference.
  3. The same conference was voting on NAMA, and many commentators expected that the Greens might vote NO to NAMA, throwing the government’s plans to deal with the banking crisis into chaos.
  4. Assuming the Greens signed up to NAMA (by no means a certainty), the legislation also had to pass through the Dail. Again this was no sure thing given the opposition to NAMA among government backbenchers and independents.
  5. Even if all that went to plan, the Government would next have to move on to the 2010 Budget, and produce about €4bn of cuts and tax increases, including very significant cuts in public sector pay – again. Could this pass through the Dail? Would the cuts be big enough?
In the event of course, all five issues above were dealt with, the bond markets remained open to Ireland, and the economy survived.
 
But a little more than one year on, we are again faced with a series of issues that must be dealt with in a relatively short period of time, and this time the crisis is far worse, as indeed the bond markets are arguably already closed to Ireland, and the size of the required cuts is much larger.
 
(Note: In this commentary I concentrate almost completely on what the bond markets want and expect. There is of course an entirely different debate which could be had about whether the bond markets are right in what they want, either from a social or economic viewpoint. But to some extent that is becoming irrelevant – as Ireland can’t possibly finance its enormous deficit, if it can’t persuade the bond markets that it is doing the right thing, it will end up calling in the IMF and EU who will almost certainly insist on doing what the bond markets want anyway).
 
Let’s take a look at this autumn’s list of “To-Dos” for the authorities.
  1. The first test is, or rather was, to announce the total size of the cuts required over the next five years, and much more importantly the size of the ‘adjustment’ required next year, as well as the detailed economic forecasts behind those plans. That announcement was of course made last Thursday, and while the market reaction was not particularly positive, it certainly was not negative. The Government announced that the total amount of cuts required over four years is €15bn, and the amount to be cut in 2011 would be about €6bn.
  2. Next up is the “four year plan”, to be released some time later this month. This is perhaps the least clear of the various announcements, as we really aren’t very sure what it will contain. We already know the size of the cuts to come, and how much will come in 2011, and the economic forecasts for the next four years. We also know that traditionally the government keeps the really detailed measures with regard to tax and spending until the Budget. So what is left to be announced in this four year plan? Well it’s hard to know  – but we do know one thing for sure. If there is any sign of slippage or uncertainty in the government’s plans, the markets will react in a very adverse fashion, and very quickly. So whatever is in it, it had better be convincing! 
  3. In the last week of November comes the Donegal by-election. Normally an economic commentary such as this one wouldn’t need to comment on a by-election, but it becomes very relevant given the tight voting situation in the Dail. The Government currently has a Dail majority of three, which would fall to just two if it does not win the by-election. And of course no sitting government has won a by-election for almost thirty years! Arguably, however, as the Government is not really expected to win the by-election, there may not be much reaction on the financial markets if indeed it is lost.
  4. On the afternoon of December 7th the Budget will be delivered. We know that it will contain around €6bn of ‘adjustments’, with the bulk of them being spending cuts and the balance being increases in tax. So what will the markets be looking for in the Budget? Certainly they will want to see that the six billion is realistic, and not based on one-off accounting tricks or overly-optimistic economic assumptions. But they will also want to be sure that the cuts are carried out in a way which will have the least negative impact on economic growth. After all, there is no point in reducing the deficit by six billion only to have the economy decline so far as a  direct result that the deficit actually rises despite the cuts. The markets would prefer the tax increases to be implemented by means of eliminating loopholes and exemptions, for example, rather than by raising marginal rates of tax. They probably also favour a property tax rather than higher income tax rates, again because higher income tax rates tend to slow economic activity and thus collect much less tax than forecast, while property taxes are generally believed not to be as negative for economic growth.
  5. Late in the evening of December 7th, the first votes on the Budget will be taken, with the exact subject matter of the first votes dependent on various technical factors. Assuming the Government loses the forthcoming Donegal by-election, its Dail majority will be just two votes. So if any two backbenchers or independents can’t stomach the six billion of spending cuts and tax increases, and vote against the budget, or if any three abstain, the Government and the budget falls, and there would be a general election between three and four weeks later. Remember that under the Constitution, a government MUST immediately resign if it loses a budgetary vote. [Of course this parliamentary arithmetic assumes that all opposition parties oppose the Budget, which seems very likely]. 

So here we are again. Five major steps on the roadmap for “bond market survival”, and five steps that must be taken if Ireland is to avoid the need to approach the EU and the IMF for emergency financial support.  And these are only the immediate and obvious challenges of course - even if Ireland gets past the next four weeks, there are still any number of external or internal factors tthat could still go wrong sometime between now and next Spring, when Ireland hopes to re-enter the bond markets.

 
My own view is that the four year plan will be reasonably credible (because it simply has to be), that the Budget will be as expected, in the sense that the government will not walk away from the tough decisions that are required, and I even think that the Budget will get through the Dail. After all, any backbencher  voting against the Budget because it is too tough will surely be aware that such a vote would surely guarantee that the IMF and EU are called in, and that they in turn will implement an even tougher budget instead, without political accountability.
 
It’s also important to remember, in fairness, that in the autumn of last year, as I outlined above, the authorities similarly faced a number of tests, and in fact got through them all successfully. To some extent they have been here before and have done what needed to be done at the time.
 
But while I do actually believe that each of these tests will be passed, the risks are extremely high. It only takes two TDs to vote against the budget, or for some perhaps obscure detail of the budget to spook the bond markets, to lead to the IMF being called in. The Irish authorities need everything to go perfectly, while those betting against Ireland only need one (of many) things to go wrong. We are surely entering the most important four week period of the entire crisis to date, and it may not even be an exaggeration to describe them as the most important four weeks in an economic sense since the foundation of the State. And of course that's only the beginning.  After that we have three more tough budgets to get through, not to mention the risk of external factors destabilising the situation in the shorter-term.

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