You Can`t Handle the Truth

26^th October 2007
The Malta Independent - Friday Wisdom

This is what Jack Nicholson told Tom Cruise in the movie A few good men when Kaffee (Cruise) was interrogating Colonel Jessep (Nicholson) in a court marshal trial of two marines who obeyed orders to administer a code red (unofficial punishment) on a colleague who was not capable of physically performing up to the expectations of the colonel.

It is this quotation that sprung to my mind as I continued to dissect the budget for 2008. It feels that this government is telling us, the governed electorate, that we cannot handle the truth and that we have to be fed a few good lies and half truths in order not to get hurt by being tempted to elect Labour in government come next elections.

Let me start with the COLA increase of Lm1.50 which is Lm1 more than what should have been paid under the tri-partite COLA mechanism in operation since 1990. Would this have happened if this was not an election budget? And perhaps more importantly how sensible it is to continue with this out-dated system of legally enforced across the board COLA increases when we are entering the rigidity of a monetary union? We are giving up the economic tools of monetary, interest rate and exchange rate policies and government has pretty little room to manoeuvre within fiscal policy given its commitment to balance the budget by 2010.

As has been repeated ad nauseam, we can only remain globally competitive if we continue to restructure, and without the economic tools that will be sterilised by the monetary union, such restructuring has to take place directly in the real economy. But how can this happen if we continue to legislate across the board COLA increases totally unrelated to productivity? Or are we still thinking that monetary union is some free lunch?

Why can’t we be told the truth that in the context of a monetary union wage indexation, that is legally enforced irrespective of productivity, is a recipe for disaster? This is so especially when we are joining in the monetary union a currency that has become irrefutably and fundamentally overvalued against all major currencies, not least the US dollar, Japanese Yen and dollar pegged currencies of emerging countries in Asia and South America including China, India and Brazil.

How else are we being denied the truth we are presumed unable to handle? Consider this. Income tax revenue in 2006 was Lm598 million. Income tax revenue projected for 2008 is Lm728 million. An increase of Lm130 million in income tax revenue over two years when in each of these two years the government has increased tax allowances to the value of Lm12 million i.e. Lm24 million forfeited income tax revenue over two years. So added to the increase of Lm130 million, this is really a gross increase in the tax take of Lm154 million which is 26 per cent of the 2006 tax base.

Even the most optimistic “Supply Side” economist will question the realism of such an increase in the tax take when the economy is growing by less than four per cent per annum in real terms and six per cent per annum in nominal terms, which at best may explain about half the projected increase in the tax revenue. Where is the other half, a whopping Lm77 million coming from and what contingencies are being made in case this fails to realise itself?

We have been here before. Roll back your memory to another election budget for the year 1996 when the government again made very generous income tax concessions in expectation of substantial increase in indirect tax revenue through the then newly introduced VAT system. The expected increase in revenue from VAT proved to be overly optimistic and the result was a harrowing actual 1996 budget deficit which we continue to nurse till this very day. Now that we are seeing the budget deficit reduced to sustainable figures, the government, for pure electoral exigencies that have no place in good financial housekeeping, is again making optimistic assumptions for tax revenues to justify distributing the goodies before the bacon is delivered.

Is this 1996 all over again? 11 years ago to this very day a Labour government was elected to find that a projected budget of Lm32 million was in fact running in excess of Lm100 million without a single word of warning being uttered about it in the election campaign.

Is the government once again gambling the stability of public finances, gained the hard way over more than a decade of oppressive tax increases, for the sake of political convenience? Does this contain the unbelievably selfish argument that if this works the PN will be back in power with a five-year term to patch things up and if it does not work they will ensure that a new Labour government will find it tough going having to nurse public finances back to health and thus being unable to deliver on the many promises being made on the basis of inheriting a strong public finance situation?

I wrote this piece before I had the opportunity to examine the Opposition Leader’s criticism of the budget. Dr Sant once defended himself from some politically inconvenient truth I had mouthed saying that I tend to reason like a banker not a politician.

I don’t regret it and presumably that’s why I did not make a career in politics. But Labour is no less guilty of avoiding the economic truth. Too little too late may be politically convenient but economically it is a non-starter. It sounds not merely gambling but doubling the odds.

Can’t we be trusted to face the truth that it is too risky for our own good to upset public finance stability in the context of a monetary union rigidity and that tax credits should not be given before we are reasonably certain that the projected inflows will in fact materialise? Can’t we be trusted to handle the truth?

Budget in Different Contexts

19^th October 2007

The Malta Independent - Friday Wisdom

You really would have to struggle to try to analyse the budget for 2008 presented this week in parliament out of the immediate context of the impending general election. Out of 93 pages of the Budget speech booklet there is only one page that attempts to put this Budget in a longer term context until 2010. All the rest speaks of performance so far, performance expected till the end of this year and measures to be applicable for 2008.

With a general election due in all probability somewhere in February next year, it is politically compelling for government to tailor the budget with the election in mind. Measures announced have been costed as putting an additional Lm21 million in consumers’ pockets and they have clearly been designed to address the laments of wide and narrow sections of the electorate that have been breeding discontent and sending signals of their readiness to switch their vote.

A second round of tax band widening is clearly addressed to reduce the tax burden of the middle to high income families that have been hit in previous years through fiscal measures such as fringe benefits taxation. The granting of the full cost of living allowance to pensioners meets a demand they have been making year in year out for as long as I can remember. Extension of the benefits under the children’s allowance scheme rolls back restrictions which had been gradually introduced rendering the application of the children’s allowance very narrow. Through the announced measures it has been extensively widened. A middle income family of four could find itself better off by about Lm7 a week through the cumulative effect of the budget measures.

Other specific measures have more telescopic impact although collectively they amount to considerable feel good generation. Exemption or reduction of VAT on selective sports and cultural activities, tax exemption of subscription fees to children’s sports club, measures aimed to ease the hardship of sick and handicapped irrespective of means testing cost little but mean a lot to those who start benefiting there from.

How all these measures are being financed without new tax measures and while continuing to reduce the budget deficit could initially be mistaken for some classic example of supply side economics. This is the economic credo of those who maintain that lowering taxes does not necessarily lead to reduction of government revenue as the reduction in taxes could generate economic growth leading the application of lower tax rates on a wider base resulting in a larger tax take for the exchequer.

A closer look at the revenue side of the budget however shows this is hardly the case. Ordinary tax revenue is scheduled to increase by 5.3 per cent well above economic growth rate and evidently contains a measure of better enforcement. Recurrent expenditure, including all budget measures is scheduled to increase by 3.3 per cent indicating substantial freezing of government operational expenditure to allow room for the funding of the announced measures from the projected tax revenue growth.

What has largely gone unexplained is the increase of revised estimates of Income Tax revenue during the current year 2007 which is projected to exceed the original estimate by Lm30 million. This increase in 2007 additional income tax revenue can by itself finance all the measures announced in the budget for 2008.

Government has been very scant in explaining this growth of income tax revenue. One liner stating “additional revenue is expected on various taxes on income” is hardly sufficient to explain more than 12 per cent increase in income tax revenue in 2007 over 2006 which is more than three times normal economic growth and this at a time when tax allowances were given by way of widened tax bands.

More detailed explanation is merited lest we start suspecting that there is an artificial exercise of shifting revenues across yearly divides purely to strike a pre-determined bottom line figure.

In the comments I heard following the presentation of the budget, there has been little or no effort to give significance to the long term context of the Budget; how will it lead to higher economic growth so that we can continue to enjoy improved standard of living based on real earnings rather than debt.

Our economy has grown by 3.6 per cent which though better than the 3.2 per cent of previous year is still the lowest of the new EU countries with the exception of Hungary. We have grown because Europe, our main trading partner, has grown. There are no measures in the budget which can make us optimistic that we can accelerate our growth to the same tempo of other new entrants. On the contrary there is total disregard of problems facing loss of competitiveness of important manufacturing units that with the strengthening Euro versus the US dollar are being forced to consider relocating fully or partially to dollar based economies in the Far East.

Mandatory cost of living increases payable in advance could in fact accelerate the pace of such relocation. This COLA business has grossly outlived its purpose and needs scrapping sooner not later except for its effect on the minimum wage. The unions must regain their role of negotiating one increase across the board with each employer taking into account efficiency gains that vary from workplace to workplace. The COLA is indiscriminate in this regard and could send a few industries to their grave prematurely.

It is healthy that in the medium term budgetary figures till 2010 government is planning to reduce its recurring expenditure from the current 35.1% of GDP to 32.2% of GDP by 2010. It is not so healthy that government is freezing the capital vote at current level during all this time. We need to continue investing in our infrastructure to render our economic outfits more competitive to withstand the challenges of a strong Euro we have de facto already adopted.

Premature Exuberance

12^th October 2007
The Malta Independent - Friday Wisdom

As we enter the final stretch towards D-day for the adoption of the euro, I cannot help noticing a measure of premature exuberance, celebrating an achievement which has not yet been achieved and risking slip ups through over-confidence at the most crucial time of execution.

It is as if Italy started celebrating winning the FIFA World Cup 2006 two months before the event when they beat Holland 4-1 in a friendly encounter.

The euro adoption project does not consist solely or primarily of the administrative steps needed for its adoption. Indeed in the long run of things this will be a relatively minor part of the project.

This is not to say that the National Euro Changeover Committee has not done an excellent job in administering efficiently the change over process. The praise they have been showered with even from foreign authoritative sources is well deserved. Their job has been facilitated by the political consensus that has surrounded the project. This has permitted the NECC to brand it with a national imprint so necessary to obtain acceptance and cooperation from a very wide cross-section of the population.

But we should not deceive ourselves into believing that this is what the adoption of the euro is all about, and that the good work of the NECC is enough to guarantee the success of the project.

The real success or otherwise of the euro project can only be assessed and measured a posteriori after the actual adoption. There will be two tests that have yet to be overcome. The first one is to ensure that the changeover will not bring about any noticeable increase in prices, neither of a one-event nature and certainly not a spiral of price increases feeding on itself.

I don’t think that enough is being done to ensure that from an inflation point of view the NECC will live up to its motto that only the currency is changing but the underlying prices should remain, all things being equal, the same as if no currency changeover has happened. In a few words if a product was being sold at LM1 before the changeover it will be sold at EUR2.33 after the changeover and there will be no rounding up to 2.35, 2.40 or 2.50.

What else can be done in this regard? We need an intensive educational process of managing expectations of price stability. The consumer has to be trained to challenge price increases caused by the rounding off effect from currency changeover. The anchoring of such no price increase expectations has to be very deeply ingrained in the consumers. In business, merchants sell their products and services for the highest price consumers can take. If merchants perceive any readiness on the part of consumers to accept price increases due to the rounding effect of the currency changeover, rest assured that they will use this pricing power to the detriment of the consumer.

Next Monday is budget day. It is tempting for the government facing an election that will probably be held within two months after euro adoption, to score some political points by offering a financial one-off reward in advance for any price increases resulting from the changeover. What’s more effective to sway voters’ opinions than sending them a cheque in the post during an election campaign?

This will go diametrically opposed to the need to anchor expectations of no price increases and will practically give a license to merchants to round up prices on changeover.

I don’t agree with muted suggestions about imposing temporary price freeze. Apart from the extreme difficulty of policing such price freeze, the price increases will at best be postponed and not avoided. What is needed is correct and easily available information which consumers can use to their advantages in policing directly unjustified price increases. The voluntary price freeze agreements being signed with private sector operators are good and welcome in so far as they go. But who is going to ensure that they are honoured where it matters ie, at the retail end to the delivery chain?

In days of ICT revolution, it should be fairly easy to enforce dissemination of information by forcing retailers, wholesalers and importers to file an official price list with the NECC or Consumer Affairs office at the end of each month between October 2007 and March 2008. This information should be pasted up an on appropriate website where consumers can search by VAT Registration number shown on their fiscal receipt to know whether prices are being unfairly rounded up or indeed increased beforehand in anticipation of the currency changeover. Information is the best tool for consumers to protect themselves from price exploitation.

In the longer term, the success of the euro project will be measured by how much our economy remains competitive to export to the rest of the world and to attract foreign direct investment. Before we joined the ERM mechanism in May 2005, I had argued that we could suffer from loss of competitiveness by locking in at a rate which I perceived as fundamentally overvalued. Once the decision to lock in at just under 43 cents per euro was made I rested my case and worked for competitiveness to be achieved by restructuring in the real economy.

Two and a half years later and just on the D-day threshold, I am pleasantly surprised that our competitiveness has not suffered and that restructuring kept pace. There is no doubt that the euro project itself served as a catalyst for acceptance of an accelerated pace of re-structuring, but we should also thank our lucky stars that the world economy has been experiencing a very glamorous period of economic growth, not perceived likely in May 2005, which has eased the pain of restructuring and helped us to regain competitiveness without resorting to exchange rate adjustments.

The restructuring cannot be considered as having reached its destination on Euro D – day. It must continue relentlessly if we are to keep winning in a competitive world. With very limited or no room for manoeuvre in the monetary, exchange rate and fiscal policies, the restructuring has to be made in the real economy, where after all it is most effective.

This is no time for irrational or premature exuberance. It is time to focus more determinedly to the need to achieve a smooth price changeover without any inflationary impulses and to ensure that euro adoption will continue to be catalyst for accelerating the pace of restructuring.



   

Rock Sand and Confidence

5^th October 2007
The Malta Independent - Friday Wisdom

The Northern Rock is melting. Confidence had turned sand into a rock. Lack of confidence in the UK financial system is causing the rock to crumble back into sand. Soft confidence can do or undo what hard sledgehammer tactics fail to scratch.

This might be of little relevance to us in Malta given that we have a very solid and overly liquid banking system and there is not even a remote possibility of the inter-bank money markets seizing up as they did in UK. But given that we adopt a similar regulatory regime as that adopted in UK, it should interest us to watch and analyse how effectively this regulatory regime has performed when put to real test of financial stress.

In Malta, as in UK, there is separation between the monetary policy and financial stability oversight duties adopted by the Central Bank from the banking regulation duties adopted by the financial regulator (MFSA in Malta and FSA in UK) that actually licenses and regulates banks at the institution level.

The purpose of this separation was meant to ensure that the Central Bank is and is perceived to be totally autonomous in the conduct of monetary policy without being influenced by the stability of individual institutions.

How has it worked out in practice in the case of the Northern Rock crisis? Not very well I must say. With this first hand experience of how the system works when put to the stress test, it might just as well be that we need to review the whole structure of regulation, financial stability and monetary policy execution.

Northern Rock was a mutual building society that converted to commercial bank status being fully licensed and regulated by the FSA. Its business model involved operating as an important niche player in the UK mortgage market with very limited branch network for raising retail deposits and instead funding its mortgage loan book by short-term funding on the inter-bank markets and the wholesale commercial paper market.

No one has in any way accused Northern Rock that it has adopted irresponsible lending practices or that it is suffering any material deterioration of delinquency ratios of its loan book. On the contrary, regulators went on record stating that they are completely satisfied of the robustness of Northern Rock loan book and that the illiquidity problems have been caused by extraneous sources of systemic disturbance. Mortgage problems in the US and direct and indirect – as yet unquantified – exposure of some of the UK bank players to such problems and the general and sudden investors’ attitude shift from one of strong risk appetite to one of substantial risk aversion, forced the wholesale and inter-bank money markets to suddenly seize up.

Without the working of an efficient and liquid inter-bank market, the business model of Northern Rock went through the shredder. While the Bank of England was adopting a hands-off approach interpreting the problem as being specific to Northern Rock, depositors started lining up demanding instant return of their deposits.

The confidence foundation built over decades and decades of central banking tradition in acting as a lender of the last resort for preserving the integrity of the banking system was thrown out of the window in a couple of days by what appears to be lack of co-ordination between the FSA and the Bank of England. This lead to some under-estimation that Northern Rock was melting down due to a systemic freezing for reasons beyond its control and unconnected with their integrity of doing business.

Then when it was too late for confidence to escape unscathed there was a vault-face by the Bank of England. Not only did they suddenly give all the necessary credit lines and liquidity for Northern Rock to fund all the deposit drain in process but when this was not enough to reinstall confidence, they forced the Chancellor of the Exchequer to take the unprecedented step to guarantee all deposits of Northern Rock, and by implication of all banking institutions that might find themselves in its same position.

I dare suggest that this would not have happened if the Bank of England was directly responsible for licensing and regulation of individual institutions as the Bank of England would have had first hand ongoing experience of the problems of Northern Rock. It would have either not approved Northern Rock’s business model in the first place or would have provided liquidity more promptly without causing systemic seizing and without tarnishing the confidence foundation on which all of our financial systems are built.

Now with this first hand experience of how well or otherwise the new separation of duties between regulation and monetary policy has worked in practice, we can pass some judgement. Which is the more damaging? The risk of monetary policy execution being contaminated by the moral obligation to save a regulated institution or the risk of lack of coordination between the various regulatory players leading to a systemic failure causing the near collapse of licensed institution for reasons that are totally extraneous to their operations, causing hardship to individual depositors, leading to anxious queues outside branches right in the City which floats on financial confidence, and forcing the government to take on the obligation of the insurer of the last resort.

How are MFSA peer institutions in the euro area countries going to increase their coordination with the ECB to ensure that the Northern Rock experience in UK is not repeated unnecessarily in the euro area we are just about to join?