Sunday, 28 June 2009

Bullying Should be Ignored

28th June 2009
The Malta Independent on Sunday

There is much to criticise on the state of Malta’s public finances chief amongst which is that the progress achieved in 2005 – 2007 as part of the Euro project, in bringing the deficit to within 3% of GDP was undone in 2008 when government did what governments often do in an election year, ergo, spend their way to fiscal irresponsibility in order to get re-elected.

But the EU warning given to Malta by Commissioner Almunia that it has to come back within 3% of GDP by end of 2010 smacks of bullying. It is a clear case where the Commission, totally impotent in its discipline upon the big EU members like France, Germany and the UK, pushes around the smaller member states to give the impressions that it is in control of a situation which has clearly escaped its grasp.

The fiscal situation of most European governments in 2009 is in a state of flux. Faced with a the sudden onset of a global financial crisis which quickly spread into a global recession, governments had to intervene to protect their economies from falling into a depression.

To keep the level of demand high enough to avoid mass unemployment, governments had to replace the shrinkage of demand by the private and the export sectors, by increasing their spend through the launch economic stimulus plans which greatly increases government spending. This increased expenditure in the context as falling ordinary tax revenues has led to many countries running huge budget deficits, well in excess of 3% of GDP, in fiscal 2009. When it would be possible to restore budget discipline and bring these deficits down again and heading towards the neutral point can only be a medium term prospect.

Regularisation depends upon withdrawal of special government stimulus programmes as much as, if not more, upon restoration of growth to the economy. The prospect for this is unclear at its best. The world economy is probably hitting the bottom of the recession at around this time. Some countries that entered the recession first, especially the US and UK, are speculating about the appearance of economic green shoots. However in reality these are more statistics of the second derivative, i.e. things are getting worse at a slower rate rather than of the first derivative i.e. things are starting to get better.

Few economists can sincerely expect a strong recovery. Hopes of a V shaped bounce are based on hope rather than logic. Growth has to follow restoration of confidence in the financial system with credit flowing freely to lubricate business investments. The financial sector is still very fragile and the main players will have to spend the next few years repairing their balance sheets rather than following new initiatives. We are seeing banks enjoying very low interest funding through Central Bank lending and ordinary deposit rates but still charging high lending rates leading to record interest margins meant to address the losses still being registered in writing down their property assets.

At best the global economic recovery will have an ascending W shape, an escalator type of gradual recovery which could take at least until 2012 to get the major economies back to their normal long term growth trend. And this depends upon the success of international co-ordination to facilitate growth by putting in the driving seat of the growth train those countries that can stimulate domestic demand without exasperating their already fragile fiscal and balance of payments positions.

Countries like China, Japan and Germany, who among them have about 50% of the international trade surpluses, need to reflate their economies to stimulate domestic demand, run down their balance of payments surpluses, and permit debtor and deficit nations, especially the US, to exit the recession through export led demand rather than stimulation of more credit-based unsustainable consumer demand.

This is easier said than done as it involves massive culture changes and launching of programmes totally and diametrically opposed to those which were delivering economic success in the past. China, Japan and Germany owe their comfortable balance of payments positions through high domestic thrift culture where consumer save rather than borrow to spend. They also owe it to their strong export economic platform. Convincing their consumers that in the midst of this recession they should spend rather than save and changing their exporting industries to outfits producing for internal demand is like teaching an elephant how to dance.

But unless this international co-ordination is achieved and the world is forced to resort to the old habits of making the western consumers, indebted they already are, as the main platform of future growth based on imports from surplus countries, the recovery will be fragile with grave risks of recurrence as the US dollar will have to bend under the weight of its own deficits causing havoc to international trade and back into a grave recession.

Against this uncertain background there are no countries that are planning their exit strategies from their fiscal stimuli programmes and restoration of fiscal sanity by end 2010. In our case the EU is right in stating that the deficit growth in 2008 is not related to the international recession. But entering the recession in 2009 with a bad fiscal position will make it harder to achieve restoration by 2010.

We are in a situation where government itself has no clear idea what its fiscal situation will be at the end of this year. Revenues from income tax and VAT are depressed as economic growth turns negative and consumption drops at the discretionary margin. Inevitable people pull back on major investments like property purchase which is a great revenue generator for the state with most deals generating instant revenue of 17% - 5% from the purchaser and 12% from the vendor.

My best guess is that the fiscal position this year will worsen further to around 5% - 6% of the GDP. How we can bring this back to 3% by 2010 if we are still in crisis mode managing a very fragile recovery from the recession is anybody’s guess.

The EU should base its efforts for fiscal sanity on the big countries who like France take pleasure in ignoring it. In any event fiscal sanity has to be framed over a medium term programme spread at least until 2012.

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