06 July 2005

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A badly advised Prime Minister

A former chairman of the Malta Council for Economic and Social Development and an economics professor by profession, Edward Scicluna does not mince his words in describing the prevailing economic situation: the country is experiencing one of the longest, even if not very deep, recessions since World War II.
Prof. Scicluna says recent statistics showing a drop in Government revenue from income tax and national insurance are an indication of a shrinking economy. He argues that increased consumption, sustained by liberal access to bank credit and inflows of repatriated funds, is partly to blame for rising inflation.
In view of the negative economic data, Scicluna says Government has thrown away the instruments with which to manage the economy. “I have a feeling the Prime Minister is badly advised on the economic front. He has blind faith in whoever is advising him to focus just on the budget deficit,” Scicluna states.
The former MCESD chairman insists the Central Bank’s decision to peg the Malta Lira to the Euro at a fixed rate upon entry into ERMII, was wrong and should be reversed.

Recent statistics show that in the first five months of the year Government income from National Insurance and Income Tax was down. What does this mean?
If we didn’t have a measurement of economic growth one would conclude that GDP is falling. When we are talking about income tax and more importantly social security, we are talking about the productive sectors. They are indicators of the employee’s income. The drop in Government revenue from these two taxes means that income earned has fallen and so an indication that the productive sectors are faltering.
These figures are confirmed by the latest GDP growth figures which show that in the first quarter of the year we had negative growth.
But it is worse than that because if this was the first time the economy shrunk it would be bad news, but there would be a possibility for recovery. However, when you look at the economy’s performance over the last five years you realise it is currently experiencing one of the longest, though admittedly not the deepest, recessions ever endured since the Second World War.

In the budget Government said it was expecting to register an economic growth of 1.5 per cent in real terms for 2005. Is this achievable given the results we have in hand at the moment?
The figure is achievable if the subsequent quarters show a compensating boost. But, even though the figures are not yet published, we have experienced the second quarter already and we all know what happened to tourism, exports and employment, they haven’t shown that there was a boost. So I would reckon we would barely reach that figure.
The point at stake is growth, whether we can come out of a recession. It is the dynamics rather than whether we can achieve a one per cent or not. We need to have economic indications, which when interpreted by an economist, will lead the person to say ‘OK the recession is now behind us.’
At the moment there is no such indication.

What is preventing economic growth?
Because we rely so much on the export of manufactured goods and on tourism as the main motors of our economy, we could easily blame the bad news from abroad as the main factor for preventing economic growth. We run the temptation of throwing our hands up in resignation saying there is nothing else we can do as a country.
First of all we should challenge this notion about the international economy doing badly. Some euro zone countries are doing badly but not all EU countries are doing badly especially the new member states like Malta. Some of them are doing really well. Secondly, the United States is doing well and many other developing countries outside the euro area are doing well. In other words, the international economy is not as bad as we want to depict it.
And the same holds for tourism. If we look at international tourism flows they are quite positive.
We then come to the second most important issue, competitiveness. Over the last few years we have lost our competitiveness meaning the price of our export and tourist package is more expensive than our competitors’. How can any businessmen expect to do well when he is selling products, of the same quality, at a higher price?
The negative economic data coming out is not surprising news to me. You can never expect an economy, whose products are priced higher than its competitors, to do well. It’s an uphill struggle and it would take a miracle to be otherwise.

Competitiveness is an issue raised by all social partners. At the start of the year there was an attempt at reaching a social pact that failed and the only plausible measure one could say Government introduced to try and address competitiveness was the public holidays’ measure. Is this proving to be enough?
First of all, whoever is managing the economy normally has various economic instruments at his disposal: fiscal policy, through the use of taxation and public expenditures; monetary policy, the use of interest rates, reserve ratios and exchange rates; and there is also the use of wage and prices policy, which we call direct controls.
Normally they are there to be used. But looking back, one can see that fiscal policy has just been ‘reserved’ for addressing the budget deficit. It is a good policy to reduce the deficit because it has been harming the country but it also means Government’s fiscal policy will be deflating the economy. If you were to reduce the deficit and the IMF has a history of hundreds of countries who tried it, during a boom time, you can manage. But addressing the deficit at a time of recession is suicidal because the economy is going down and Government is deflating it further.
Monetary policy is there to help fiscal policy. It can be used to revive an economy or else if it is booming to help cool it down. What did we do with monetary policy?
The Central Bank said that because of ERMII we had to defend the peg and therefore the Bank’s hands were tied and it could not use monetary policy. Ironically enough the Central Bank has used monetary policy in a perverse way by increasing the interest rates at a time when the economy was not asking for it. Why was it done? To protect the peg.
We were then left with the last instrument at hand, wages and controls of prices. It was the last window of opportunity but because no agreement was reached on a social pact it was also sidelined as an option.
We have literally thrown away all the available economic instruments. How can we expect Government to control the situation in such circumstances?

The experience of the past years indicates Government’s increasing use of an expansionary fiscal policy, by introducing new taxes and increasing others. What do you suggest needs to be done in fiscal terms?
We have to talk about the tax burden. If you agree with the introduction of an eco-tax, you can make it revenue neutral by reducing taxation on the productive sectors. But if eco-tax is simply introduced on top of the taxes currently in place it just increases the tax burden.

Would you suggest some form of tax cut at this stage?
I would never have dreamt of saying this but in view of the prevailing situation, deficit reduction should now be spread out over a greater number of years. The convergence plan criteria for deficit reduction are suicidal at a time when income from NI and income tax is falling.
I would rather keep the deficit as it is for a year or two, reduce public expenditure on a yearly basis by one or two per cent and pass on those cost savings directly to the taxpayer through a tax cut aimed at boosting the productive sectors. Rating agencies and other similar international agencies are expecting a significant cut in public expenditures.

When confronted with the situation whereby Government is collecting less from NI and income tax, the Prime Minister responds by quoting the increase in Government’s VAT intake and says it is a positive sign of growing consumption…
On the contrary I see that as a problem because increased consumption is symptomatic of the current inflation. I vividly recall my Oxford economics tutor, many years ago, telling me ‘Edward, where there is inflation there is too much money chasing too few goods.’
We are flooded with money and the repatriation scheme is a major contributor to this phenomenon, while the productive sectors are shrinking.
According to Eurostat data, Malta’s productivity per person over the last few years relative to the productivity of the EU average has fallen from an index of 95 to 83.1. At the same time other EU states, especially the new entrants like us have seen their relative productivity increase. This means we are producing less and less per person.
While this is happening we have schemes for people to regularise their position by declaring funds kept abroad but people are not just registering their money, they are also repatriating it.
A lot of this money has been inherited by a younger generation of people, who previously could not utilise it because it was not declared. They may not have the same financial prudence of their fathers or grandfathers and so would go and buy the car and property they always dreamt of.
These hot money flows are pushing up inflation otherwise it cannot be explained how exports and tourism are going down while imports and consumption are increasing.
If income is falling how can consumption increase?
It is just some source of past saving increasing your permanent income.

Government predicted an average inflation of 2.4 per cent for 2005. The Central Bank Governor recently expressed his apprehension at the rising inflation, which seems to defy economic logic. Is the target achievable?
Rising inflation is not defying my own logic. What is very worrying however is that with a fixed peg the only competitive advantage we can gain is if our inflation were to be lower than our competitors’. By being on par we would have gained nothing. But being higher is cause for worry. Inflation is going to feed into the price of exports.
We also need to look at the availability of credit. At the last quarter of last year the banks increased their credit into the economy (loans) by Lm30 million. Of these, Lm23 million were snapped by individuals buying cars, household goods and houses. Manufacturing industry and companies linked to tourism such as hotels and restaurants got zero from that increased credit. The banks are flushed with money and they are just loaning to consumers. That contributes to inflation.

The Central Bank’s increase in interest rates this year was precisely aimed at controlling access to easy credit…
What has happened is that the increased interest rate applied for both individual consumers and businesses. The monetary authorities should have tried to control credit to consumers but make it easier and cheaper for the productive sector to loan money for investment purposes. More importantly they need to neutralise incoming hot money flows.

There was a significant drop in exports in the first quarter. Politicians have tried to sugar the pill by saying that the drop was partly to blame because of ST’s dominant position in the economy. Is it just to exclude ST from the equation?
Exports in real terms have been falling on average from the year 2000 according to NSO statistics. ST is a respectable firm like any other and is the epitome of a competitive firm. So we should worry, not because of its size but because it is an example of a competitive company and if it falters, then something must be going wrong. It is sensitive to the exchange rate, and to our wage and price policies.

On joining ERMII the Central Bank decided to peg the Malta Lira to a particular fixed rate giving up the option to allow the currency to fluctuate within a 15 per cent band allowed by the ERM mechanism itself. What do you think of this decision?
Economic historians, 10 to 20 years from now will consider this as the worst economic advice Government could have had.
Let me draw a comparison. The ERM is a test period for our exchange rate, just like the new jumbo Airbus is undertaking test flights before going into full production. During the first test flight of the new aircraft, the pilots were offered a parachute. The pilots had full confidence in Airbus but they accepted the parachute.
The monetary authorities were going for a two year test flight with ERM. They were offered by the European Central Bank a parachute in the form of a 15 per cent band, plus or minus around the peg and a standby arrangement from the ECB to support the peg if needed. We told them ‘thank you very much but we’ll do without the parachute’.
This means that any shock coming from outside will directly have an impact on our economy. Shocks are coming all the time such as the unstable oil prices, fluctuating exports, money flowing in and out. The 15 per cent band could have acted as a shock absorber, a parachute. But we decided to drive the car without shock absorbers.

The third instrument available is the wage policy, which would signify direct action where it matters most. The social pact was aimed at addressing this issue. Why did it fail?
Looking with hindsight I think the unions wanted Government to paint a realistic picture of the economy by which they would be able to sell the sacrifices they were being asked to undertake to their members. That was the failure; there wasn’t enough admittance on Government’s part that the economy was bad.
To sell bitter medicine to your members as a union leader you either have to be stupid or else you have to convince them that it is in their interest to accept it and there is light at the end of the tunnel. The union leaders felt they could get neither of these two.

Some argue that Government should have still gone ahead and implemented most of the measures in the social pact over which there was agreement on by the vast majority of people around the table. Could this have been a solution?
What is frightening to me is the complete silence from the social partners on the situation. You can almost cut it with a knife. There was a flurry of comments after the social pact failed with unions threatening a referendum on the public holidays measure but apart from that complete silence. It is suffocating. Nobody mentions anything. The unions are mum, employers are silent, Government is saying nothing and what about pension and health reforms, the economy and so many other issues?
Why all the noise during budget time and now almost nine months later nothing has happened? Do we have to wait for budget day to speak as if during the year nothing has happened?
When did we last hear the MCESD met and said something significant? I don’t recall any such meeting. It is frightening for the social partners not to talk.

But what can be done?
The problem is partly political in the sense that if you paint yourself in a corner it will be very hard for politicians to go back on what they said. That is the only problem I can see.
If I were advising somebody in the driving seat I would definitely have some strong short term ‘first aid’ measures to start addressing the situation. Government has to swallow hard and go back on the ERM fixed rate to make use of the permitted fluctuation. This is something very important. That would immediately absorb some of the shocks and help the economy become a bit more competitive. It would also enable the monetary authorities to utilise the interest rate not to protect a peg but to apply it to the economy.
On the fiscal side, I would consider a tax cut. Now, you cannot suggest a tax cut at a time when Government is short on revenue and trying to solve a deficit problem. So I would start by controlling expenditure in a meaningful way. Reducing the size of the civil service by 100 people a year is not enough. If we look abroad we can find various ways and means of controlling expenditure. Any savings made from such a measure I would not contribute to deficit cutting but translate into a tax cut for the productive sectors only.
The tax cut should not be used to increase consumption but has to be targeted towards industry, productive sectors, research and so on.
Thirdly, the unions are definitely feeling the pinch. It is their members who are suffering from a sliding economy and Government should not simply write them off. It should open a dialogue with them. Eurostat statistics show that our unit labour costs have been increasing by about four per cent. Although wage increases lately have not been enormous, in view of our declining productivity, unit labour costs are increasing making our product more expensive. The unions have to be shown the statistics.
Something has to be done on all fronts. The wider the front the less the pain will be shouldered by each party. What we definitely cannot do is simply blame our ills on the international economy.

With the Prime Minister leading his government into its third year in office would you expect him to adopt this multi-faceted approach to deliver pain to the electorate?
I have a feeling the Prime Minister is badly advised on the economic front. He has blind faith in whoever is advising him to focus just on the budget deficit. His picture of the economy seems at times to be different from mine. I am sure that his welfare as Prime Minister is my welfare too, and we both want the economy to do well. Whether that would translate into something else for the politician is another issue altogether. As far as I am concerned my objectives are to see the country become more competitive enabling us all to increase the standard of living.
The budget deficit is a means to an end, the convergence criteria, ERM are all a means to an end and the end is not the EU but the Maltese economy.

Prof. Edward Scicluna was interviewed by Kurt Sansone

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