Friday, 15 July 2011

The Macroeconomic costs of the Naval Base blast

In this third article on the “E Florakis” base I will consecrate on the macroeconomic problems that arise from the disaster. Just to recap, up to now we have seen the very serious microeconomic effect to companies, and that the lowest estimate possible of costs of the disaster is €3.1 billion, or 17.9% of the whole income of the economy (GDP).

Sadly this only captures what we call the static costs of the accident. This only takes account of income lost until the damage is fixed in the electricity generation and in fixing the generating capacity of Cyprus. However, experience has shown that the dynamic costs on the economy can be much more significant, and still have an effect in the economy after many years.

The dynamic costs will reduce not just income today but create conditions that keep the growth of income of Cyprus lower than it would have been. I will focus on three issues: Inflation, Reduction of Capital intensity, and national debt.

1) Inflation:

The electricity produced either by the existing stations or through generators is by far more expensive to produce that the (relatively) cost efficient Vassiliko power station. At times like this the emphasis on basing our energy future on carbon based power stations rather than diversifying in renewable energy is clearly seen for what it is: totally myopic. The cost per MW hour of many of the power sources currently used to make electricity are more expensive than renewable resources, resources for whom funding was partially reduced in an effort to cut costs in the last 2 years.

Part of this additional cost of electricity will be passed to the consumer: it is not possible for firms and the electricity authority to absorb this added cost in their entirety as they have already been struggling due to the economic crisis. An increase of fuel bills though a hike in electricity bills or indirectly through emergency taxation, is unavoidable.

Thus prices will increase (i.e. inflation) across the board, and inflation tends to create a self fulfilling cycle of further inflation in the future. This increase in prices will have two main effects that will create further downward pressures in our total income (GDP). The purchasing power of the income of those working in the private sector will fall, reducing consumption and thus further reducing the expenditure that keeps the economy afloat. More serious is the second possible effect of a reduction to competitiveness. An increase in prices makes all our products and services less competitive relative to other EU countries, who can freely export to Cyprus. Thus imports are expected to increase while exports fall, making it very difficult for the economy to find the road to recovery.

2) Reduction to capital intensity

Economic growth depends on many factors, but the most important are considered increases in capital (both human - education and physical - power stations) and the adoption / generation of technology. In my first article I explained how the lack of power is slowing down the rate of technology adoption (or even at times making people go to older less efficient technology, like analogue phones). This will reduce the rate of economic growth in the future, as long as our electricity needs are not fulfilled.

More serious is the loss of capital intensity, or the amount of capital per worker in the economy. According to all theories of economic growth (Unified Growth Theory, Endogenous Growth Theory, Neo Classical Growth theory) the increase of the amount of capital per worker is the single largest component of economic growth and prosperity. Simply put, a man with just a needle can only sew one shirt a day, but with a sewing machine (more capital per worker) he can produce much more. Using a personal example i cna relate it to what we are experiencing today: I am writing this by candle light, without internet access.

The destruction of the largest investment project of the island though ineptitude lead to a mass reduction in capital intensity. It is not just that the capital stock of the economy is poorer by €2 billion euro. It is also the fact that so much capital is lain dormant at as the unexpected power cuts prevents their use.

All growth theories argue that a reduction of capital intensity can lead not to just lower growth, but in extreme cases it can lead to a reversal of the growth process. This is by far the most serious consequence of the blast: it reduced not just our current capabilities for growth, but our future capabilities for growth as we need an ever greater amount of capital to reach the capital to labour ratio that we had on the 10th of July, since our population keeps rising.

3) National debt

The debt we will need to incur for Vasiliko alone is in excess of 1 billion; even if we assume that the insurance will pay 600 million despite not being an act of god or war damage. This is debt was not projected for 2011 and for 2012, and the ability for the government to borrow both from domestic and for external markets was already being questioned before the accident and the additional need to find resources to rebuild the damage. The issue is how the government can raise the money for repair without raising too much debt, and without lowering the GDP. Both are crucial as Debt to GDP (Debt / GDP) is a measure used by international markets and the EU to judge solvency of a country.

The choices of the government are thus as follows:
a) Appeal for aid: This will be ineffective our traditionally major aid donors (US, UK, Greece), since they are already in debt trouble of their own. EU aid is a possibility.
b) Save: An emergency withholding of 5% of government wages to be used to repair Vasiliko will have little impact in terms of GDP as additional revenue created by the government wage bill (i.e. the multiplier effect) is very small.
c) Tax: Taxation will need to go up, but as taxation reduces output, this can actually still increase the debt to GDP ratio as the economy will shrink further.
d) Borrow: It will be at much higher rates that previously; thus government will still need to save through a reduction of government wages in order to afford the repayment of the debt. It will also lead our debt to GDP ratio at close to the levels seen in other Eurozone countries when they requested EU/IMF bailouts and hence we will be running the risk of handing fiscal control to outside organizations.

Choice A and B are by far the “least bad” choices. We must remember that even before the explosion we were talking about the need to lower wages in the government sector: this negligent homicide has me convinced that the best policy right now is an across the board reduction in wages, for both the government and the private sector, bit with an greater cut for the government employees.

This is not unprecedented in face of disaster; union agreed a large pay cut and an increase in hours worked after the 1974 invasion and it must be understood that what happened in the 11th of July is the second biggest calamity faced by Cyprus since independence.

A reduction in wages (especially if wage indexation is suspended until Vasiliko is repaired) can aid both with inflation low, and the reduction of the wage bill will allow for repair expenditure at Vasiliko.

What can we due to reduce this Macroeconomic costs:

1) Buy Cypriot:

Our producers of goods and services will need support since they are now competition with other EU countries while facing power cuts and higher costs.

2) Regular and planned power cuts:

The cost of planned outages is estimated at one third to one tenth of unplanned ones in Thailand, about one fifth to a quarter in Nepal, or about one half in Sri Lanka, etc. Planned outages reduce the microeconomic and macroeconomic consequences of the loss of Vasiliko.

3) Set up an Escrow account for repair:

The civilians, companies and government officials that might be requested to make monetary sacrifices will need to feel that such sacrifices are not misused. A separate account from central government accounts needs to be created, with deposits only being withdrawn if they are to be used to repair the effects of the calamity. This account needs to be transparently managed, allowing the people to make the sacrifices without feeling that accounts are misappropriated (i.e. it is not being used for dental work for government officials).

4) Wage reduction:

The government unions must now understand that there is not choice: the only real savings that can be made in the government budget, is a substantial reduction of the pay scale at all levels. This is the “least bad” way of financing reconstruction as it calms the markets and prevents us going to the international markets with a large amount to borrow. PASIDI, OELMEK and other government unions need to realise that the most patriotic think is to allow the government to withhold a 5% of their monthly wage in an Escrow account to rebuild Vasiliko, or else the whole economy will be in much greater danger of default.

5) Immediate debt restructuring:

We do not need to wait until we are in the position of Greece to ask the private sector to come to a new, more favourable deal with the government for the existing debt. Even if we can reduce debt repayment by 1% through such voluntary re-negotiations, this can release valuable funds for the immediate repair of the damage.

Sadly all of the above needs a government that is willing to be innovative and acts decisively fast, and the events since the 11th of July seem to indicate that the present government seems incapable of taking accountability, acting rapidly and being brave.

No comments: