Craig Simmons ...Cont.

For the first time, a PLP government will not have the luxury of windfall tax revenues to support its less than stellar capital spending record .  The people of Bermuda will also have to expect and live with fewer government services whist paying more for those that remain. 

         It is highly probable that this and last year's budgets will have current account deficits.  This is historically significant.  Fiscal tradition dictates that the current account be in surplus, i.e., current government spending should not exceed tax revenues.  The surplus is used to partially fund capital projects.  Tax revenues are down whilst spending has increased as planned.  Next year should be no different.  A government stimulus is needed.  Deficit financing cannot be avoided.  The question is, 'what type of policies will give the people the biggest bang for their tax dollars?'  Should the stimulus package emphasise increases in capital spending or targeted tax cuts.  Historically, governments like capital projects, but given that the necessary spending controls are not in place, this option is less attractive than it should be. 

Tax cuts have the advantage of not increasing the physical size of government.  There is research to suggest that a $100 million payroll tax holiday on Bermudian jobs would do more to fight the recession than the same spent on capital projects [2] .  When targeted at jobs that pay fewer than $50,000, working class women and men will spend more.  Employers will have an incentive to create jobs for working class Bermudians and those who do will be rewarded.  Tax cuts are easier and quicker to organise than capital projects.  A working class tax cut also has the benefit of spreading beyond the construction industry into areas that are more representative of the labour force [3] . 

Stimulus will likely be needed until the end of 2011.  Until then, the debt will rise to over a billion dollars.  By 2012 spending will have to decrease, followed by tax increases in 2013.  If the economy can begin to grow within two years, the current account could return to surplus and debt repayment can start in earnest by 2017.  As our friends in Iceland recently discovered, it is the taxpayer who is ultimately responsible for the debts of a country's banking system.  Whilst a bank's profits are its own, its losses, if big enough, can be passed onto taxpayers.  This is the moral hazard problem.  With that in mind in addition to society's need to avert another property bubble, Government or more specifically Bermuda Monetary Authority (BMA) should limit the financial services industries ability to produce credit.

Presently, private debt stands at over $6 billion.  This includes $5.2 billion in Bermuda dollars and $1.1 billion in foreign currency, according to a December 2009 BMA regulatory update.  Local banks are overly exposed to both interest and exchange rate risks on their foreign currency loans and have a highly leveraged loan book. 

These exposures are potentially destabilising to the macro economy and more specifically to credit markets and the construction industry.  BMA regulation should seek to reduce fragility in the financial system caused by asset price bubbles, leverage, current account imbalances and under pricing risk.  There are a number of policy instruments at the disposal of BMA policy makers.  Banks' capital ratios can be raised if leverage appears excessive.  Loan-to-value ratios can be decreased to restrained housing prices. 

Between 1998 and 2008, foreign currency borrowing increased at an annual average of 17 percent.  Such credit creation is partially responsible for the housing bubble.  Capital controls can slow foreign currency borrowing by reducing incentives on short positions.  The carry trade, popular when banks can borrow at low US interest rates and lend to locals at a higher rate, is a case in point.  Yet another instrument would require banks to back their foreign currency loans with reserves deposited at BMA.  Alternatively, a tax could be levied on short-term debt or minimum-stay requirements placed on loans [4] . 

Private and public debt reduction will suppress consumer and investment spending and therefore growth.  But this is to be expected after nearly two decades of excess. 

The island is in uncharted waters.  A storm is upon us.  The Bermudian thing to do is to hunker down, placing our confidence in time-tested building practices.  The analogy extends to the economy.  Our economic infrastructure is beyond sound.  There is no doubt that when the global recession's grip weakens, growth will resume.  One lesson to be learned is that taking on debt, whether public or private, at an unsustainable rate is bad.  The other is that we seem not to learn, that we don't learn. 

^[1] Exit strategy: process by which public debt will be reduced.  E.g., ¯ G_K by X%; ¯ G_C by Y%; ­ T by W%; ­ sinking fund payments by V%; ¯ borrowing by V%; 2020 target for (debt/GDP) = 4%

^[2] Christina Romer, Chair of the Council of Economic Advisors, THE MACROECONOMIC EFFECTS OF TAX CHANGES: ESTIMATES BASED ON A NEW MEASURE OF FISCAL SHOCKS

^[3] Women make up the majority of the Bermudian labour force. 

^[4] All of this is a moot point if deflation risks increase.  Inflation-adjusted retail sales have been declining since April 2008.  We infer that consumer spending, which comprises 65 to 70 percent of GDP is also declining.  As the construction industry slows, investment spending (11 to 15 percent of GDP) also contracts.  A lack of domestic spending has helped bring inflation down to two percent.  Further declines in spending run the risk of initiating a vicious cycle of declining spending, job losses, and lower wages, followed by lower prices to stimulate demand.  But demand does not respond, so more jobs are lost.  This is deflation.