Cleaning out the cobwebs | Karm Farrugia

Interviewing veteran economist Karm Farrugia a few days before the Budget does have its advantages, not least on the personal education front. Not only am I in for an intensive crash course in local and international economics... but I also learn to find my way around the otherwise uncharted territory that is Madliena heights, where I quickly manage to get totally and irretrievably lost.

Farrugia eventually gives up trying to give directions over the phone, and drives out himself to meet me halfway. It marks the beginning of a very steep learning curve, from which I will eventually emerge a little wiser, yes... but more than just a little dazed.

I decide to kick things off with a simple observation: just before our interview, it was announced that European Commissioner Ollie Rehn publicly clashed with Finance Minister Tonio Fenech over deficit reduction projections. Fenech argues that he will reduce the national debt to 2.8% by the end of the year; Rehn sees this as unrealistic, and predicts that the deficit will stand at 3.5% instead. Which does Farrugia think is the more realistic scenario?

"First of all I have to commend Tonio Fenech for standing his ground like that. Challenging the Commission is not an easy thing to do. He has a lot of guts..."

"Governments in debt love inflation."

 

However, Farrugia's take on the predictions themselves is impartial. "I think Fenech is determined not to do what they think he'll do. But what he is actually planning, I don't know. He says he has a different way of going about things. Perhaps he is not assessing the force of the storm clouds on the horizon sufficiently in the eyes of the Commission. We'll see in tomorrow's budget..."

Farrugia does not disguise his admiration for Fenech as a 'doer', and is clearly willing to give him the benefit of the doubt when he says his own targets are attainable. "Considering that he started with a deficit of 5% at a time when the world was entering recession in 2008, and somehow still managed to reduce the deficit... that was an achievement. I'm not commenting on his methods, mind you. The methods he used were partly economic, but mostly political..."

As things stand, the only 'negative mark' Farrugia gives the Finance Minister was over the decision to charge full rates for water and electricity: a factor which has since pushed up inflation and undermined Malta's competitiveness... although Farrugia argues that utility bills are now no longer the overriding inflation contributor.

"The cruel thing is this: at present our rate of inflation is more than double the average rate of our partners in Europe. And yet, this year the utility rates have not gone up at all... except for a small raise affecting gas prices. And yet, inflation stands at around 2.5%."

Farrugia argues that the gas price hike alone cannot possibly account for this figure. He argues that there must be other forces in the economy pushing up the cost of living: forces the government is familiar with, but is "unable or unwilling to do anything about".

"This increase in inflation cannot be caused by labour costs. Our wages have just about covered cost of living - thanks to COLA. But Tonio Fenech should investigate why inflation is so high in 2011. There is clearly a worm eating away at the heart of the economy. I see no reason why our inflation should be double that of the rest of Europe..."

However, Farrugia spares Fenech the bother of investigating by elaborating his own explanation instead. According to him, the problem concerns competition: which exists aplenty in retail... but not at all at importation stage.

"There must be a hidden agreement not to compete at the level of importation. An unofficial cartel, if you like. Otherwise, why the inflation? When you consider that most of our imports come from Europe - VAT-free, and without customs duty to be paid... why are certain goods more expensive in Malta than anywhere else in the EU?"

Farrugia reasons that, at some point in the path of distribution, operators are not being allowed to compete. "One example we all saw very recently was the cost of medicines. Government is boasting (rightly) of a reduction in the price of certain medicines. I commend the government for taking action in this respect: but that is only a case of clearing out the cobwebs. Where is the spider? This is the question government should be asking if it wants to seriously address the problem." 

Farrugia points out that medicines - while certainly an important consideration - are not the only products affected by artificially inflated prices. "Foodstuffs are another example, but here there has been no attempt to adjust prices. If government is in the know, and yet does nothing, then its motivations are clearly political, not economic..."

What political interest could government have in keeping inflation high, I naively ask? Farrugia pauses for a moment, then slows to the pace of a teacher repeating a point for the benefit of the more backward students.

"Growth and inflation are the best friends of government," he begins, exuding patience. "Growth translates into more revenue for government; inflation reduces repayments on loans. It helps the financial state of government... which by the way is distinct from the economic state of the country. In a nutshell: governments in debt love inflation..."

Farrugia adds that these are also among the factors that make it easier for Tonio Fenech to predict deficit reduction to 2.8%. "But there are still six weeks to go until the end of the year, and even then, we will have to wait until March for this year's financial statistics. Still, there are forces working to Fenech's advantage, and others against him. High growth rate of around 2%, as well as high inflation - not to mention an increase in exports this year - are all plusses for the government...  bearing in mind I am looking at this from a purely economic, and not political, point of view".

The forces working against government, Farrugia goes on, involve the constraints imposed by EU membership, and above all, membership of the eurozone.

Turning to the increasingly bleak European scenario, Farrugia points out that prognostics are not helped by the fact we are surrounded by so many partner countries in trouble.

"Even Germany, the powerhouse of Europe, is now afraid that its growth figures are on the decline: thus risking its ability to finance the correction of the crisis."

But if Germany is starting to worry, what are we to make of the apparently insurmountable crises facing Italy and Greece?

"These countries abused the advantages of the eurozone," Farrugia begins when I ask for an overview of the situation. "They relied on the strength of the euro to hide their internal economic deficiencies. If they had their own currency, they would surely have been more careful in their decisions. But they took shelter behind the euro; and this marks the difference between what happened in Malta..."

Farrugia argues that Malta was, by way of contrast, 'on its best behaviour'.

"We did not take advantage of the strength afforded by the euro. We entered the eurozone on our own merits; the others cooked their books...."

As things stand, the only possible criticism concerns the timing of our entry. "First of all, eurozone membership itself was a condition of EU accession. There was no real choice about it. So the question was not whether we should join, but when. I admit I was surprised than government took only three years from EU accession to join the eurozone. Why so much hurry? We could have taken four or five years... but then, with hindsight, we would have entered the zone only to face a global recession. As things stand, government's haste stood us in good stead: though whether this was the result of foresight or good luck, I can't say...."

Such a speedy, successful eurozone membership also brought with it immediate advantages. "Up until 2007, the central bank had a lot of investments in other currencies to bolster the Maltese lira. Once we were in the eurozone, these investments were freed up, allowing government a little breathing space..."

Nor was this the only factor that placed Malta in a slightly better position to face up to the international crisis. "The background to all this is that the Maltese have always been good savers. In the past, it was typical for some 20% of disposable income to be saved. Today, that figure is down to between nine and 10%: lower than usual, but still relatively high compared to other countries. This has traditionally enabled banks to be full of liquidity. Banks have always had funds to invest... which I need hardly add is a good thing. On top of this, the banks' coffers were further boosted by a recent tax amnesty, which brought 'hidden' funds out into the open, where they now contribute to the economy..."

This pre-empts a question I was going to ask anyway: the same amnesties were much criticised at the time - among others by the GRTU - which described them as a 'money-laundering exercise'... 

Farrugia nods. "Yes, but these are political considerations, not economic ones. I'm not saying that the amnesties were necessarily right from a moral point of view. People might argue that it is unfair on those citizens who have done always things by the book. You can even say it is an example of rewarding people for breaking the law. But my concern here is with the effect of these decisions: which in this case was beneficial to the economy. Whether it was morally correct or not is another question..."

Either way, the initiative translated into massive liquidity, conveniently for government at a time when its deficit was high. More fortuitously still, local banks did not (as other countries' banks did: for instance, Iceland's) encourage investment in European sovereign bonds.

"With hindsight, it is hard to say whether this was the result of foresight and planning, or just plain good luck," Farrugia observes, "though in my opinion it probably had less to do with foresight, than with the fact that local banks had at their disposal a much better source of revenue anyway. They encouraged a lot of people to invest in collective schemes, bonds and shares, and made their money through commissions. Having said that, there were occasional exceptions, such as the BOV property fund: BOV should really be whipped for its handling of that particular issue. But by and large, banks found it far more lucrative to invest in local schemes than foreign ones..."

Separately, Farrugia observes that government can also take some credit for the resulting economic serenity. "The banks should be grateful to government, for enabling them to make huge profits in ways that other banks couldn't... for instance, by charging a withholding tax of 15%, which also encouraged hidden funds to become mainstream."

Again, Farrugia stresses that he is limiting himself to looking at things only from an economic point of view. "As an economist, I view this as a good thing. Politically it's a different story..." 

But while Farrugia paints a rather rosy picture of Malta's economic situation as infinitely more stable than either Italy's or Greece's, there is one aspect where the foundations can be seen to be a little shaky. Part of the current eurozone crisis can be traced back to 'hidden' or undeclared debts that never showed up in the figures presented by countries like Italy and Greece to the European Commission: monies that were tied up in what have since been euphemistically termed 'special purpose vehicles'.

On at least one level, there is an analogous situation locally: government debts associated with corporations such as Enemalta and Water Services Corporation are likewise not included in the financial reports sent to Brussels... and are rumoured to run into very large figures indeed. Doesn't this also qualify as hiding debts through 'special purpose vehicles'? And if added to the national debt, wouldn't the money owed by Enemalta, etc., throw government (and Commission) projections into disarray?

Farrugia acknowledges this to be a serious downside. "The issue concerns the way these corporations are actually financed. If government loans the money to Enemalta and WSC, among others, it does so indirectly. The corporations are technically financed by the banks; it is the bank loans that are guaranteed by government. Theoretically, all these loans will one day have to be paid back... if and when the corporations manage to make a profit. If not, there will come a time when the banks go knocking on government's door,

asking it to make good on its guarantees. If or when that happens, then yes, those debts will suddenly show up on government's finances. Until then, however, they will not be added to the cumulative deficit..."

So shouldn't this shortfall also be counted as part of the national debt?

"Of course it should," he replies without hesitation. "But the way the Commission looks at these things is slightly different. From an accountant's point of view, those debts do not constitute an actual debt on the part of government; but only a potential or contingent debt. It will become debt when the loans are called in. But until that day, there is always the possibility - however remote, that Enemalta may in future turn things around and become profitable. So the Commission will not consider the amount owed to national corporations - which, if you add up all such guarantees given by government, will amount to around €1 billion, over and above the declared deficit of €4 billion - as part of the national debt. Otherwise it would be different story..."

Meanwhile, Farrugia suggests that the government has yet another ace up its sleeve: its own people.  "Luckily, the Maltese still have faith in government, and is happy to lend it money. Otherwise, government would have to borrow from overseas; and that's when the trouble will really begin..."