Monday, September 6, 2010

Economics 6/9/10: Summer of missed opportunities

This is an unedited version of my column in the current edition of Business & Finance magazine.


To those of us who practice economics in the real world of markets and private enterprises, the homo economicus is a species endowed with the picture of the past but a vision of the future. To academics, economic reasoning is almost exclusively descriptive. This difference is not about the power or accuracy of forecasts. No one, familiar with the field would ever vouch in economists ability to deliver reliably accurate and useful predictions of specific outcomes.

Last few weeks offer a somewhat unusual, quasi-experimental insight into the future for Ireland Inc. July and August are the doldrums months in the giant global markets. Whatever happens around these months in Ireland, therefore, says more about our own capabilities and failures than what takes place in the rushed days of September and October.

So here is a picture of Ireland, then, in the Petri dish of our own policies.

Courtesy of the independent analysts first, followed by the IMF’s July report, we have learned that Irish Government deficit is doing the opposite of what the Government has hoped. Department of Finance projections for 2010 pencilled in 11.6% borrowing requirement for the Exchequer. May forecasts by the independents was for a figure ‘closer to 20%’. IMF July prediction is 19.9%. And that is before the latest spill of Anglo and INBS ‘bad’ loans news.

Overall tax receipts are now running €1,536mln below 2009 numbers for the first seven months of this year, and are still way off 2008 numbers by €5,520mln on 2008. This means we are now 8.22% below 2009 and 24.35% on 2008. Vat is €483mln or 6.9% below 2009, and €2,453mln or 27.5% behind 2008. And this is after the massive Vat boost from automotive sales increases driven predominantly by the vanity 2010 plates. Income tax shows a similar pattern: down €537mln on 2009 (-8.45%) and €1,060 on 2008 (-15.4%).


On the expenditure side, savage cuts to capital investment account for virtually all ‘savings’ achieved to date. This is fine, were the Government to undertake significant reforms in the current spending in the forthcoming Budget. However, all indications are that it will not do anything of the sorts.

The Machiavellian Croke Park deal enshrined in stone the very structure of pay and employment practices that makes up for one third of our gargantuan public spending bill. We even had a veritable drama performance befitting Abbey from the ICTU/SIPTU/CPSU leaders who worked tirelessly to ‘sell’ the deal to their members. The end result was the complete shedding of public sector liabilities onto the shoulders of ordinary taxpayers.

Social welfare reforms can at the very best be minimal in the current climate of chronic and continuously rising unemployment. In addition, timing of Liver Register increases suggests that many of the unemployed are close to exhausting their job seekers’ benefits and redundancy payments, pushing them deeper into the welfare trap. Add to this the fact that de facto the ruling coalition has no political capital left to fight its corner on a deep reform, and you have only one conclusion to make about the next Budget: prepare for savage tax increases all ye who hold a job!

This signal to the rest of the world and our own entrepreneurs and the workers in the productive (i.e. exporting) sectors is inescapable. Pro-business Ireland will hike your taxes to make you pay for the ‘industrial peace’ achieved in the public sector wards.

And it is highly unlikely that such policies can lead any significant stabilization of the Exchequer finances at any rate. Tax increases have been significant since the beginning of the crisis, yet tax revenues continue to decline. The fabled ‘stabilization’ across some tax heads to-date has been nothing more than the slowdown in the rate of tax receipts decline. There is no tax receipts uptick. Meanwhile, expenditure side remains worryingly sticky. The end game here is that the IMF (and even our own stockbrokerages – not exactly the paragons of critical assessment of the Government’s official position) are now predicting 2015 deficit to remain at ca 5.3% of GDP, more than 1.8 times the size of the deficit we promised to deliver to the EU Commission back in December 2009.

To put even more sparkle into Ireland Inc’s already shining portrait of competitiveness, the semi states are now desperately searching for any possible ways to beef up their revenues. Electricity costs went up to support such environmentally insane practices as drainage of bogs and burning of peat. As Richard Toll of ESRI summarised one side of Minister Ryan’s policy Bermuda Triangle – we are dumping a massive subsidy to producers of some of the most polluting energy the mankind can have. Transport costs are continuing to rise. All state-controlled sectors continue to show positive inflation through the entire crisis.


The other two sides of the said triangle are equally internecine. Firstly, hiking energy costs – one of the most frequently cited obstacle to our cost competitiveness – during a recession is equivalent to an economic sabotage. Secondly, the only real beneficiaries of this scheme will be semi-state companies, where ‘jobs creation’ costs multiples of what it costs in functional exporting sectors. In other words, given the ESB average rates of pay and value added in this economy, spending €85 million that latest price hikes will net the company in straight subsidies can ‘create’ roughly 3 times fewer jobs than using the same funds to support, say, a new pharma or IT firm entry into this market.

In the mean time, Irish banking sector continued to take on water. Losses in AIB and Bank of Ireland came to cumulative €3.9billion in the latter and a whooping €2bn in just six months for the former. Within days after their respective H1 2010 results announcements, both banks were exposed as having underreported their true loss by a cumulative €817 million thanks to a timing loophole. Anglo and INBS popped their ugly heads out of the somnambulistic slumber to ask taxpayers for €1.9 billion more in funds. Hence, within a span of just 4 months (post March banks pledges made by Minister Lenihan), Irish taxpayers were presented with more than €2.7 billion in new liabilities. At this rate, banks demands on our cash, that Messrs Cowen, Lenihan and, now, Honohan claim to be ‘one-off’ measures, will be running at an annualized rate of €8 billion – or over 26% of our entire 2010 tax take forecast by the Department of Finance.

All of the Ireland’s six state-guaranteed banking institutions remain firmly behind the reality curve when it comes to provision for future losses. Something that the Government appears to accept without a challenge, suggesting that instead of being an active large shareholder (and in the Anglo and INBS cases – the sole shareholder), our state is just letting the banks go on with the business of denying the obvious. Even the stockbrokers at this stage have stopped covering the banks with deeper analytical notes, resorting instead to a quick overview of the interim announcements.

Looking at independent analysis, through the cycle losses in banking institutions are expected to total €50-53 billion in total. This implies additional losses in the system of ca €22-25 billion, split between Anglo further losses of €9-12 billion, INBS losses of additional €2-2.3 billion, AIB further demand for capital in excess of already pre-announced to the tune of €8 billion, Bank of Ireland’s additional €2 billion and EBS €1 billion.

These estimates are based on the balancesheet analysis performed by the banking expert, Peter Mathews and my own modelling using past property and asset markets busts in the OECD, plus updated information from Nama and banks’ own results. The fact that the two estimates virtually converge by institution and in the aggregate gives us more comfort that they are closer to reality than the ‘hit-and-run’ numbers being produced by the banks and official analysts.

All in, my prediction is that Ireland’s state and quasi-state (e.g. Nama) debt pile will grow to over €210 billion by 2014, which puts into perspective the latest ‘successful’ auction of Irish bonds. At the yields achieved, financed with benchmark 10 year bonds, the debt accumulated through the deeply flawed banks recapitalizations and Nama, plus egregious current spending deficits will impose an annual interest bill of €11,310 million our economy. That’s right – by 2014 we are risking paying out more than 33% of our entire 2009 tax revenues in interest charges on the debt.

Adding insult to the injury, the Government has passed every opportunity presented to it so far to impose meaningful reforms on Irish banks. The latest missed opportunity came with the extension of the banking guarantees through December 31, 2010.

At the point of granting this measure to the banks – this time around absent the duress of an immediate crisis – Minister Lenihan could have simply required the banks to adopt deep changes in their operational models and strategies. Such a list could have included the following Nine Steps Reform Plan:
  1. Require banks to negotiate significant haircuts on subordinated and senior bond holders, including debt for equity swaps. Time frame – 3 months;
  2. Require banks to prepare detailed equity issuance proposals. Time frame – 1 month
  3. Require banks to prepare binding estimates of expected future losses through 2012 (3 months) which can serve as a benchmark for board performance on annual basis going forward;
  4. Require banks to reform their boards and board members reimbursement to be tied into long term performance by the bank (3 months);
  5. Require banks to create independent strategy, risk and operations oversight and advisory committees with the power of direct reporting to the Boards and external strategy and risk audits of the annual results (3 months);
  6. Require the banks to commit to a full root and branch reform of upper management (3 months);
  7. Force banks to accept salaries and bonus caps on all senior management and board members (1 month);
  8. Require banks to achieve conversion of existent outstanding mortgages to a tracker rate of euribor plus 225 bps (allowing the banks a ca 140-155 bps margin on all loans) whenever such a conversion is requested by the mortgage holder (6 months);
  9. Actively engage in the process of renegotiating mortgage contracts terms (e.g. maturity and payment schedules) with distressed households, under direct oversight of the Financial Services Ombudsman

At the time of public debate concerning the Guarantee extension, I made the above proposal public and brought it to the attention of several senior members of the ruling coalition. Despite this, and despite a clear cut need for deep reforms of the banks operations and strategies, Minister Lenihan simply opted to walk away from using another opportunity to change the way Irish banks are run.


All in, the summer of 2010 has proven to be a season of missed opportunities and foregone reforms. Whether in academic, or in practical economic analysis terms, this sets the stage for only one outcome to the rest of the year. Instead of engaging pro-actively in building the future of this economy, our leaders have taken to a role of being passive observers on a sinking Titanic of domestic non-exporting economy. The cost of this inaction is likely to manifest itself through a Japan-styled long term recession and a rising burden of the state and its clientele (the banks and semi-states-dominated sectors) on the society at large.
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