Economics 20/01/2010: Knowledge Economy and Dublin Water woes

It is beyond any doubt that Ireland has had its share of bizarre unlucky events and disasters:

1. Man-made crises: economic recession, banking collapse, fiscal meltdown, construction/property bust and policy/regulatory legitimacy, a schism between the public sector and the ordinary folks trying to make a living (yes, it is back - industrial strife is now clogging our transport and threatening our healthcare system);
   
2. Natural: swine flu, measles pandemic (remember that one?), floods, a snow storm, a freeze, most current - vomiting bug is apparently back;
3. Natural/man-made: water shortages (with parts of the country still covered in floods).

There have been severe costs imposed on people and the economy at large. And there are lessons to be learned and, hopefully this time around - few people responsible for (1) and (3) to be punished.

But one lesson has not been discussed to date. Recall a year ago, the Government came out with a grand plan for creating a 'knowledge' economy in Ireland. This plan is still alive (as plans go), although, of course, nothing has been done to deliver on its promises. Now, the EU is about to come out in February with a comprehensive platform for building a brighter better Union through 2020. I've seen the document. It too aims for 'Knowledge Economy' thingy.

So now to the lesson of our crises: 'Knowledge Economy' needs functional, efficient and excellent services. Public and private. Functional, efficient and excellent services is what our public sector simply cannot deliver.

That was, of course a two part proposition.

Let us take the first part: 'Knowledge Economy requires functional, efficient and excellent services". I hope this is pretty much apparent:

• PhDs and high quality entrepreneurs who will fuel the 'Knowledge Economy' will require good housing (as opposed to substandard shoe-box apartments we built for cheaper laborers during the Celtic Tiger boom), good on-time and on-schedule transport systems (as opposed to completely random travel times at Dublin Bus), cheap and quality air connections to the rest of the world (as opposed to what passes for airport out on the North side of the city), high quality healthcare (as opposed to waiting lists for tests and procedures measurable in light years instead of days), affordable and superior in quality education for their children (as opposed to schools where teachers do not engage in any post-university life-long training and where doors are shut after 3 pm - when the rest of us, mortals - have to be at work) and so on. They will require parks that are safe and pleasant, the sea front that is free of industrial rubble and incinerators. And air that is clean.
  
• PhDs and high quality entrepreneurs who will find these services wanting in Ireland will require either a much higher rate of pay, making their output, no matter how much 'Knowledge'-infused it might be, uncompetitive in the world markets. Alternatively, they will simply move on to build 'Knowledge Economy' somewhere else - in Paris or Singapore or Hong Kong, where such services (also known as inputs into the 'quality of life') are better and more efficiently supplied.

Agree? Ok, second part of proposition needs to be proven. Does it? Really? Anyone still believes that our public sector delivers excellent services? Or that the shambolic quality of these services has nothing to do with knowledge economics?

Instead of proof - an example. We all can agree that our nation's top university is and must be at the centre of the 'Knowledge Economy' activity. It must be its heart. Well, the speed of the body is related directly to the speed of the heart beating. Here is a snapshot:

From today's email to faculty and students (this is a second such notice this week):

"Dear all,

As we are all aware following the severe cold weather...

Within College we use a large amount of water and must during this period make an additional effort to reduce our water consumption. ...The following water saving tips should be considered by all [I omit the measures proposed that actually should be a normal practice for all times, not just at the time emergency]:

· In laboratories reduce water consumption for vacuum pumps and water cooled condensers

· Ensure all water supplies are turned off when experimental work is complete

· Only run dish washer, glass washers and autoclaves when full

· Consider can any experimental work consuming water be stopped during the current water crisis"

Of course, conserving water is a good practice - it is a scarce resource and should not be wasted. But if three days of snow and -3 degrees temperature can stop experimental work and lead to reduced operational capacity of our best University, are we really getting the public services that can support 'Knowledge Economy'?

I personally don't think so. So why on earth have our policymakers - wise enough to set numeric targets for PhDs well into the first half of the century and capable of producing tomes after tomes of white papers on 'Knowledge' economics - have so utterly failed to even mention the need for proper electricity supply (yes, TCD routinely warns staff that the University is teetering on the top edge of its supply capacity and that ESB supply might be disrupted) and decent water supply?

Before science and technology policy proposals, shouldn't we be first served with a decent emergency response system that can make sure flooding is contained when it happens, roads are gritted when the icy conditions advance and water/power/communications/gas/energy are delivered when adverse weather hits? It might be not 'Knowledge'-intensive and not too glamorous of a task, but it would serve a much greater purpose.

Economics 20/01/2010: Banking Inquiry

I have three simple points to contribute to all the discussion concerning the Banking Inquiry proposals:

1. Any Inquiry must be fully public, to the point of live television broadcast of all proceedings. Imagine a case of not one, not two, but six largest hospitals in the nation recording serial acts of systemic malpractice that were to result in some Euro 70 billion worth of damages. Would Mr Cowen call for a closed-doors inquiry?
2. Any Inquiry must be swift and must lead to convictions and severe punishment of anyone found guilty of malpractice or non-fulfillment of duties (including public officials in charge of regulatory and supervisory functions, should they be found guilty). Imagine a total collapse of six largest bridges in the country at the peak traffic - would Mr Cowen sum up the situation as 'We are where we are, now is not the time to deal with the past'?
3. Any Inquiry that does not cover Nama and Banks Guarantee scheme will simply fail to deliver full account of the causes and the full extent of the damages caused by the current crisis. This is why I oppose an idea of the 'wise men'-drafted preliminary report to set terms of reference for the second stage inquiry. Given this Cabinet will be selecting the 'wise men', I have serious doubts as to the integrity of the process or the group put in charge of restricting any direction of the future inquiry.

Ireland needs its own Truth & Reconciliation Commission to deal with the systemic failures of our supervisory, regulatory and banking systems. If public operation of such a Commission results in irreparable damage inflicted on our banks - how can one tell? After all, with Anglo at the helm, these banks have already done enough to damage themselves. The price of keeping them alive on artificial respirator of paucity, opacity and public cash is the collapse of public trust in our institutions and in our financial system - a price that is much higher than the withdrawal of all international bond holders from Ireland Inc can ever be.

After all, am I the only person one noticing the complete and total ethical collapse of our social system that takes ordinary folks' money to pay the cost of the full and unlimited guarantee of the (largely) foreign bondholders in Irish banks, while their own deposits are now under the risk of being covered by a limited guarantee up to Euro100K?

Economics 20/01/2010: Long term comparatives for Ireland

Some time ago I promised to publish some long term macroeconomic comparatives for Ireland relative to other small open economies of Europe. Here they are (all data is courtesy of the IMF's Global Economic Outlook dataset with some forecasts adjusted to reflect Government own forecasts in Budget 2010):

First output gap as percent of potential GDP

There is really no doubting who's worse off in this picture. And notice how much more dramatic is our output gap volatility compared to, say, Austria - another small, but more stable economy, despite it having a massive exposure to high growth and high volatility Eastern and Central European countries.

Next, we have GDP per capita.

Several features of the chart are worth highlighting.

Obviously, Iceland is now on the path, per IMF to close the gap between themselves and us in terms of GDP per capita. Dynamics-wise, it is expected to do better relative to Ireland than it ever did in the period since the late 1990s through the bubble. Taking medicine on time and in full, obviously pays for Iceland. Back in 1999 Ireland moved onto a path of GDP per capita in excess of Iceland. In 2009 it moved on the path of GDP per capita converging with Iceland.

Who's doing better here? By the end of 2014, Iceland is expected by the IMF to fully recover from the crisis, reaching peak GDP per capita once again, after a shorter recession than the one enjoyed by Ireland. And Iceland will do so with faster growth in population than Ireland will (see later charts).

Under DofF dreamy assumptions, Ireland too will reach its pre-crisis peak by 2014, but it would have taken us a year longer to get there than Iceland. And this is under DofF assumptions.

Now, I also provide my own forecast - somewhat gloomier than that of the Government - which implies that i do not expect Ireland to reach the pre-crisis peak income per capita any time soon. And this dynamic will be paralleled by a slower growing population.

Also, do remember - our GDP is not a measure of our income (GNP is), while for Icelanders the two measures are more closely related.

Next inflation as measured by CPI:
Do tell me we are just fine with 5% deflation in the current cycle. Not really, folks. In order to get us back to price levels that imply competitiveness, we need a good 40% deflation if not more.

Unemployment - the one that we are being told is getting better now that 'the worst is already behind us' per official Government view:
Again, think Iceland and Greece. Greece is a good one in particular - their unemployment was high since the late 1980s. Ours was low since the mid 1990s and sub-zero since 2001. But, thanks to our 'head-in-the-sand' economic policies during the current crisis - we are now at the top of the league.

Demographics - some say this is our saving grace, the golden 'get-out-of-the-slump' card:
Nothing spectacular that I can spot here. And these are IMF projections that lag in incorporating what we, on the ground already know - the rapid depletion of our foreign workers' population and waves of young Irish people leaving the country.

Let's take a look at employment (as opposed to unemployment) as % of the total population. basically, the higher the number, the lower is the country dependency ratio (in other words, the greater is the number of people working than the number of people they support):
We were doing pretty well - just below Iceland and Switzerland. Post crisis, Iceland will retain its second best position, but we will slide below Lux. Again, this is in the environment where our population will be growing slower than that of Lux...

General Government Balance:
Well, yes - per Brian Lenihan we have taken the necessary steps... Did we? How is fooling who here? Iceland will be ahead of us with default and without a mountain of international bondholders' and depositors' liabilities on the shoulders of its people. We will both, destroy our public finances and our private households' finances as well. All for what? To make sure we do not upset banks bond holders? But wait - these figures do not reflect Nama and its cost. They do not reflect future bank recapitalisations. Were they to do so, our Government Balance would have fallen way beyond 16-18% mark.

But let us take a different look at the same figure:
Now, remember all the talk about Charlie McCreevy being a profligate spender as the Minister for Finance. Actually, not really. Over his tenure - longer than that of his successor, McCreevy presided over relatively mild deterioration in fiscal position. Primary balance under McCreevy in cumulative terms was close to break even. Under Minister Cowen things spun out of hand. Noticeably, Minister Lenihan is doing a much better job than his predecessor, although it is hard to say whether he is doing it because he actually believes in some sort of fiscal discipline or because he simply cannot borrow all the money he would like to borrow.

Current account balance:
For an economy that is staking its survival on exports (and we really do not have much of hope of doing otherwise), we are not looking all too strong in 2010-2014 projections by the IMF. Iceland, in contrast, is looking mighty alright relative to us, having undergone massive devaluation. Again, our deflation at home is simply not enough to compensate for the fact that we cannot devalue the grossly expensive euro.

Let me take you through more comparatives. Back to Government deficits. Now, recall there are two components to deficit - structural (due to chronic overspend) and cyclical (due to a recession).
Again, notice how Greece and Austria are on virtually identical path, although Greece is above Austria. This means that on average, the share of their overall deficit that is structural is relatively the same. If Greeks were to cut their structural deficit relative to its position today, their overall deficit will decline by a lower percentage than the same drop for Ireland. In Ireland's case, we have smaller cyclical deficit than the Greeks do, but greater structural deficits. Relative to Austrians, we are simply a drunken sailor hitting the first pub on the shore.

Take a closer look at the Irish data alone:
In the 1980s through late 1990s - much lower structural deficits than since 1998. Why? I guess Bertie really was a profligately spending socialist of the old variety.

Last chart: just to drive home the same point as before: Note the dramatic deterioration in structural balances under Mr Cowen - throughout his years as Minister for Finance, he was spending not only the money he had (shallower surpluses than his predecessor), but also the money he did not have (deeper structural deficits), leveraging lavishly future generations' wealth. Mr McCreevy, in contrast, really was spending what he had, with structural deficits starting to cause problems in his tenure only around 2002.
And one last point to make - notice how our structural deficit has caught up with its 5-year moving average line. This suggests that even in the Budget 2010 we still did not do enough to reverse longer term trend leading us deeper and deeper into permanent insolvency.

Paraphrasing Fianna Fáil's 2002 general election slogan: "A Little Done, More To Do"...

Economics 19/01/2010: Irish banks - a rational model of risky strategies

I just came across a very interesting paper, written back in November 2007 and published by the Bank for International Settlements as a Working Paper No 238. Authored by Ryan Stever and titled “Bank size, credit and the sources of bank market risk” the paper “…examines bank risk by investigating the equity and loan portfolio characteristics of publicly-traded bank holding companies.” The study is based on the US banks, with sample being a panel of ‘at least 339 publicly trades BHCs at each point in time” for the period of 1986-2003. “These range in size from American Bancorporation at $31 million in book assets (200 employees) to Citigroup at $1.26 trillion (over 280,000 employees).”

“Unlike the pattern for non-financial firms, equity betas of large banks are two to five times greater than those of small banks. In explaining this, we note that regulation imposes an effective cap on banks’ equity volatility. Because the portfolios of small banks are less diversified, this cap has a greater effect on small banks than large banks.”

In other words, there is plenty of evidence that even when effective, regulators can induce some unintended consequences onto the banking system and that these consequences, if unaddressed can lead to systemic failures.

Here is how it works:

• Regulators (and/or shareholders through exercise of their voting rights) place a limit on the total volatility of each bank’s assets regardless of size, which tends to minimize bank risk; however
• Small banks have more idiosyncratic risk inherent in their loan portfolio “because they cannot diversify away idiosyncratic volatility as well as large bank” (practically – smaller banks are more specialized, making their loans books more exposed to idiosyncratic strategy risk).
• Smaller banks inability to diversify comes about in “a number of different ways – for example; less total loans held, less diversity in borrower type (they do not have access to large borrowers) and geographic restrictions (small banks tend to be more localized);

 Because their total equity volatility is limited by regulation smaller banks must then find a way to eliminate their idiosyncratic volatility that is in excess of larger banks’ idiosyncratic volatility. To do this, small banks do not necessarily pursue higher levels of equity capitalization or lending to different sectors in the economy – in other words, they do not strive to become like larger banks, but instead they either:

•  make loans with less credit risk than large banks (Swiss private banks, for example). This has the effect of reducing idiosyncratic volatility (as desired) and also reducing the beta of each loan (and thus the equity beta of small banks); or
• demand more collateral (e.g. Irish banks).
  

Of course, the problem with selecting the latter path (beefing up collateral) as opposed to the penultimate pathway (more conservative, risk-sensitive lending) – as Irish banks should have learned from the current crisis – leads to additional problem, not highlighted in the study. This problem is manifested in the selection bias induced onto collateral – smaller banks opting for higher collateral requirements will take on less diversified collateral that is more likely to be positively correlated with their own (risk-skewed) loans books. Thus collateral risk becomes positively correlated with loans risk.

Just think of what type of collateral Liam Carroll was supplying for his property development loans? You’ve guessed it – property-based collateral.

In fact, the study does find that small banks did not lower their equity volatility through lower leverage. Instead, “the reduced ability of small banks to diversify forces them to either pick borrowers whose assets have relatively low credit risk or make loans that are backed by relatively more collateral.”

Economics 19/01/2010: Nama - adverse selection is happening

Newspapers today are reporting that banks may be pressuring Irish developers to sell their UK assets to write down the loans that are bound for NAMA. This is an interesting development. As UK market has shown some signs of revival (although these signs are tenuous at best), prime properties with less recent vintage can be sold off to generate cash to pay down some loans. Now, the problem for Nama is that of selection bias.

On one side of this equation, developers willing to do this will be disposing of the more liquid and better properties, depleting their own risk-weighted assets base.

They will be using cash to pay down the loans that are marginally at the boundary of being transferred to Nama. Why? Elementary, Watson!

Suppose Nama imposes a discount of 30% on your loans. You have two loans. One is recoverable at 80%, another at 0%. You have a choice – pay down one loan and let the other go Nama. If you take loan A with 80% recovery, you get 70cents on the euro from Nama. If you hold it to maturity you get 80 cents. If you take loan B with 0% recovery, you get 70 cents on the loan from Nama and zilch from the market. Guess which loan will be repaid and which will be heading for Nama?

In the mean time, naïve and inexperienced in collection and recovery business Nama is still sticking to 30% average discount claims, thus further incentivising this adverse selection process against itself. NAMA chief executive Brendan McDonagh few days ago repeated this much.

So the end game here is that, if the banks are successful, even poorer quality loans will be transferred to Nama, while Nama’s CEO is running around town committing himself to valuations before any valuations are even done.

Lovely.

Economics 18/01/2010: Systemic Risk Regulation EU-style

Before we dive into the issue of Systemic Risk Regulation, a quick note on travel industry troubles (those who would like to do so can skip down to the second topic)

Some of the readers of this blog and of my articles in press disagree with my assertion that high charges at the Dublin Airport and the travel tax imposed on passengers matter to our travel figures. I have wrote before about:

• an independent Government group report calling for abolition of the tax, and 
• on an independent economic assessment from international transport economics consultancy linking travel tax to jobs losses and revenue collapse in the sector; and
• evidence on routes closures and aircraft cut backs that were explicitly linked by the airlines (Ryanair, EasyJet and Aer Lingus amongst them) to the charges and taxes collected in Dublin. 
• Withdrawal of BMI earlier this year from Dublin, with a loss of 30 jobs and some 300,000 passengers was also not enough.
  

This was not enough to convince some. Sadly, many continue to insist that protectionist barriers to travel (trade) are an effective means for ensuring viability of Irish tourism and domestic sectors (see last Sunday Times letters page).

Now, Irish media reports that the DAA will be offering substantial discounts to airlines that launch new short and long haul services, amounting to 25-100% cuts in charges for the first five years of a route opening.

Of course, DAA had seen a 17% year-on-year drop in traffic in December 2009, while Cork saw a decline of 15.5% and Shannon – 29.9%.

Offering deep discounts is a funny thing to do, if the charges and taxes were not the problem with traffic in the first place. Unless, that is, people like myself have been all along correct in stating that high costs of services provided by the DAA (inclusive of travel tax – which DAA had nothing to do with) act as an impediment to sustaining tourism and business travel to Ireland.

It is a basic feature of international trade theory and practice – tariff protection does not work. Not in the short run, nor in the long run. Visitors to Ireland are price-elastic, while many of us, living here with families and connections (personal and business ones) overseas are less so.

Hike tax and foreign tourists will have a greater ability to avoid coming here, while domestic travellers will have to adjust their expenditure (abroad and at home) to cover the additional cost.

What the former means is that a Spanish person deciding on where to take a city break will be less inclined to chose Dublin or Ireland in general because of a higher tax/cost.

The latter means that an Irish person going to, say, Paris, will have an added incentive to shop there more (to generate greater savings over the comparable purchases in Ireland and thus compensate herself for extra costs incurred in travelling) or equivalently – to shop less in Ireland (to avoid incurring added cost). Both effects act in the direction of reducing total revenue to businesses based here.

Ann Siebert has weighed in on the issue of systemic risk regulation in Europe in today’s voxeu column (here):

"Any committee dealing with assessment of systemic risks “should be small and diverse. …ideally it should be composed of five people: a macroeconomist, a microeconomist, a financial engineer, a research accountant, and a practitioner. …As the size of a group increases so does the pool of human resources, but motivational losses, coordination problems, and the potential for embarrassment become more important. The optimal size for a group that must solve problems or make judgements is an empirical issue, but it may not be much greater than five. The reason for diversity is that spotting systemic risk requires different types of expertise. A board composed of entirely of macroeconomists might, for example, see the potential for risk pooling in securitisation, whereas a microeconomist would see the reduced incentive to monitor loans.”

Needless to say, these are not the principles taken on board by Nama and the Irish banks. Nor is it an approach even being discussed for the Irish Financial Regulator or the Government. Why? Why not?

“The committee should be composed of researchers outside of government bodies and international organisations; career concerns may stifle the incentive of a bureaucrat to express certain original ideas. It is of particular importance that the board not include supervisors and regulators. [Again, look at Nama – virtually the entire top management of this organization is composed of  people unqualified to deal with the task of spotting structural risks]. This is for two reasons. First, it is often suggested that supervisors and regulators can be captured by the industry that they are supposed to mind, and this may make them less than objective and prone to the same errors. Second, a prominent cause of the recent crisis was supervisory and regulatory failures, and these are more apt to be spotted and reported by independent observers than the perpetrators.” [No illusions here - Nama is captured by the industry, and to boot - by the worst parts of the industry, not the best.]

"Finally, it is important that the board be made sufficiently visible and prominent that a member’s career depends on his performance. Given the importance of the task, pay should be high to attract the best qualified, and the members should not have outside employment to distract them.” [Good luck to anyone who thinks that Nama board or any of its risk structures will come close to these parameters, except one - they will be handsomely remunerated for their work].

Alas, this dreamy transparent and professionally sound proposal is too late, even in the EU case, for: “The Eurozone has already swung into action, creating the European Systemic Risk Board (ESRB), set to begin this year. Unfortunately, this board, responsible for macro-prudential oversight of the EU financial system and for issuing risk warnings and recommendations, is far from the ideal. It is to be composed of the 27 EU national central bank governors, the ECB President and Vice-President, a Commission member and the three chairs of the new European Supervisory Authorities. In addition, a representative from the national supervisory authority of each EU country and the President of the Economic and Financial Committee may attend meetings of the ESRB, but may not vote. This lumbering army of 61 central bankers and related bureaucrats is a body clearly designed for maximum inefficiency; it is too big, it is too homogeneous, it lacks independence, and its members are already sufficiently employed.”

Pretty much on the ball, I would say.