Economics 31/10/10: Mortgages, relief and stimulus

David McWilliams' idea of deferring mortgage repayments for 2 years is continuing to generate some discussions in the 'new' media. Here are my thoughts on the topic.

David's idea starts from the right premise that households are currently suffering from mortgage/debt repayment burden that is non-sustainable in the current economic conditions and acts to depress consumption and household investment. But in my view, it is not going to yield any significant impact on the economy.

As expected incomes fall due to:

• continued recession in the economy (courtesy of the insolvency crisis we face across the entire economy);
• elevated risk of unemployment (ditto);
• rising tax burden on households (courtesy of the Government's perverse logic which puts the needs of financial services and Exchequer ahead of those of the real economy - households and firms);
  
• heightened risk of further tax increases in the future (ditto);
  
• behavioral implications of the severe and deepening negative equity (being further reinforced by the FR and Government denial of the problem and asymmetric treatment of development debts and household debt); and
• continued increases in the cost of mortgages finance and credit (courtesy of the Government approach to dealing with the banking crisis)
  

Irish households are indeed under a severe financial stress. This stress is amplified by the adverse selection of younger (and thus more heavily leveraged) households into the higher risk of unemployment. These very households are also more important contributors to future private investment side of the economy, as older households are dis-saving to consume.

Collapse of consumption and household investment we are witnessing today is the direct outcome of the above forces and it will continue to worsen as long as households' disposable after tax incomes continue to decline and remain at risk of further pressure. In addition, non-discretionary segment of consumption (energy, education, transportation and health) show no signs of price deflation, implying that discretionary disposable after tax income - the stuff we get to spend in the shops or invest - is even more distressed.

The problem here is not that we face a temporary shock to our income. The problem is of debt overhang - basically, the insolvent nature of our households' balancesheets.

Thus, any solution to this problem will require a permanent debt writedown. It cannot be resolved by temporarily suspending mortgages repayments for several reasons:

1. Temporary suspension of mortgages repayments will not draw down the overall debt burden, as banks will reload increases in mortgage finance costs into the future to offset for losses incurred during the holiday even if there is no roll up of interest during the holiday. In other words - suspending mortgage repayment for 2 years will likely lead to banks pushing even higher cost of mortgages interest into years 3 and on for all households concerned;
2. Any rational household will anticipate (1) above to take place and will ramp up precautionary savings to compensate for expected cost increases in their mortgages, withdrawing even more cash from today's consumption. A mortgage holiday in these conditions will lead to zombie banks turning into zombie households;
3. Any rational household will, also in anticipation of (1) withhold any purchases of property until the full realisation of true future mortgage finance costs takes place post holiday;
   
4. If any suspension of mortgages finance involves rolling up of the interest for 2 years, the burden of future mortgage liabilities will increase dramatically, which, once again will be anticipated by the rational households. As a result, households will take 2 years worth of 'free' rent and then default at the point of interest roll up kicking in. We can expect a wall of mortgages defaults in 2013;
   
5. In order for the repayment holiday to have any real effect, the long term growth rate in personal disposable income will have to exceed: increase in the cost of mortgage finance post-holiday + inflation - tax increases expected. This, using current growth estimates etc suggests that in order for a 2 year holiday on repayment of mortgages to have any positive effect, our aggregate expected growth rate in personal income should be in excess of 50% in years 2013-2018. This is clearly not anywhere near being realistic.
   

Once again, the problem we face is the size of leverage taken on by the Irish households. Whether reckless lending or borrowing or both caused this problem is irrelevant. Households become long-term insolvent when their total debt liability rises above 4-5 times their earnings even in the moderate growth in income environment.

We have - on aggregate - households facing:

• current long and short term debt burden of ca 145% of GNP, and
  
• expected (2014) sovereign debt burden of ~140% of GDP or ca 165% of GNP (under rather optimistic assumptions on GDP/GNP gap) - at least 80% of this will have to be repaid out of the pockets of our households.
  

The problem is that these headline figures conceal imbalances in distribution of debt.

While on per-capita basis the overall household debt liabilities amount to ca 310% of our national income, in real terms what matters is the incidence of the debt on productive households. We currently have ca 41.3% of population in employment (or 1,859,000). Of these, 552,900 are in the age group of 25-34 years of age, 469,600 are in 35-44 years of age and 393,900 are in the age group 45-54 years of age. Assume that the demographic pyramid does not change (for better or worse) in the next 10 years. Total employment pool of those that can be expected to carry the debt burden is actually closer to 1.42 million or 31.5% of the total population of the country.

This raises public and household debt leverage ratio on population that can be expected to repay it to a whooping x10 times household income. This, folks, is a bankruptcy territory for roughly speaking 1/3 of our entire population or for nearly 100% of our productive population.

A 2 year holiday from mortgages repayment will simply not solve this problem. Only significant debt write-off of household debts or full restructuring of our sovereign debt and deficit (to eliminate the need for future tax increases and reverse recent tax increases) or a combination of both will be able to correct for this severe debt overhang.

Economics 31/10/10: €15bn in cuts will not be enough

This is an unedited version of my article in yesterday's Irish Examiner.

The last three days have seen dramatic volatility and extreme upward pressures on Irish, as well as Greek and Portuguese Government bonds. Briefly, early on Thursday morning, Irish 10 year bonds have set a new all-time record with yields reaching North of 7.07%. Much of these changes have been driven by the budgetary news from all three countries.

First, Greece and Portugal have shown the signs of increasing uncertainty about projected tax revenues and ability to deliver on ambitious austerity programmes.

Then, Ireland came into the line of fire.

Back in December 2009, the Government outlined a plan for piecemeal cuts in deficits over 2011-2014 that added up to a gross value of €6.5 billion (with at least €3 billion in tax measures). This was supposed to get us from having to borrow €18.8 billion in 2010 to a deficit of ca €9 billion in 2014. All courtesy of robust economic growth of more than 4% per annum penned into the Department of Finance rosy assumptions for 2011-2014.

This week, the Minister for Finance had to come down from the lofty heights of the “now you see the deficit, now your don’t” estimates by his Department. Courtesy of continuously expanding unemployment, declining tax revenues, plus ever-growing interest bills on Government debts, the headline gross savings target for 2011-2014 has been increased to €15 billion.

Dramatic as it might be, this figure is still far from being realistic – the fact that did not escape the bond vigilantes and some analysts. More than that, it represents the very conservative ethos of the Department of Finance and the Government that got us into a situation where three years into the crisis Ireland is still light years away from actually doing anything serious about correcting its fiscal position.

Let me explain.

First of all, take the actual announced plans for cuts in public spending. Over two months ago I have argued in the media that to get us onto the track toward reaching the goal of 3% to GDP deficit ratio, we need ca €7 billion in cuts in 2011, followed by €5 billion in 2012. The grand total of gross deficit reductions from now through 2014 adjusting for the effects of these cuts on our GDP and unemployment, plus steeper cost of financing Government debt, excluding new demand for funding from the banks is not the €15 billion, but €19-20 billion. In other words, once fiscal stabilizers (automatic clawbacks on Government spending) are added in, to achieve 3% target requires more than 33% deeper cuts than Minister Lenihan announced this Wednesday.

The markets know this. Just as they know that given the Government record to date there is very little chance that even €15 billion in cuts will be delivered. This mistrust in Government’s capacity to actually administer its own prescription is manifested most explicitly by the Croke Park agreement that effectively put one third of the current public expenditure out of reach of Mr Lenihan’s axe. It is further highlighted by the fact that this Government has failed to
substantially reduce public spending bills from 2008 through today. Back in 2008, net government spending stood at €55.7 billion. This year, we are likely to post a reduction of just €2.4 billion on 2008, all of which is accounted for by cuts in capital investment programmes.

Third, the markets also understand long-term implications of deficits. Even if the Irish Government manages to bring 2014 deficit close to 3% target, our Sovereign debt will grow by over €5 billion in that year. At this pace, Irish Exchequer is likely to be on the hook for a debt to GDP ratio of 125% by the end of 2014 reaching over 140% if expected additional banks liabilities materialise in 2011-2014. And all of this after we account for Mr Lenihan’s €15 billion cuts planned for 2011-2014.

Fourth, Government budgetary arithmetic falls further apart when one considers economics of the proposed deficit reduction measures. So far, the Government has planned for €3 billion increase in taxes on top of tax revenues gains due to rosy economy growth expectations between now and 2014. €15 billion target announcement raises this most likely 2-fold.

I have severe doubts that this economy has capacity left for tax revenue increases. Signs are, households are struggling with personal debts and their disposable after-tax incomes are barely sufficient to cover day-to-day spending. Credit card debts and utilities arrears are rising, savings are falling – all of which points to growing stress. Weakening sterling is pushing more retail sales out into the North just in time for Christmas shopping season. Cash economy – judging by
anecdotal evidence and corporate tax revenue in light of booming exports sectors – is expanding. The tax base is shrinking due to unemployment, underemployment and falling earnings.

Again, any rational investor will look at this as the evidence that the Government has run out of capacity to tax itself out of the fiscal corner.

But wait, this is only half of the story. The other half relates to the banking side of consumer affairs. In 2011 we can expect significant increases in mortgages costs as Irish banks once more go rummaging through the proverbial couch in search for a new injection of pennies. Bank of Ireland’s bond placing this week, with a yield of 5.4%, suggests a bleak future for lending markets. Any increases in mortgages costs will hike Government expenditure (by raising the cost of interest subsidies), hammer revenues (by reducing household consumption) and trigger new demands from banks for capital (to cover defaulting mortgages).

None of which, of course, appears to be attracting much attention from the Upper Merrion Street. At least judging by the budgetary projections released so far. At the same time, these numbers are impacting our long term growth potential and increasing the probability that Ireland, in the end, will have to restructure its public debt.

This week, similarly brutal arithmetic concerning Greek fiscal situation has prompted Professor Nouriel Roubini to make a dire prediction of the inevitable default by Greece on its Sovereign debt. Given Minister Lenihan’s recent statements and his boss’ staunch unwillingness to scrap the Croke Park agreement, it is hard to see how the forthcoming budgetary framework for 2011-2014 can get us out a similar predicament.

Economics 30/10/10: Euro area growth forecast

Updating leading indicator data for Euro area growth from Eurocoin:
Having posted bang on forecast for September (forecast was 0.34 and this is what the final number came in at), I missed October turning point. The latest uplift suggests growth of 0.9% in Q3, but I am not convinced for a number of reasons:

• Growth in the lead indicator is driven strongly by the EU Comm survey of business expectations which has been trending strongly up since Feb 2010. In the mean time, PMIs-based expectations metric is showing a renewed expectation for a slowdown.
• Consumer confidence surveys are flat.
• Exports (to August) are down

So I am still sticking to Q3/Q4 growth at 0.2-0.25%

Economics 29/10/10: Retail sales

After two weeks of absolutely excessive work loads, including a week of marathon teaching (gotta love that feeling of total exhaustion after 5 days worth of 6 hours straight lecturing on top of regular work), the blog is back.

The first order of the day - catching up with today's data. Retail sales... well, they are still tanking. Predictably, given weakening sterling (incentive to shop North), beginning of the festive season shopping (another incentive to head North for larger ticket items savings) and continued decline of overall economy.

Per CSO today, let's deal with the volumes and values of total sales first

• Retail Sales volume decrease by 0.3% in September 2010 compared with September 2009
• The volume of retail sales (i.e. excluding price effects) decreased by 0.3% yoy and declined 0.9% mom.
• The value of retail sales decreased by 2.6% yoy and there was a mom change of -1.2%.

Few charts now:
Looks like bottom fishing just got slightly more fun on both value and volume. And it's too bad you can't short retail sales:
Relative to peak, total sales are......errr... sickening?

As I highlighted on many occasions before, our Government's desire to subsidize Japanese, Korean, French, German etc manufacturers of motor vehicles, coupled with the vanity plates year have meant that our total retails sales are rather overly optimistic when it comes to determining the real retail environment out there. So let's drop Motor Trades out of the data:

If Motor Trades are excluded, there was

• an annual decrease of 4.1% in the value of retail sales and a monthly decrease of 0.9%
• volume of retail sales decreased by 2.5% in September 2010 yoy and fell 0.8% mom.
• thus, increases yoy in volumes were posted in: Motors (+13.2%), Non-Specialised Stores (+0.8%)
• of course, decreases were led by Other Retail (-12.4%) and Bars (-11.6%).
• mom declines in the volume "were evident in ten of the categories while only three categories showed monthly increases in September 2010". So broadly, monthly adjusted series were heading down.

Charts:
Yeah, that does look like an AIB share price chart... and then the rates of change:
Painful? Yes. Brian & Brian will not be happy campers - VAT receipts must be depressed. Jobs are also clearly going to be under pressure as we exit festive season, implying that absent a dramatic reversal of the recent trends, retail sector will be in severe pain comes January.

Not that it was avoiding that pain in recent past:

We now have provisional estimates for Q3 2010, so let's update quarterly graphs - which confirm broadly the weakening trend:

• volume of retail sales increased by 0.2% in the third quarter of 2010 compared with the same quarter in 2009, and
• there was no change in the volume of retail sales when comparing the third quarter of 2010 with the second quarter.
  
• If Motor Trades are excluded the volume of retail sales decreased by 2.3% year-on-year, while the quarterly decrease was -2.0%.
  

Economics 14/10/10: Innovation Union from European Union

Just in case you thought our own Government's naive and overly optimistic 'knowledge economy' papers were original in their lack of understanding of business, take a look at the latest EU-wide policy idea.

According to the European Commission boffins, by 2020 we will be living not in a Fiscal Union (won't happen, cause Germans wouldn't want a de jure responsibility for PIIGS) or the Monetary Union (can't last much longer in its current shape due to contradictory forces of sovereign economic policies) or even a Bailout Union (the current reincarnation of the big idea)... instead we will be the happy citizens of an Innovation Union.

The details (if one call them such) of this well-meaning stuff are provided here.

Not to waste anybody's time with navigating the lofty dream space of European 'thinkers' on development policy, let's cut straight to the chase. Two things come to mind reading the document.

1. It is aspirational (good thing) of benefits of the Innovation-driven economy and is strong on traditional bits of bureaucratic competency, promising good targets on legal environment and strategic partnerships, but
2. The big iceberg awaiting the Euro dreamliner (err... Titanic) is also right here - on the Welcome page: "Innovation as described in the Innovation Union plan broadly means change that speeds up and improves the way we conceive, develop, produce and access new products and services. Changes that create more jobs, improve people's lives and build greener and better societies."
   

Spot what's missing in the grand vision? Here:

• Sales
• Marketing
• Logistics
• Commercialization
• Consumer
• Finance (especially the issue of relationship between current fiscal imbalances and promised subsidies)
  

You see, folks in Brussels think that once a nerdy type draws a squiggly thingy on an i-pad and another nerdy types says 'Cool, man!', you instantaneously get more jobs, improve lives and green-up the bettered society. Not much else is required:

• Lower taxes to promote greater consumption, especially given we are facing rapidly aging and more risk averse European demographic, which is not exactly representative of early adopter consumer types needed for Innovation Union? Nope, not needed.
  
• Lower state charges to promote more investment, again especially in economies where savings will be increasingly consumed by pensioners instead of invested by the younger income earners? Why bother!
  
• Fewer Nanny State regulations to improve 'access', especially in the regulatory environment that has by now even managed to ban insurance companies from pricing the basic risks? Will have Innovation without that, thank you.
  
• More entrepreneurship to support deployment of products into the marketplace, again a major bottleneck in the aging and largely socially immobile society of EU? Uh, oh, what's 'entrepreneurship'?
• Improved early stage finance environments with fewer state subsidies inducing distortions in the market, especially crucial given the state of public finances in the non-Innovation EU? We can't have anything that involves 'fewer subsidies'!
  

So this is why, in my view, the latest idea, despite being aspirational and well-intentioned risks becoming yet another Titanic of economic policy, to join such hits of the past as:

• The Lisbon Agenda (which aimed for EU to overtake US in terms of economic growth, jobs creation etc by 2010);
• The Social Economy (which aimed for the EU to become a singular welfare state where the young labour away assets-less and savings-less to preserve the status quo of landed gentry and pensioned state employees);
• The Knowledge Economy (which aimed for the EU to become a heaven for all sorts of knowledge), and
• The Green Economy (which aimed to turn EU into one big nature preserve at a wave of a magic wand of subsidies).

What can possibly go wrong this time around with Innovation Union, then?

Economics 14/10/10: Rip-off Ireland is roaring its ugly head

CPI for September is out... kinda out... it was sent out yesterday without an embargo, by mistake, and now it was re-released again.

So the headline figure is: +0.5% yoy gain in CPI and -1.0% yoy loss in HICP. Mixed bag, you'd say. By one measure (CPI) it looks like things are getting back to a (positive) normal, while by HICP reading we are still in the (crisis) normal.

But let's take a closer look at decomposition of price changes. Per CSO, the most notable changes in the year were:

• increases in Education (+9.5%),
  
• increases in Housing, Water, Electricity, Gas & Other Fuels (+8.5%) and Communications (+2.9%) [Note: monthly CPI ex mortgage interest decreased by 0.2% in the month and was down by 0.9% in the year], and
  
• decreases in Clothing & Footwear (-7.4%), Furnishings, Household Equipment & Routine Household Maintenance (-3.7%) and Alcoholic Beverages & Tobacco (-3.1%).
  

The annual rate of inflation for Services was 2.1% in the year to September, while Goods experienced continued deflation of -1.6%.

The most significant monthly price changes were:

• decreases in Transport (-1.6%) - driven by airfares drop (not by the state-controlled bus and train fares, mind you) and
  
• decreases in Miscellaneous Goods &Services (-0.4%) - primarily due to cuts in health insurance charges;
• increase in Clothing & Footwear (+4.5%).
  

Per CSO: "The CPI excluding tobacco index for September decreased by 0.2% in the month and was up by 0.4% in the year. The CPI excluding energy products fell by 0.2% in the month and decreased by 0.2% in the year. "

So good news then is that:

1. State services, such as Education (+9.5% ! in 12 months);
2. Banks payback to consumers for propping them up (CPI is up +0.5% yoy and ex-mortgages CPI is down -0.9% over the same period. So far, we have had, courtesy of our banks rescue plans: in a year to September 2009 mortgages costs fell 48%, in a year to September 2010 they rose 25.1%. All despite the fact that Irish banks are no longer facing higher costs of funding - instead they are simply borrowing from ECB using our bonds, for which you, me and our kids will be liable);
3. State-set charges on energy (+8% yoy);
4. State set health costs (+0.5%);
5. Largely state-set or influenced transport costs (+1.4%)

are all signaling that we are living in a public sector boom times, as the Government seemingly pushes forward with the agenda of beefing up semi-states revenues at our expense.

Clearly, we've turned another corner, folks, and it's the 'Ugly Boulevard' ahead of us, consumers.