24/6/2012: Sunday Times June 17, 2012

This is an unedited version of my Sunday Times column from June 17, 2012.

The current Government policy, and indeed the entire euro area crisis ‘management’ is an example of ‘the lesser of two evils’ con game. The basic set up involves presenting the crisis faced by the euro area or the Irish economy as a psychological construct, e.g. ‘We have nothing to fear, but fear itself’. Then present two options for the crisis resolution, similar to the choice given to Neo by Morpheus in the Matrix. You can take the blue pill, the surreal world you currently inhabit will continue unabated (the ATMs will keep working, the banks will be repaired, the economy will turn the corner, etc) but a cost of complying with the demands of the system (the banks bondholders and other lenders must be repaid, the EU systemic solutions must be embraced, confidence in the overall system must continue). Take the red pill, you go to the Wonderland and see how deep the rabbit-hole (of collapsed banks, wiped-out savings, destroyed front-line services, vulture-funds circling their prey, etc) goes.

Unlike in the Matrix, it’s not a strong, cool, confident Morpheus who’s offering the option, but Agent Smith, aka the Government and its experts. And, unlike in the Matrix, we are not heroic Neo, but scared humans, longing for stability and certainty in life. This disproportionality of the power of the State as the offerer of the false choice, and the powerlessness of the society assures the outcome – we take the blue pill and go on feeding the Matrix of European integration, harmonization, and self-validation. The very fact that the blue pill choice leads to the ever-accelerating crisis and ultimate demise of the entire system is irrelevant to our judgement. We are in a con-game.

How I know? I was told this by the Government own statistics.

We all agree that our real economic performance is abysmal. Take unemployment – officially, it rose to 14.8% in Q1 2012, unofficially, broader measure of unemployment – that including those recognized as being under-employed – is hovering over 22%.

But to-date, our fiscal performance has been so stellar, we are ‘exceeding Troika targets’. Right?

Ireland’s Exchequer deficit for the period from January 2012 through May was €6.5 billion or €3.7 billion below the same period last year. This ‘improvement’ in our deficit is due to €1 billion transfer from the banks customers and taxpayers (via banks holdings of Government bonds) to the Central Bank of Ireland that was paid out by the Central Bank to the Exchequer. Further ‘improvement’ was gained by the ‘non-payment’ of the €3.1 billion due on the promissory note, swapping one government debt for another.

Underlying day-to-day Government spending (ex-banks and interest payments on debt), meanwhile, is up year on year. Tax receipts are rising, up €1.6 billion, but if we take out the USC charge which represents reclassified non-tax receipts in the past currently being labelled as tax revenues, the increase shrinks to €726 million. In the mean time, interest costs on Irish national debt rose €1.3 billion on same period of 2011, wiping out all gains in tax revenues the Government has delivered on.

Take that blue pill, now and have a 15% increase on the 2007 levels of budgeted Government spending (protecting ‘frontline services’, like HSE senior executives payouts in restructuring and advisers salaries), or a red pill and face Armageddon. Yet, the red pill in this case would lead us to the realization that the entire charade of our reforms and austerity measures is nothing more than a false solution that risks making the crisis only worse.

This week, Professor Karmen Reinhart of the Kennedy School of Government, Harvard University was dispensing red pills of reality at the Infiniti 2012 conference over in Trinity College, Dublin. Her keynote address focused on the area she knows better than anyone else in this world – debt overhangs and the pain of deleveraging in resolving debt crises. The audience included many central bankers and monetary and fiscal policy experts from around the world, including even ECB. No one from the Irish Department of Finance, the NTMA or any branch of the Irish Government, save the Central Bank, showed up. Blue pills crowd don’t do red pills dispensations.

Professor Reinhart spoke extensively about Europe and, briefly, about Ireland. In our conversation after the speech, having met senior Irish Government decision makers, she reiterated that, like the rest of the euro area, Ireland will have to face up to the massive debt overhang in its fiscal, corporate and household sectors and restructure its debts or face a default. In 26 episodes of severe debt crises in the history of the world since the early-1800s she studied, only three were corrected without some sort of debt restructuring, and in all three, “the conditions that allowed these countries to resolve debt overhang problems absent debt restructuring are no longer present in today’s world”.

Worse than that, Professor Reinhart explicitly recognized that “Ireland has taken debt overhang to an entirely new, historically unparalleled, level”. She also pointed out, consistent with this column’s previously expressed view, that in the Irish case, it is the household debt that “represents the gravest threat to both short-term stability and long-term sustainability of the entire economic system”.

Per claims frequently made by the Government that debt deleveraging is on-going and progressing according to the policymakers’ expectations, Professor Reinhart stated that “in the US, deleveraging process had only just begun. Despite the fact that house foreclosures and corporate defaults have been on-going since 2008, the amount of deleveraging currently completed is not sufficient to erase the build up of debt that took place over preceding decades. With that, the US is well ahead of Europe and Ireland in terms of what will have to be achieved in terms of debt reductions.” Furthermore, “structural differences in personal and corporate insolvency laws between the US and Europe imply the need for even deeper debt restructuring, including direct debt forgiveness and writedowns in Europe. And, once again, Ireland is in the league of its own, compared to the European counterparts on personal bankruptcy regime.”

But don’t take Professor Reinhart’s and my points of view on this. Take a look at the forthcoming sixth EU Commission staff report on Ireland, leaked this week by the German Bundestag. The Troika is about to start dispensing its own red pills of reality to the Irish Government.

According to leaked report, the IMF and its European counterparts are becoming seriously concerned with two key failings of our reforms. The first one is the delay in putting in place measures to address – on a systemic basis, not in a case-by-case fashion as the Government insists on doing – the problem of households’ debts. Incidentally, this column has warned about this failure repeatedly since mid-2011. The second one is the rising risk that accelerating mortgages defaults pose to banks balancesheets. Again, this column covered this risk in April this year when we discussed the overall banks performance for 2011.

From independent analysts, to world-class researchers like Professor Reinhart, to Troika, red pills of reality are now vastly outnumbering the blue pills of denial that our Government-aligned experts are keen at dispensing. The problem is – no one seems to be capable of waking up inside the Matrix of our doomed policymaking.

To put it to the policymakers face, let me quote Professor Reinhart one more time: “Europe’s solution to the crisis, focusing on austerity instead of restructuring household and sovereign debts will only make the crisis worse. The pain of deleveraging is only starting. …Europe’s hope that growth can help in addressing the debt crisis is misplaced, both in terms of historical experiences and in terms of European economic realities.” And for our home-grown Mr Smiths: “Ireland’s current account surpluses [or exports growth] are welcomed and will be helpful [in deleveraging] but are not sufficient to avoid restructuring economy’s debts.” So fasten your seatbelt, Dorothy, cause Kansas is going bye-bye…

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Box-out:

Few months ago I highlighted in this very space the risks poised to the Irish banks and Nama from the excessive over-reliance, in the pre-crisis period on covered bonds and securitization-based funding. The core issue, relating to these two sources of funding, is the on-going deterioration of the quality of the collateral pools that have to be maintained to sustain the bonds covenants. Things are now going from bad to worse, and not only in Ireland. Per latest Moody’s Investors Service report, across Europe, 79 percent of all loans packaged into commercial mortgage-backed securities rated by the agency that came due in Q1 2012 were not repaid on time. Three years ago, the non-repayment rate was only 35 percent. Per Moody’s, “real estate with mortgages that match or exceed the value of the property… suffered defaults in nearly all cases in the first quarter. About a third of borrowers with LTV ratios of up to 80 percent didn’t pay on time.” If this is the dynamic across Europe as a whole, what are the comparable numbers for Ireland, one wonders? And what do these trends imply for the Irish banks and Nama?